In the good old days one could open a car’s hood and repair the engine. Not today. Technological advances have taken car repairs out of backyards and into the hands of specialists. The same can be said for managing retirement portfolios. The financial market is so sophisticated, and planning so complex, that it is becoming more and more difficult to go it alone safely.
Yet governments and employers are increasingly moving employees from professionally managed defined benefit (DB) plans to do-it-yourself defined contribution (DC) plans. In a DB plan, employees typically receive a fixed payout based on length of employment and amount of earnings. In a defined contribution plan, the participant chooses from a range of investment options, and the final payout depends on how well those investments actually perform.
This places the burden of ensuring their old-age security squarely on the shoulders of individuals who often lack the basics in financial literacy. At one point in my career, I built a personal finance center at Hewitt Financial Services to give people retirement guidance. Instead of answering retirement questions, we often found ourselves answering basic questions relating to emergency funds, budgeting and saving.
POWER OF INERTIA
If people do not know how to manage basic budgets, how can they be expected to save or invest? Fortunately, more workers are automatically enrolled and invested in DC plans to at least get them started down the right savings path. Once in the DC program, the power of inertia tends to keep participants saving at the default contribution rate and within the default investment structure. This reality places important power in the hands of the plan sponsor to select an appropriate default rate and investment.
DB plans consistently outperform DC plans. During a 17-year period ending in 2011, for example, DB plans in the US outperformed their DC counterparts more than 75% of the time by an annual average of 76 basis points, based on net investment management fees, according to the Towers Watson report
D (July 2013). This performance gap can narrow – particularly in the case of large plans – by importing DB investment approaches into DC plans: for instance, with building asset allocation strategies that integrate more diversifying and global assets. efined Benefit Plans Outperformed Defined Contribution Plans Again – Should We Care?
Over a 40-year career, the small DB return advantage adds up. Indeed, for someone starting with a salary of $35,000 – and assuming 3.5% annual wage gains, a 10% savings rate (including employer matching) and annual 7.76% portfolio returns (compared to 7.0% for a passive portfolio) – it compounds after 40 years into more than an extra $230,000.
Australia is heading in the right direction with mandatory DC plans now covering nine out of ten workers. Employers must contribute more than 9% (increasing to 12%) of workers’ salaries to DC plans that, by law, are professionally managed. Yet, Australians are still not saving enough to replace the 40% to 60% of income that experts calculate is needed to live independently in old age.
In the US, DC plans are not mandatory. With the decline of DB plans, the 401(k) – the dominant form of DC plan – is rapidly becoming the backbone of the retirement system. Altogether, almost 50 million actively employed workers have a balance in a DC plan with total assets approaching $6 trillion, and these assets will continue to grow.
DC plans will grow stronger over time as more plan sponsors set contribution default rates at a higher level and offer investment defaults that are broadly diversified and risk appropriate.
If people don’t know how to manage basic budgets, how can they be expected to save or invest? Stacy L. Schaus MYOPIC SEARCH FOR LOW FEES
The consequences of poorly managed plans are dire. In the US, for example, as the gathering wave of baby boomers exits the workforce, less than one-fifth will rely on DB funds to live – many with a meager DB payout short of $10,000 a year. The rest will depend primarily on Social Security as well as savings they have accumulated in defined contribution (DC) plans or individual retirement accounts (IRAs). The trend is that workers around the globe are looking to DC programs to replace upwards of 40% of their final pay.
Many plan sponsors, perhaps prompted by legislated or signaled regulatory DC fee caps or fear of litigation, have engaged in a myopic search for the lowest fees possible for their DC plan. As a result, they often select market capitalization-weighted index strategies that passively track indexes such as the S&P 500 Index and the Barclays US Aggregate Bond Index (BAGG). To help keep costs low, plan sponsors may also use a purely passive target-date strategy or index- seeking managed-account approach as a participant default.
The stakes are huge. As Warren Buffett famously wrote in his February 1988 shareholder letter: “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” DC and IRA participants in the US held $12.4 trillion of savings in the capital markets at the end of 2013, according to the Investment Company Institute. By buying into index strategies, their hands are shown: they will keep buying as stock prices go up and will buy more of those stocks the more rapidly their relative price grows. In the meantime, smart money may take advantage of DC buyers by selling to them as prices escalate.
BEWARE OF BEING THE PATSY
Similarly, within the bond market, buying a market capital-weighted index strategy forces the DC participant to give more of his hard- earned savings to issuers who are borrowing the most, without regard to the yields provided or the ability of the borrowers to repay. The smart money again may take advantage of the constant buyer by selling holdings at prices that do not reflect their fundamental value. Not to mention those borrowing money on the cheap – more than 70% of which is government related for the BAGG. This brewing inequality and financial repression should raise concern.
DC investment structures are best entrusted to plan fiduciaries who take an institutional approach to investment management. While investment results can never be guaranteed, such techniques – including offering custom target-date strategies – may lower risk and improve returns to plan participants. Pooling assets can deliver reduced fees and provide access to a wider asset group (such as inflation-hedging and global securities) not readily available to individual savers, as well as enable active management that may both deliver alpha and reduce risk.
But while well-run DC plans can reduce the need for individuals to get “under the hood” of their retirement plans, they still must get into the car and keep their hands on the wheel. To reach their retirement goals, savers must understand the value of their savings. This is the fundamental financial literacy workers need to steer safely into old age.