RandTons of independent research provides more than sufficient evidence to prove that giving investment choice to plan members in tax-assisted defined contribution (DC) pension plans is a dumb idea from a legal perspective and even dumber from a financial performance perspective. Yet more than 95% of employers set up their plans up that way. Why?
From a legal perspective, offering investment choice means a material expansion of legal risk. If an employer does not provide individual investment choice, legal risk is limited to managing one pool of assets reasonably.
I’ve heard some employers say “we have to give members investment choice to comply with CAP Guidelines.” But the very first section of those Guidelines makes it crystal clear; they don’t apply if no choice is given. Accordingly, if an employer doesn’t provide any investment options, the employer relieves itself of having to comply with many of the responsibilities identified in the Guidelines, especially many of the suggestions relating to communication, investment education, process, and documentation as well as management of fees and expenses related to the investment offerings.
Another objection is that a single fund may not be the optimal mix for each individual in the group. In most plans the vast majority are in the default fund anyway. In virtually all cases there will be plenty of room for individuals to balance things out in their own personal DC plans and their other savings. Bottom line: employers can reduce legal risk by NOT giving choice.
If giving choice is a bad idea from a legal perspective, it’s even worse from a financial perspective.
It is well-documented that both DC participants and their investment advisors are not very good at investing, at least by comparison with defined benefit (DB) plans. More than 95% of DC investment advisors can’t even achieve for themselves the rates of return realized in an average DB plan, let alone doing it for their clients. An interesting Canadian study indicates that participant-directed investment arrangements result in the portion of the final benefit coming from investment returns dropping from 75% in a typical DB arrangement to 45% in a DC plan. By eliminating investment choice, DC plans should be able to reduce that differential and get closer to DB performance. They should also be able to dial back the many added costs associated with managing many individual investment accounts and the information and education costs that go along with providing choice. All of those costs put a significant drag on net investment performance – and are the most frequent source of class actions relating to DC plans.
No doubt a high degree of participant investment choice makes DC plans very attractive in accommodating individual desires, decisions and feelings of control. Nonetheless the vast majority of participants are in the default fund. Those who aren’t, don’t always follow expert advice, don’t monitor fund performance on a periodic basis, and most participants certainly don’t have properly balanced portfolios. For example one U.S. study found that more than 50% of DC plan members had either no funds invested in stocks – exposing them to very low investment returns – or had almost all assets allocated to stocks, making for a much more volatile portfolio. Anecdotally, I am aware of many members invested in fixed income who think they are being conservative. They have no clue that the value of their holdings could tank if interest rates go up!
Behavioural finance recommends simplifying DC plans and limiting investment choices. What could be simpler than providing no investment choice at all?
Some of our clients spend a lot of resources on participant education. But ultimately being good at retirement savings requires discipline, goal setting, and an ability to appreciate or estimate, economic and demographic uncertainties such as lifetime earnings, asset returns, health status and longevity. In other words, it requires expertise. As one researcher put it, “No one would imagine that you or I could perform surgery to remove our own appendix after reading an explanation in a brochure published by a surgical equipment company. Yet, we seem to expect people to choose an appropriate mix of stocks, bonds and cash after reading a brochure published by an investment company. Some people are likely to make serious mistakes.”
It is no secret that DB plans are too financially risky for individual employers. It is also no secret that, on average, it costs approximately 92% more to provide the same $1 of retirement income under a DC plan than under a DB plan. DB plans are just that much more cost efficient. To provide more satisfactory results, DC plans should take the best features of DB plans – lower legal risk and better investment returns – while simultaneously avoiding the often lethal financial risk associated with DB funding and financial reporting requirements.
One smart way to start getting those financial and legal advantages with individual account based DC plans is to eliminate individual plan member-directed investment choice and move to an administrator-directed investment plan design.