How to Improve the Experience of Defined Contribution Participants

Transcription

1 DIMENSIONAL FUND ADVISORS DEFINED CONTRIBUTION SERVICES How to Improve the Experience of Defined Contribution Participants 2011 Investment Trends, Behaviors, and Attitudinal Research AUGUST 2011

2 1 Tim Kohn, Head of Defined Contribution and Vice President, Dimensional Fund Advisors Warren Cormier, Founder and President, Boston Research Group EXECUTIVE SUMMARY The defined contribution plan participant has been the subject of twenty-plus years of study and debate between corporations and policymakers. At stake has been how the traditional three-legged stool retirement paradigm should be redesigned. To this end, Dimensional Fund Advisors wanted to examine the behaviors, attitudes, and investment trends of active DC participants and their plan sponsors in order to determine: 1) current investor sentiment in light of the bear market, 2) receptivity and concerns surrounding qualified default investment alternatives (QDIAs), and 3) possible actions for plan sponsors to consider to improve the participant experience. Dimensional Fund Advisors engaged the Boston Research Group to conduct an online quantitative study with 1,000 DC participants who actively participate in a DC plan. A subsequent phone-based, computer-assisted telephone interview was conducted with 200 plan sponsors. Data was collected from January 11 13, In designing this study, we started with several hypotheses based on Dimensional s experience working with defined contribution plans and Warren Cormier s thirty-plus years experience in researching participant decision making. Our hypotheses included the following: Participants are still nervous about the market downturn and have made active decisions, removing risk from their portfolios. Participants closest to retirement have the lowest retirement confidence ratings. Receptivity for more defined benefit-like investment options should increase. Plans sponsors are concerned about recent publicized loses in target date funds ( TDFs ) designed for retirees and pre-retirees, so-called 2010 target date funds. We will see that most of these hypotheses prove correct. The data indicated that for those participants active during the 2010 investment year, those closest to retirement felt the least prepared, programs that feel more DB-like are gaining in acceptance at both the participant and plan sponsor level, and finally, participants are more risk averse as opposed to risk seeking with their retirement nest egg. These findings point to a new set of products focused on an appropriate income replacement rate and strategies based on income outcomes as opposed to lump sum outcomes. Working with the help of an advisor or plan sponsor and employing these types of strategies, participants may be able to create a better retirement.

3 2 CURRENT PARTICIPANT SENTIMENT Traditionally, participants are inactive investors, exhibiting extreme inertia as defined by reallocation of one s investment portfolio. Studies by the Corporate Executive Board and the Boston Research Group indicate that as many as 80% of participants never reallocate their investment portfolios which means a majority of participants will begin employment with a company and never make changes to their initial investment instructions. Our findings (see Figure 1) indicate that last year, however, about one-third (31%) of participants made some change to their allocations indicating a relatively high level of activity. The top changes were adding a new investment, increasing salary deferral, and removing an investment from the fund lineup. This increased level of activity indicates that participants are looking at their balances, salary deferrals, and investments and making active decisions. Looking forward, we see that just over one-third (37%) of participants plan to increase their future salary deferral, and just under half (44%) don t plan to make additional changes in FIGURE 1 Changes to Account Balances and Future Planned Changes Changes to Account Balance (Previous 12 Months) 31% 69% Yes No Changes Made (Previous 12 Months) Added an investment Increased the percentage of salary contributed to account Dropped an investment Decreased the percentage of salary contributed to account Took a loan against the balances in account Stopped contributing own money to account None of the above 10% 10% 5% 11% 47% 40% 31% Planned Changes (Next 12 Months) Increase the percentage of salary contributed to account 37% Add an investment 17% Drop an investment 7% Decrease the percentage of salary contributed to account 5% Take a loan against the balances in account 4% Stop contributing own money to account 3% Don t plan on making changes 44%

4 3 As we look at future decisions, it is important to note that behavioral experts have commented on a participant s forward-looking sentiments, stating that, in essence, tough decisions, such as increasing one s contribution to retirement, are easier when the action is separated by time. According to Cormier, participants will again and again sign up for tough decisions when the decision and action are separated by time; thus, we often see a disconnect between what is actually done and what optimally should be done. This form of investment procrastination is not new and spans both good and bad economic times. The realization of this behavior is one of the reasons for the creation of automatic investment features, such as automatic enrollment and escalation of salary deferrals. The recent uptick in adoption of these features is greatly attributable to the passage of the 2006 Pension Protection Act (PPA). The PPA created safe harbor protection for plan sponsors that implemented automatic enrollment as long as the defaulted investment was a QDIA. As we examine QDIAs, one approved solution, the target date fund (TDF), has become the QDIA of choice with respect to plan sponsor usage. TDF growth has been spectacular, growing from relative obscurity since their introduction in the early 1990s to over $340 billion today. Before we dive into TDFs, let s finalize our analysis of participant sentiments. When we asked participants about their desire to swing for the fences or if they would rather stay more conservative with their retirement savings, we saw a trend toward risk-averse decision making. We phrased the risk-averse versus risk-seeking decision making question by setting up two scenarios. One scenario asked if participants would like to improve their retirement by taking on risk, and the other scenario asked participants if they would rather maximize their retirement wealth at the risk of impacting their minimum desired income levels in retirement. The findings indicate that participants, by a healthy majority, tend not to be risk seeking with their retirement assets. FIGURE 2 Risk-Averse vs. Risk-Seeking Investment Behaviors Risk Averse Try to improve future retirement lifestyle by making potentially profitable investments that involve risk Avoid taking any risk and be comfortable with that lifestyle 39% 61% Risk Seeking Wealth maximization at the risk of not having enough money for a minimum acceptable lifestyle retirement Wealth outcomes in a range between minimum acceptable to a comfortable lifestyle retitrement 20% 80%

5 4 RETIREMENT CONFIDENCE LEVELS AND THE IMPACT OF AGE Finally, we examined overall retirement confidence by asking participants about six issues, ranging from their ability to make good investment decisions (in support of their retirement goals) to confidence in their ability to manage and spend down their retirement nest egg throughout retirement. The results speak volumes and indicate that a vast majority of participants do not feel confident about their retirement prospects. When we look at each of the retirement confidence questions, we find that those who are very confident range from a high of 29% of respondents to a low of 12% (Figure 3a). Not surprisingly, the lowest numbers indicate that participants do not know how much money they will need in retirement to support their desired lifestyle. Logically, if participants do not know how much money they need in retirement, it makes sense that subsequent savings and investment decisions become increasingly hard for participants to grasp, thus reducing confidence and increasing participant confusion. FIGURE 3A Retirement Confidence Findings and the Impact of Age Retirement Confidence Ratings Confident Somewhat to not very confident Ability to manage and spend down lump sum in workplace retirement savings account throughout retirement Ability to make good financial and investment decisions Investment decisions are the right ones to meet financial retirement goals Will have enough money to retire at planned age On track to have enough money in retirement to live desired lifestyle Know how much money is needed to accumulate in order to live desired lifestyle in retirement 29% 23% 20% 20% 18% 12% 71% 77% 80% 80% 82% 88% The Impact of Age Under 30 ( Confident) Age ( Confident) Ability to manage and spend down lump sum in workplace retirement savings account throughout retirement Ability to make good financial and investment decisions Investment decisions are the right ones to meet financial retirement goals Will have enough money to retire at planned age On track to have enough money in retirement to live desired lifestyle Know how much money is needed to accumulate in order to live desired lifestyle in retirement 28% 25% 26% 21% 25% 15% 25% 19% 22% 13% 14% 11%

6 5 How to Improve the Experience of Defined Contribution Participants Somewhat to AUGUST 2011 Retirement Confidence Ratings Confident not very confident Ability to manage and spend down lump sum in workplace retirement savings account throughout retirement Ability to make good financial and investment decisions Investment decisions are 20% Before the right we ones leave to meet the issue of retirement confidence, we want to examine this confidence (low as it financial retirement goals 80% may be) for future savings, and the disconnect between what participants intend to do and actually Will have enough do. In other words, do we think participants are generally more 20% money to retire confident about retirement when they at planned are young hoping age 80% to adjust their investment behaviors in the future? As we suspected, the impact On track of to age have enters enough a new low for each of our retirement confidence 18% findings and signals an urgent money in retirement call to live to desired action lifestyle for those closest to retirement (see Figure 3b). 82% Know how much money is needed 12% to accumulate in order to live FIGURE desired lifestyle 3B Retirement in retirement 88% Confidence Findings and the Impact of Age 23% 29% 71% 77% The Impact of Age Under 30 ( Confident) Age ( Confident) Ability to manage and spend down lump sum in workplace retirement savings account throughout retirement Ability to make good financial and investment decisions Investment decisions are the right ones to meet financial retirement goals Will have enough money to retire at planned age On track to have enough money in retirement to live desired lifestyle Know how much money is needed to accumulate in order to live desired lifestyle in retirement 28% 25% 26% 21% 25% 15% 25% 19% 22% 13% 14% 11% Please note that very confident ratings in Figure 3a are the average of each age cohort; thus, the numbers differ for those who are specifically in the under 30 category (Figure 3b).

7 6 RECEPTIVITY/ CONCERNS SURROUNDING QDIAs With the passage of the PPA in 2006, the first and most dramatic change to America s retirement system since the Employee Retirement Income Security Act of 1974, we have seen the creation of QDIAs and corresponding safe harbor protections for employers. Not surprisingly, the years after 2006 saw numerous employers seeking to redesign their DC plans, adding QDIAs along with automatic investing and escalation programs. The biggest asset-gathering QDIA to date has been the TDF by some estimates, as many as 60% of QDIAs are TDFs, with managed accounts and balanced funds splitting the remaining 40% of mandates. Based on the relatively new and untested TDFs and their increasing popularity, we wanted to examine current sentiments around TDFs, especially in light of the recent bear market, which saw the average 2010 TDF lose 30%. Most notably, we found that only 22% of participants are very satisfied with TDF returns (See Figure 4). When examining the top reasons for participants being neutral or dissatisfied with TDFs, we found that almost half were dissatisfied with the returns of TDFs when compared with other standalone investment options. Most telling, only one in ten participants who currently invest in a TDF would be very likely to recommend a TDF to a friend, colleague, or family member. Most participants (four in ten) remain mostly neutral with respect to a TDF recommendation. FIGURE 4 Target Date Fund (TDF) Satisfaction with Returns and Likelihood of Recommendation Satisfaction with Rate of Return or Earnings in Target Date Funds Satisfied Somewhat Satisfied Neither Satisfied nor Dissatisfied Somewhat Dissatisfied Dissatisfied 22% 57% 13% 8% 1% Likelihood of Recommending Target Date Funds Likely Somewhat Likely Neither Likely nor Unlikely Somewhat Unlikely Unlikely 10% 32% 43% 8% 8%

8 7 LESSONS FROM BEHAVIORAL FINANCE Leading behavioral finance academics have attempted to tackle the issue of why participants make the investment decisions they do and why certain actions seem contrary to good investment sense. These actions include participant inertia, apathy, loss avoidance, and other heuristics or biases that impact decision making. Max Bazerman and Don Moore refer to overconfidence and hindsight in their book, Judgment in Managerial Decision Making, as a barrier to effective professional decision making. This may be a root cause behind our findings on retirement readiness and the impact of age. When we asked participants how they felt about retirement readiness, those furthest from retirement often felt the best about their retirement odds. This could be indicative of both the concept of investor procrastination as well as overconfidence. According to Bazerman and Moore, overconfidence is related to the confirmation heuristic 1 meaning that people generally refer to confirming as opposed to disconfirming evidence when making decisions. Our participants may be exhibiting this confidence early in life, and those closest to retirement may be basing their low confidence levels on the unfortunate facts that present themselves in the form of account balances. WHERE DO WE GO FROM HERE? The potential retirement outcome for participants spans a wide range depending on participant investment elections, salary deferrals, available fund options, plan design, communication and education, and the impact of rules and regulations. In order to maximize outcomes for participants, and in light of this recent study, we believe the following actions should be considered to improve the participant experience: (1) Re-frame the discussion to focus on income. Today, most participants see retirement in the form of a lump sum they spend their working years acquiring a lump sum and then transition from accumulation to spending with little guidance. This view leads to issues around longevity and inflation protection concepts that participants rarely understand and risks they can rarely mitigate on their own. Today s financial services marketplace is filled with products to protect against longevity and inflation risk; however, the uptake on these products is historically very low. In fact, a recent paper by Svetlana Pashchenko from the Federal Reserve Bank of Chicago examined why people do not annuitize and found that only about 8% of people aged 70 reported owning a private annuity. 2 In 2010, LIMRA analyzed 55,000 annuity contracts, representing $250 billion, and found that only 7% of income annuity contracts included an inflation or automatic payment increase. 3 Showing a participant s current holdings in terms of retirement income (as opposed to a lump sum) may help participants see their account balances through an income lens and start the conversation on retirement income today. 1. Max Bazerman and Don Moore, Judgment in Managerial Decision Making, John Wiley & Sons, Inc., Source: Accounting for non-annuitization, Svetlana Pashchenko, The Federal Reserve Bank of Chicago, Working Paper Data from HRS/AHEAD data set, Source: LIMRA Guaranteed Income Annuities Report, November 22, 2010.

9 8 (2) Automate, automate, automate. Taking lessons from how participants make decisions (or choose not to), every plan should tackle participant inertia by considering automatic enrollment, deferral escalation, and rebalancing programs. When implementing automatic enrollment, each plan sponsor should consider the pluses and minuses of each QDIA category and our recent findings on TDF acceptance among participants, especially those closest to retirement. (3) DC 4.0! We hear a lot about DC 2.0 (the next new breed of retirement solutions that incorporate income into current offerings such as with TDFs or guaranteed minimum withdrawal benefit plans). However, we would contend that the evolution of DC plans has had the following glide path: fund proliferation (DC 1.0); introduction of risk-based funds (DC 2.0) typically balanced funds with the conservative, moderate, or aggressive nomenclature; introduction of TDFs (DC 3.0); and finally, next generation retirement solutions (DC 4.0). These next generation solutions are designed to provide more customized solutions than DC 3.0 offerings. Typically, these solutions are offered in the form of a managed account and combine the lessons learned from behavioral finance provide easy participant intake and decision making with the lessons from modern portfolio theory and defined benefit plan management. These 4.0 solutions include automation, customization, and a DB-like experience (longevity and income protection), and provide participants with a stream of inflation-adjusted income throughout retirement. (4) Get professional-grade help for your participants. Our research findings point to the need for a new set of retirement products, and with the help of an advisor, participants may be able to create a better retirement that is focused on income outcomes as opposed to lump sum outcomes. Plan sponsors can take meaningful action to help guide participants through their investment and spending glide paths. Advisors can help mitigate the effects of longevity and inflation, reducing fears around annuitization while providing custom, professional-grade income solutions. CONCLUSION Our behavioral and attitudinal study uncovered some interesting data points, confirming that some things never change and some do. It is those things that changed with participants decision making that required our further exploration. We found that participants were fairly active in making investment decisions and increasing salary deferrals in The study also pointed to the age-old dilemma of participant inertia or procrastination. The existence of this inertia led to the landmark Pension Protection Act of The PPA, through its Department of Labor-led regulations, transformed the retirement marketplace, creating a boon for TDF providers while legitimizing much of the work of Dr. Shlomo Benartzi and Richard Thaler with the inclusion of automatic enrollment into modern DC plans via QDIA safe harbor provisions. In looking at TDFs, we find there is very little overt acceptance of these solutions at the participant level. The primary reason for neutral and dissatisfied feelings toward TDFs continues to be their performance relative to

10 9 other investment options. Most likely, these feelings are a consequence of the bear market, in which the average 2010 TDF experienced a loss of 30%. When looking at 2010 TDFs, we did so realizing these were the funds most used by retirees and pre-retirees. Not surprisingly, the impact of age showed that participants closest to retirement had the lowest retirement confidence of any age cohort. The US retirement system has been in a state of flux as DB plans terminate or freeze, thus increasing the role of the modern DC plan. Since the passage of the PPA we have seen landmark changes in this industry, from broad acceptance of automatic enrollment to the rise of the TDF as the QDIA of choice. Time will tell whether these small steps will increase the retirement confidence of America s workers. For now, the outlook is quite grim: Participants do not know how much money they need to retire, how to spend that money in retirement, or how their investment decisions will fare along the way. To address this uncertainty, we offer a few suggestions: Focus on income as opposed to lump sums, implement automatic programs and managed accounts, and get the help of professionals for your participants. These small steps, implemented on a wide scale, can help move the retirement preparedness needle, resulting in a more secure retirement for America s workforce. A summary of this study was originally published in the July 2011 issue of DC Dimensions CONTACT INFORMATION For more information about the services that Dimensional offers to defined contribution plan sponsors, consultants, and recordkeepers, please contact: TIM KOHN (512) tim.kohn@dimensional.com If you are an investment advisor, please contact: APOLLO LUPESCU, PhD (310) apollo.lupescu@dimensional.com This article is distributed for informational purposes only and should not be considered investment, tax, or legal advice or an offer of any security for sale. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.