Break Free of The Past and Build a Better Plan
Change, as the saying goes, is the only constant. But for most of us, the pace of change is the bigger issue. We like to think that slow, steady evolution allows populations and systems to adjust. New practices develop incrementally and often it is only in retrospect that we recognize the extent of the drift from one era to another. In reality, evolutionary changes, like encroaching glaciers, can crush everything underc foot. There is real danger in failing to recognize that changes are occurring or stubbornly sticking with the tried and true despite its decreasing effectiveness.
At other times, change is obvious, sudden and dramatic. Systems fail, new worlds arise overnight and everyone is sent scrambling for answers. Or the law of unintended consequences strikes yet again and some seemingly simple regulation renders previous best practices obsolete. Here the danger is not in failing to act, since circumstances force at least some response. Rather it is in reacting too tactically by meeting the immediate need without being mindful of the long term consequences.
So what is defined contribution facing today, gradual evolutionary shifts or dramatic upheavals? In a word: both. Over the past two decades, social security and defined benefits pensions, the previous mainstays of retirement in the United States, have moved to the periphery and are likely to play only a small role in the retirements of younger workers. Meanwhile, DC has slowly taken their place at retirement's center stage.
On the other hand, the global financial crisis was just the first of a series of sudden, perhaps fundamental, shifts in the financial markets. Even after the US stock market regained most of what it lost in 2008, global markets have remained volatile. Yields are at historic lows. Pending regulatory guidance may drastically change previous best practices. The atmosphere of uncertainty has left many plan sponsors asking what to do with their participants' money.
Time to Break Free
Chip Castille, BlackRock's Chief Retirement Strategist, reminds us that we have been through uncertainty before. "If plan sponsors look at the DC landscape today, they'll see it's very different than what we saw five years ago," says Castille. "Five years ago we were looking at the passage of the Pension Protection Act and the recent appearance of the qualified default investment alternative. We were also talking about plan design and the risk of holding company stock."
We emerged from that uncertainty to establish new best practices that pushed the evolution of defined contribution. "Today there's a consensus on the risk of holding company stock in a 401(k)," he says, "Best practices around multi-tiered plan design are now well understood. Finally, with 80% of plans using a QDIA1, the conversation has shifted from whether or not to use a QDIA, to which QDIA to use."
Unfortunately, new best practices quickly become a new comfort zone. We forget that they were born in response to risk and uncertainty. Instead, they become an orthodoxy that gets in the way of fresh thinking. Today, we have seen changes in the financial markets, regulatory environment and demographics that we need a response. "The ground has shifted; solutions that were appropriate to conditions just a few years ago need rethinking," says Castille.
Stable value funds face new pressures on yields, wrap capacity and regulations. The proliferation of target date funds have made selecting a QDIA far more complicated than it was a few years ago. And the challenge of how to use accumulated 401(K) savings to create lifetime security through retirement income is growing more urgent. Castille believes that retirement income risk may have shifted from adopting new, untested solutions, to acting too late and being faced with participant grievances and, possibly, government-directed solutions.
We need to get out of our collective comfort zones and rethink our approaches. The reward, however, is not simply avoiding risk – it's creating a better plan. "The QDIA choice and low risk options may account for as much as 70% of a plan's assets,2" he notes. "If a plan sponsor is confident that the plan is getting these two areas right, they can be confident that they are placing their DC plan on a firm foundation."
With bold thinking and fresh perspectives, we can respond to changes and push the evolution of DC to a new level. Let's start with one of DC's longest standing best practices, the stable value fund.
The growing risk of low risk
"We have more conversations today about stable value than anything else," says Castille. It's easy to see why; stable value and even money market funds may have been impacted by the new world of investing more than any single area of defined contribution.
Previously, risk free and low risk options seem to require little thought, at least in the eyes of participants. Retirees use stable value or money markets as a source of ready cash and risk-averse investors turn to them as a sanctuary from the market's ups and downs, taking their $1 per share net asset values as a fact of nature.
The financial crisis put enormous stress on these options. As spreads widened many stable value funds came under stress, and market values plunged below book values which caused wrap providers to revisit the attractiveness of this business, and subsequently revamp terms to make it more attractive to them. As for money markets, one fund "broke the buck" – that is, saw its NAV fall below $1 per share, a risk once wrongly assumed to be a merely academic possibility.
Fiduciary risk with stable value and money market funds is not introduced strictly through extreme market conditions. The source of risk is much more subtle than that. As Castille explains, "Plan sponsors and participants have very different perceptions about low risk options, particularly stable value, and these options tend to be very attractive to participants when these risks are a highest."
Stable value funds are subject to counterparty risk, that is, the risk that a wrap provider will be unable to meet its obligation to maintain the fund's $1 per share net asset value. There are also restrictions on the movement of assets under certain conditions. It's highly unlikely that participants understand these fairly sophisticated risk concepts. Plan sponsors do, however, and that gap in perception creates fiduciary risk.
Matt Rauseo, the stable value business manager for BlackRock suggests stable value will become even more complex. "A number of wrap contract providers, a critical component of stable value funds, have either left the business or severely cut back on their capacity," explains Rauseo. "Many of those that remain have increased fees and created stricter underwriting guidelines, both of which challenge yields."
New wrap contracts have also been more restrictive than previous versions, reducing flexibility for plan sponsors and participants. "The combination of reduced wrap capacity, higher fees, stricter guidelines and new wrapper-friendly contractual terms," says Rauseo, "may send many plan sponsors looking for new low risk options".
Castille suggests that rethinking the low risk end of the spectrum can lead to new solutions. "Participants need NAV stability when they enter a fund and when they exit. They don't need NAV stability every day they're in the fund," he explains. "If you can plan your liabilities around when participants expect to withdraw savings, you can expand the range of solutions that can meet participants' short term needs."
Recently, BlackRock has worked with plans to create portfolios of high-quality fixed income securities with explicitly stated maturities, such as one, three or five years. The portfolios are managed with a decaying duration feature, so that as each individual fund ages toward its target term, the duration shortens and NAV grows more stable.
"We believe it's a promising approach," adds Rauseo. "It should provide better yields than money markets without the restrictions of wrap contracts, or the point-in-time risk of typical unwrapped bonds. The portfolios are fully liquid. On the surface the biggest challenge appeared to be communicating to participants how the portfolios work, but we think we have a good handle on how to message this product to participants in a way that they can understand."
Castille adds that these portfolios are similar to target date funds, except that the term is much shorter (typically 1 to 5 years) and they are comprised of shorter duration fixed income securities.
"In fact, in addition to meeting participant liquidity needs," adds Castille, "these decaying duration portfolios can replace the short term allocation within a target date fund." suggests Castille.
Is your QDIA meeting YOUR objective?
In interviews for an upcoming issue of DC Edge, BlackRock's publication for DC advisors and consultants, we asked how advisors defined their value in a space dominated by qualified default investment alternatives. After all, recent figures show that 80% of plans3 use a QDIA, with most choosing a target date fund. If the choice to use a target date fund is almost "automatic," how do they add value?
The answer is that there is nothing automatic about finding the QDIA choice that meets the needs of an individual plan. There are dozens of "off the shelf" target date funds and numerous customization options. They represent a wide range of investment objectives, with multiple implementations in terms of asset classes, management styles and investment vehicles.
That is why Chip Castille believes this is an ideal time to review the QDIA choices made following the passing of the Pension Protection Act in 2006. "Almost half of the target date funds in the market today didn't exist when PPA was passed," says Castille, "which makes it pretty clear that this a far more complex market than it was a few years ago."
Castille also believes that the differences in target date fund objectives were not sufficiently understood in the initial rush to select a QDIA. That is one reason 2008 came as such a shock: funds with a 2010 target date showed a range of losses from -4% to -40%1 for the year4. For anyone who assumed that there was little difference in target date funds with the same date, it was a rude awakening. "Too many plan sponsors assumed that funds with the same target date are alike," he says. "It's unlikely that they are trying to do the same things or their performance wouldn't have been so disparate."
2008 sparked the "to versus through" debate about target date funds, a debate that Castille believes misses the point. "What's important is the investment objective," he suggests. "Should a target date fund seek to maximize the investment return on every dollar invested, or should it seek to offer a predictable range of returns that focuses on preserving savings?"
A maximizing objective takes on more risk and creates a broader range of potential returns – higher if the fund is successful and lower if it is not. A more conservative objective creates a narrower range of outcomes. Unfortunately, many plan sponsors have not asked about the investment objective – often because they have not sufficiently thought out their own philosophy.
"Plan sponsors need to think about what they want to do for their participants," explains Castille. "Do they want to ensure that their participant's retirement balance is as high as possible, or do they believe that they need to help make up for a savings shortfall?" Ultimately, plan sponsors should select an objective that executes their philosophy.
The Case for Income
The case for retirement income hardly needs to be restated. Millions of Baby Boomers are reaching retirement just as traditional sources of retirement income, including defined benefit pensions and social security, are being diminished. This is rightly seen as a societal problem, and appeals to enact solutions are often positioned as "doing the right thing" for loyal employees.
There are other dimensions of the retirement income question that do not get the attention they deserve. One can be found in the origin of traditional company pensions. "It's clear that it was a workplace management issue," Chip Castille explains. "The first pensions were given by railroads. They had safety concerns about the increasing numbers of aging workers around the rail yard."
By granting pensions, the railroads gave older workers the ability to retire. Castille speculates that incorporating income solutions into DC plans can provide similar workplace management benefits. This is reinforced by a number of recent surveys that many younger workers who accepted jobs that included DB benefits listed the existence of the traditional pension as a reason for accepting a job offer.
If workplace management is a potential benefit of delivering retirement income, fiduciary risk is the potential threat. The case for income is so widely discussed – among plans, providers and government – that the risk may be in not acting. Millions of retirees may try to make the case that their plan sponsors were aware of the problem and did nothing to solve it.
Fortunately, there are a wide range of solutions coming into the market. BlackRock's approach is to embed a growing share of an annuity pool into a target date fund, while other providers utilize annuity wrappers or individual annuities. BlackRock is also exploring target income approaches that let participants buy a stated amount of future income.
If stable value and short term options are top of the agenda for DC plans today, the need to make decisions about income solutions is fast approaching. Income may not yet be "the elephant in the room," but it is may be the elephant lurking in the hallway.