The answer should be simple: if you know what your objectives are, you can test whether you are on track to meet those objectives. However, while clear objectives may have been defined for individual fund managers, the reality is that most defined contribution (DC) plans do not have clear objectives.
In terms of member objectives, there are many questions regarding the appropriate level of financial replacement; however, instead of focusing on “what is enough,” let us consider the factors that combine to produce that financial replacement in retirement – everyone is in favor of more financial replacement.
As shown in the following diagram, at least eight different factors have a direct impact on financial replacement in retirement. In addition, the ninth and tenth factors have important indirect effects. A key learning is that a lot of factors need to be aligned for a “successful” financial replacement.
Objective: Financial replacement in retirement
INDIRECT FACTOR 9.
Communication / education
2. Rate of salary increases
3. Investment asset allocation, including changes over time
4. Market returns
5. Managers adding value (alpha)
6. Leakage fees
7. Leakage: borrowing, withdrawals
8. Conversion into retirement assets (income)
11. Governance structure
Each of these factors should be considered in turn:
1. Contributions to the Plan
This factor also deals with the rate of contribution to the plan. One must ask the following questions: Are members contributing or participating at all? Are they maximizing any employer match, or are they paying the lowest contribution rate?
This factor also refers to the period over which contributions are paid to the plan. A member is obviously likely to have a more successful retirement if he or she has been contributing to the plan or a similar plan for longer.
2. Rate of Salary Increases
A target replacement ratio may often be set, but for a given contribution rate the key financial parameter is the degree to which investment returns exceed salary increases. Consequently, a calculation may suggest that with investment returns of 7% and salary increases of 2%, the target replacement ratio may be expected to be achieved. The corollary to this is that if an employee is promoted or receives higher salary increases (than the 2%), his or her required investment return increases (that is, he or she will need to earn more than 7%). This partly explains why “high-fliers,” who have had a rapid rate of salary increase, are often disappointed with the projected replacement ratios.
So what is the answer? Low salary increases? No. But be aware that if a member’s salary jumps, he or she may want to consider putting a bit more into his or her pension plan. Do you know what the salary experience of your plan members has been? The answer may surprise you.
3. Investment Asset Allocation
Almost everyone is familiar with the quote (or misquote) that states that asset allocation explains 90% of the return. With DC plans, asset allocation is the responsibility of the member, so ensuring that members make reasonable asset allocation decisions is exceptionally important. If 80% of these members sit in cash, having the best-performing equity manager is of little help. So where are your members invested?
4. Market Returns
In reality, even if plan members’ asset allocations are reasonable, if market returns are poor, the outcomes are likely to disappoint. This largely acknowledges that there are some factors that are clearly outside of one’s control, but market returns will have a material effect on whether or not a member feels successful in retirement.
5. Managers Adding Value (“Alpha”)
Most DC plans spend a lot of time evaluating their fund managers. While there is no doubt that better performing managers do make a difference, particularly over time, this may not be as important as having members in reasonable asset allocations. This is one area in which most plan fiduciaries do know whether or not their managers are adding value.
6. Leakage: Fees
Fees are a hot topic among plan sponsors and regulators. The long-term impact of high fees on DC accumulations is well-documented. While fees are a key issue that needs to be monitored, they also need to be kept in context. Fees must be compared to the value obtained from them. Higher fees may lead to better financial replacement in retirement if these fees result in members making improved asset allocations or in managers providing better performance. Are your fees reasonable? Does the value-add justify the fees?
7. Leakage: Borrowing and Withdrawals
Borrowing and withdrawals vary worldwide, but in instances where plan members can borrow or withdraw their retirement assets, this will lead to lower financial assets in retirement. For this reason, many countries prevent borrowing or withdrawals. However, even in countries such as the US, people have been documenting how in-service withdrawals can materially affect a plan member’s ultimate benefits. How many of your members are borrowing from their plan or making in-service withdrawals?
8. Conversion into retirement assets and income
For a given amount of assets at retirement, there is a wide range of products available to plan members. The choice of product(s) will influence the amount of income that can be produced and how that income will vary over time. Do you know what plan members are doing with their assets when they retire? Do you know what income members are generally drawing?
Three key indirect factors that affect a plan member’s (and hence a plan’s) success are communication/education, design and governance structure.
Communication/education is one of the most powerful ways that fiduciaries can (hopefully) positively influence the experience, and ultimately the success, of plan members. Through communication, the advantage of contributing more, staying invested and not being too conservative can be addressed. In addition, communication/education can be a key way to ensure that members value the plan, which is another key objective.
Design is becoming increasingly important, as it is now recognized that it can have a very powerful impact on plan members’ behavior. Design aspects include the design of the contribution formula, the addition of auto-enrollment or auto-escalation features, the investment structure and the introduction of lifecycle-based default investments – all of these can increase the likelihood of members achieving success.
11. Governance structure
Governance structure may have the least direct effect on financial replacement in retirement but this does not mean it is unimportant. The governance of a plan is analogous to the foundations of a building. Without strong foundations, it is difficult to build a great building, and without a strong governance structure, it is difficult for a plan to be successful over the long term.
Some of the key factors that contribute to a member’s financial replacement are clearly outside of the plan fiduciary’s control – for example, there is little one can do about market returns. However, even in this case, a fiduciary can have an indirect impact by deciding and structuring which investment options are made available.
The interesting issue is that in any calculation that projects a member’s likely benefits (whether it be a bulk retirement income adequacy exercise, a defined benefit (DB)/DC conversion exercise or a recordkeeper’s member benefit projection calculator), assumptions are made about each of the eight direct factors. The fact that we often make assumptions provides us with the means to assess how much progress we are making to achieve “success”. If plan fiduciaries wish to assess how “successful” the plan is for their members, a good starting point is for them to compare the actual experience of each of these factors against the initial assumptions. If the experience is worse, the members are obviously expected to have worse outcomes, and in all likelihood to regard their plan as unsuccessful.
Over the past few years it has become clear that the great challenge to DB plans is that their cost is very uncertain – this has caused many plan sponsors to move away from DB. DC plans have the opposite problem – the costs (that is, contributions) are predictable but the outcomes (that is, benefits) are not. The more it is possible to monitor the factors that will affect the benefits that members receive, the more it will be possible to anticipate the degree to which the DC plan is likely to be successful from a member’s perspective. Perhaps more important, such a process will assist in evaluating what actions are most important to try and improve the likelihood of a successful retirement for members. Certainly, such a process will help enable a plan fiduciary to have more confidence in answering the question: Is your plan succeeding?
About the author:
NEIL LLOYD, Vancouver
Neil is a Principal and a Senior Consultant in Mercer’s Investment Consulting business. Based in Vancouver, Neil uses his actuarial, investment and international expertise to advise on the setting of investment policy, asset liability management, and the selection and evaluation of investment managers for both DB and DC plans. In addition, Neil is the Intellectual Capital Leader for Mercer’s Global DC Consulting business.
Neil is a Fellow of the Faculty of Actuaries, an Associate of the Society of Actuaries, a Fellow of the Conference of Consulting Actuaries and an Affiliate of the Canadian Institute of Actuaries.