DC Plan Investments. A Path to Improve Long-Term Outcomes

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1 DC Plan Investments A Path to Improve Long-Term Outcomes

2 Plan sponsors know the importance of defined contribution (DC) plans. After all, they have recently helped to improve savings levels, employee education and DC plan investment structures. Yet another improvement would make a real difference: Include less liquid investments by reducing the need for daily trading. This paper explains our view and addresses what needs to change for it to become reality. In short, with some legislative change and alignment of strategy with participants investment horizon, DC plans could gain the investment effi ciencies enjoyed by many defi ned benefi t (DB) plans. Summary In DB plans, a single asset pool and fl exibility in handling portfolio liquidity allows plan sponsors to diversify investment exposures across many strategies, including some that benefi t from a substantial liquidity premium. As a result, many plan sponsors have reduced total plan volatility without compromising the level of return. Even better, the larger asset base also supports lower fees through sliding fee schedules and lower-cost vehicles. These advantages could clearly also benefi t DC plan participants. And with the recent growth in targetdate funds, which hold investments based on a target retirement date, and pooling of strategies in these funds, the traditional benefi ts of asset pooling are now becoming increasingly available. However, before further improvements can happen, regulations and the emphasis on the perceived benefi ts of daily valuation and daily liquidity need to refl ect something more akin to global best practices. This paper discusses these views in more detail, beginning with the benefi ts of asset pooling and illiquid investments before addressing impediments to change. Benefi t #1 Lower fees We all want to make our retirement savings last longer. Fees are one of the most predictable and controllable components that erode savings growth over time. 1 As we show in Figure 1, reducing fees by 0.2% to 0.5% a year can lengthen the lifetime of retirement savings from one to eight years. 2 Figure 1. Years of retirement saving lost to fees 4% saver Salary level $25,000 $45,000 $75,000 $125,000 Years Years Years Years 0.2% fee effect % fee effect % fee effect % saver 0.2% fee effect % fee effect % fee effect % saver 0.2% fee effect % fee effect % fee effect DC Plan Investments: A Path to Improve Long-Term Outcomes 2

3 Lower fees are accessible to larger asset pools primarily due to the scalable nature of investment management, as well as custodial and administrative systems. This benefi t is made evident by reviewing the fee schedules for institutional separate accounts for various account sizes (Figure 2). While the benefi t of lower cost varies by asset class and portfolio size, roughly 10 to 20 basis points of investment management fee savings is available (based on median institutional fees for traditional asset classes). Applying this fee savings to Figure 1 translates into one to three years of additional lifetime retirement income, depending upon a participant s salary, age and savings rate. Benefi t #2 Better investment effi ciency via illiquid investments One crucial difference between DC and DB plan investing is the potential for immediate liquidity. We would argue that neither structure requires the current high level of liquidity, given the long-term nature of the investment. Most retirement plan participants have a fairly long time horizon and are well-suited to capture the illiquidity return premium associated with a longer holding period. Even so, most DC plans currently provide participants access to daily liquidity, should they request it. As a result, all plan options must be priced daily, inhibiting the use of less liquid strategies (such as hedge funds, real estate and private equity). Figure 2. Benefits of large mandate sizes 3 Fees (bps) Fee savings due to mandate size ($50 million $500 million) Asset classes U.S. core fixed income 9 U.S. large-cap equity 15 Basis points Mandate ($ million) U.S. small-cap equity 12 Non-U.S. developed equity 18 Emerging market equity 14 Emerging market equity U.S. small-cap equity Non-U.S. developed equity U.S. large-cap equity U.S. core fixed income While the benefit of lower cost varies by asset class and portfolio size, roughly 10 to 20 basis points of investment management fee savings is available (based on median institutional fees for traditional asset classes). DC Plan Investments: A Path to Improve Long-Term Outcomes 3

4 This inhibition is unfortunate, as these relatively illiquid strategies could improve the investment efficiency of most portfolios. We demonstrate this view in Figure 3. As you can see, adding more illiquid strategies into target-date funds improves their risk-adjusted expected returns. That is because these strategies generally improve diversifi cation, lower volatility and create the potential for higher long-term return premiums from the use of less liquid investments. Figure 4 profi les the types of return-seeking asset classes currently used by target-date funds against generally less liquid strategies proposed for future designs that could improve risk-adjusted returns as shown in Figure 3. Each strategy offers unique portfolio benefi ts that can be broadly categorized as either a return enhancer or portfolio diversifier. Many of the strategies proposed for future designs provide the benefi t of diversifi cation, lowering total portfolio volatility without signifi cant sacrifi ce of expected total return. What needs to be done for DC plans to gain from these benefi ts? Investing in these illiquid assets does not come without challenges. Doing so requires more sophistication, governance and ongoing commitment than does investing in more traditional assets. 5 Specifi cally, it likely will require our industry to improve its: Regulatory guidance. Regulators should recognize the benefi ts of long-term investments and work to remove ambiguity and perceived fi duciary concerns in certain areas. These areas include daily pricing, liquidity, fees and reporting. Monitoring and implementation processes. This challenge can be demonstrated with a simple example. Private market investments often require a 10- to 15-year capital commitment appropriately allocating, tracking and distributing participant cash fl ows for this type of investment over such an extended period needs greater resolution. We believe, however, these types of challenges can be resolved with suffi cient commitment and improvement in decision-making processes. Figure 3. Benefits of adding less liquid asset classes to target-date funds 4 Expected return 9.0% 8.5% 8.0% 7.5% 7.0% Diversification enhances portfolio efficiency, lowering risk and improving long-term returns. 6.5% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% Standard deviation With illiquid assets Without illiquid assets Figure 4. Target-date funds Return-seeking asset classes and reason for inclusion Asset classes TDFs without illiquid assets TDFs with illiquid assets Reason for asset class inclusion Large-cap equities Yes Yes Return enhancer Small-cap equities Maybe Yes Return enhancer Emerging market equities Maybe Yes Return enhancer Commodities Maybe Yes Diversifier Alternative credit strategies No Yes Diversifier Hedge funds No Yes Diversifier Core property No Yes Diversifier REITs Maybe Maybe Diversifier Private markets No Yes Return enhancer DC Plan Investments: A Path to Improve Long-Term Outcomes 4

5 Yet, even if these changes were made, would DC plan participants be willing to behave in a long-term manner? The evidence suggests so. Due to either commitment to the strategies or inertia, most DC participants have retained their higherrisk investments through recent diffi cult market environments. Alongside other traits, participant behavior indicates a willingness and ability to maintain relatively longer holding periods evidence that supports our contention that illiquid strategies have a place in DC plans (Figure 5). Figure 5. Do DC plan participants have the right traits for illiquid investments? Investor traits for illiquid strategies Long investment horizon Need for real asset growth Long-term commitment Suffi cient capital base (collectively) DC participant Yes Yes Selective Yes Investing in these illiquid assets does not come without challenges. Doing so requires more sophistication, governance and ongoing commitment than does investing in more traditional assets. What change is on the horizon? Fortunately, recent events illustrate a growing commitment to support employee retirement readiness. Thanks in part to recent legislation, participants now have greater access to onestop strategies such as target-date funds with complex structures that are nevertheless simple to understand. 6 In this way, they can access lower-cost investment options, because fees for the underlying services and embedded products have come down substantially. Looking ahead, three areas offer potential catalysts to accelerate change: Needs. Employees need capital growth opportunities to prepare for an adequate retirement, and the economy needs capital to pursue new growth initiatives. The natural outcome of DC plan assets becoming a major capital resource is for these two needs to intertwine. Regulations. A little support can go a long way. The government s decision to make target-date funds a qualifi ed default investment alternative supported a rapid migration toward professional account management that helps employees access sophisticated investment expertise at a low cost. If regulators provide more support to fi duciaries by shifting emphasis to long-term investing and addressing current concerns, direct access to illiquid investment opportunities could be incorporated with the support of professional service providers. Commitments. The investment industry already recognizes the quickly growing base of available DC plan assets and is committed to improving participant retirement readiness. Business service professionals are investing substantial resources and time to support sophisticated analytical tools and improved access to diversifi cation and advice. Regulators recognized the benefi t of using target-date funds as a qualifi ed default investment alternative, and they likely will come to appreciate how DC plans can support economic development while improving employee preparation for a better retirement outcome. The question remains: How long will it take to get more illiquid assets into target-date funds? DC Plan Investments: A Path to Improve Long-Term Outcomes 5

6 Further reading Towers Watson s 2012 Defi ned Contribution Plan Survey Report Further information For further information, please contact your Towers Watson consultant or: Peter Grant peter.grant@ Endnotes 1. Fee considerations are not new to the industry; many sponsors have lowered the cost of their plans through regularly conducted fee negotiations with plan providers and greater use of passive investment strategies. For example, Towers Watson s 2012 Defi ned Contribution Plan Survey found that one in fi ve plans offers only passively managed equity options. 2. Analysis profi les years of lost retirement income due to fees. The fee effect depends on a participant s salary and saving rates. We assume a participant at the start of a 40-year horizon and include the impact of Social Security benefits. Lifetime of retirement income represents the amount of time that assets saved prior to retirement persist once a participant starts spending for retirement. 3. Analysis was completed using separate account median fee information for account sizes varying from $50 million to $500 million using evestment Alliance database information. 4. This figure shows the risk/return trade-off between target-date funds without illiquid asset classes and those with illiquid asset classes. Funds without illiquid exposure use a generic glide path consisting of public equities, commodities and REITs in the return-seeking portfolio, and U.S. long- and intermediate-term bonds as well as Treasury Inflation-Protected Securities in the fixed-income portfolio. The funds with illiquid strategies use the same fixed-income portfolio, while the return-seeking portfolio consists of a more diversified basket including emerging market and high-yield debt, hedge fund strategies, direct real estate and private markets. The points shown on the efficient frontier represent glide paths of varying risk levels. The benefit of diversifying into less liquid strategies existed at all risk levels examined. Analysis was based on a 40-year period and Towers Watson s Asset Return Assumptions as of Oct. 1, Of course, many institutional investors have already gained the pooling and fee advantages available to DB plans. Specifi cally, this was done by shifting their assets to separate accounts or lower-cost commingled pools, by engagement in fee negotiations and by relying on mutual funds to invest in alternative asset classes (e.g., real estate and commodities). 6. DC plans typically operate with individual participant-directed asset accounts that belong to each employee. These accounts offer benefi ts such as portability (i.e., ownership and liquidity), but also have the drawback of a signifi cant individual governance burden because each employee assumes responsibility for investment decision making. Target-date funds reduce the investment decision-making burden by regularly modifying the investment allocation based on a participant s age. Regulators catalyzed a substantial industry change in 2007 by making target-date funds the qualifi ed default investment alternative (QDIA), which led to most plan sponsors replacing money market and stable value options with target-date funds as the default investment option for the plan. About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Copyright 2013 Towers Watson. All rights reserved. NA