Five Sources of DC Plan Risk

For plan sponsors and providers, defined contribution plans are highly complex systems. But for participants, the success of a DC plan can be reduced to a single question: “Will it help me retire on time?”  

According to Dagmar Nikles, head of Investment Strategy for the BlackRock US Retirement Group, that seemingly simple question provides a powerful framework for understanding the multiple dimensions of risk within a DC plan. “We have a tendency to think of plan success in terms of investment returns and participation rates,” she explains. “Certainly both are critical but so is an understanding of the risks that can derail retirement goals. Inappropriate allocations resulting in excessive or insufficient investment risk is an obvious pitfall. But so are inadequate contributions, frequent loans and hardship withdrawals, and a number of other variables.”

Nikles’ team, along with BlackRock Solutions®, is developing tools designed to help plan sponsors understand whether their participants are on track for retirement, where the shortfalls are emerging and, most importantly, help provide insights into how the retirement readiness gap can be closed. These tools, she says, can help plan sponsors see their plans in a new light and help spur action. “Even large, well-integrated investment committees sometimes fall into silos, where everyone concentrates on their own area of expertise. If they stop and think about their plan from the participant’s perspective, the function silos can be replaced by a single, holistic view of the plan.”

Understanding Sources of Risk

A holistic view requires a broader understanding of what can help create a successful plan beyond investment returns – and of what can put the goal of building retirements at risk. The Investment Strategy team has identified five areas where risk can emerge:

  • Flawed Plan Design:  Intelligent plan design using tools such as auto-enrollment and auto-escalation can help nudge participants into better choices. Failure to take advantage of best practices for current plan design is a missed opportunity.
  • Complex Investment Menus: The indecision created by having too many investment choices leaves some participants opting for potentially underperforming, “safe” options such as stable value funds. Other participants, who may lack the time and expertise to properly allocate their savings, may overreach by selecting excessively risky funds.
  • Insufficient Participant Engagement: Even a great plan will fail to achieve its goals if no one takes advantage of it. Yet simplistic attempts at participant communications, limited to once-a-year mailings or meetings, can often fail to produce the desired goal of changing individual behaviors.
  • Participant Demographics: Most DC plans are designed to accommodate participant populations that mirror the general population. Industries that differ significantly from the standard profile, or have heterogeneous participant populations due to a merger, can be challenging to accommodate. It can be difficult to fit solutions designed for one population to the needs of another.
  • Market Returns: While investment returns can be projected with some confidence over a long period of time, returns within a short timeframe are much less predictable. Participants whose portfolios are reduced by a bear market just before retiring can take small comfort in the idea that their portfolios are constructed based on a long-term investment horizon.

Creating a Framework

Once risks are identified, we need to ask if we can measure their impact. According to Nikles, we can. The first step to consider is to create a proxy participant, using the firm’s income data, to project the outcome at age 65 if a participant sticks with the default options –auto-deferral, auto-escalation, and so on--throughout the participant's career.

“The estimate can be used as a benchmark for the plan’s optimal outcome,” says Nikles. “From here we can explore whether that projected income-replacement ratio is sufficient. We also can compare participants’ current balances vis-à-vis the benchmark at any given age to see which cohorts are on track.”

Even more intriguing is that the projections can be rerun to demonstrate the effect of changes in the plan options, such as an increase in deferral rates. “We can show how adjustments can help minimize or increase the risk of participants falling short,” she says. The result is a holistic framework through which plan sponsors and providers can assess all aspects of their DC plans and understand the impact of a wide range of corrective measures.

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DC-1390 / 07-14