Plan sponsors put in a lot of effort monitoring the performance of investment options. Perhaps going one step further can prevent DC disasters.
Investment performance measurement has often focused on portfolio managers, individual funds available in the plan, and “plan” performance. But what does “plan” performance represent in a capital accumulation plan (CAP)? As a weighted average of the returns of all plan members, it gives no clear indication as to how individual members are doing. Worse still, a good “plan” return may hide the fact that many members are actually doing poorly… as it often turns out.
So what can plan sponsors do to ensure their members’ defined contribution (DC) assets are properly invested? A paternalistic, hands-on approach might be the answer. In order to gain insight concerning the rates of return that individual plan members are actually getting, Morneau Sobeco recently conducted an internally-disseminated study covering the five-year period ending Dec. 31, 2004. This analysis proved to be quite an eye opener.
The results described here are those of a large Canadian DC pension plan covered in the study, with about 5,000 members and well over $100 million in assets. As is the case for many CAPs, the plan offers 10 investment options, including one balanced and one money market fund (the default option). Communication and educational efforts could easily be described as surpassing best practice, and each fund and fund manager’s performance is thoroughly monitored.
With all this in place, it appears that plan members feel quite comfortable with all the investment options and confident with their investment knowledge, as they are diversifying accordingly: only 6% have invested and completely remained in the balanced fund (a very strong performer in this category). Another 3% have stayed in the money market fund for the entire period covered (mostly “defaultees”), whereas over 90% have spread their contributions into various combinations of funds—including the balanced fund, which represents, overall, about a third of total plan assets.
The Results
Despite the quality of the plan and all the information made available to members, the results are downright shocking. Over the five-year period, a whopping 85% of members who have opted to create their own investment mix have not managed to beat the balanced fund. And over 50% of them have underperformed the money market fund. Finally—and sadly—nearly 5% have actually witnessed a negative cumulative return during the same period.
Obviously, one would think that the happy few who beat the balanced fund must be savvy investors, following the markets and bringing timely changes to their asset allocation at the adequate moment. Think again. In fact, Morneau’s study shows that the rate of return obtained by members actually decreases when the number of transactions increases over the period.
What does this example indicate? It certainly seems that new ways of measuring plan investment performance are in order. An overall plan rate of return, along with individual fund performances, simply does not cut it, potentially hiding ugly situations.
One solution? An annual review of how members are doing should be used to fine tune communication strategies and educational efforts. A sponsor who is open to a more “paternalistic” approach may decide to delicately herd members towards balanced or asset allocation funds, and consider making one of these the default option.
If warranted, the sponsor may also wish to make changes in the investment option design, such as reducing the number of funds available or introducing new ones that are better adapted to plan members’ needs. This will lower the design’s sophistication, but in all likelihood increase its effectiveness. Some sponsors are finding that leaving plan members to their own devices might actually hinder the retirement savings process. They’re discovering that a subtle intervention before it’s too late may be in everyone’s best interest after all.