The New Defined Contribution Landscape
The COVID-19 pandemic has transformed the macroeconomy, spawned the Great Resignation and jolted markets – including changes that are accelerating evolution of the defined contribution (DC) landscape. At the same time, plan sponsors confront regulatory developments such as the SECURE ACT, substantial growth in assets, pressure to align plan features with participant needs and preferences, and disruptive trends such as inflation. Here we outline five key themes we believe plan sponsors will need to address as they cultivate and evolve their plans to meet participant demands and expectations.
1. Offer a more personalized approach to QDIA participants
Advances in technology, data and analytics are driving demand and expectations for more personalized experiences and customized solutions – and this is increasingly the case for qualified default investment alternative (QDIA) options.
To be sure, off-the-shelf target date funds (TDFs) have been – and continue to be in our view – an effective tool to guide participants through the retirement savings journey. However, the degree of personalization and appropriateness can be limited because TDFs are based chiefly on a single factor – the participant’s age.
Managed accounts, of course, are at the opposite end of the customization continuum. They generally offer greater personalization. Yet adoption has been historically limited by the need for participant engagement, perceived complexity and often significant incremental costs.
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In between these two poles of customization lie new solutions that may offer personalization without significant additional cost or burden on participants. These include personalized target date funds and dual QDIAs. They can respond to the increasingly wide range of circumstances and objectives investors face as they approach retirement (see Figure 1).
2. Seek the most from fixed income in a low-return environment
After a decade-long bull market, driven in its latter stages by pandemic-related fiscal stimulus measures, many asset classes have enjoyed significant and above-average returns. Not surprisingly, many expect more muted returns that could jeopardize retirement savers’ chances of achieving their objectives.
There are, of course, less desireable options. These include modifying spending profiles and living standards, or increasing investment risk exposure. Yet these have obvious drawbacks, especially for participants near or in retirement.
Fortunately, active management of fixed income has the potential to overcome or offset a potentially lower- return environment. Thus, we believe sponsors should assess whether their plans offer an appropriate degree of active management.
A thorough analysis of the data can lead one to argue that active fixed income management can offer strong potential for excess return generation, both in absolute and relative terms. Indeed, as Figure 2 shows, nearly 80% of active fixed income managers outperformed their median passive peers over the past five years ended 31 December 2021. This compares with less than 30% for active equity managers.
Importantly, potential excess return generated from fixed income allocations in DC plans could have a substantial impact on plan participant outcomes. Taking longevity of assets as an hypothetical example (as shown in the bottom panel), the possible excess return generated by active management of fixed income allocations throughout a full plan-participant horizon could extend the longevity of assets in retirement by more than seven years, or approximately 26%. Given these trends, we suggest DC plan sponsors make it a priority to evaluate whether participants are getting the most from fixed income allocations – both on core menus and within the QDIA option.
3. Help participants weather higher-inflation environments
While inflation had been muted for years, it has resurged powerfully in recent months and could create problems for plan participants seeking to preserve purchasing power. Recovering demand, easy access to credit, and broad government stimulus to confront the economic impact of the pandemic coincided with constrained global supply chains – resulting in inflation rising to its highest level in almost 40 years. Inflation may remain a major concern for investors and participants given its potential volatility and both upside and downside risks.
Amid high or rising inflation, stock-bond correlations have tended to be high, and many traditional portfolios can lack a sufficient allocation to real assets, which often serve to help mitigate the impact of inflation on portfolios (see Figure 3).
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DC core menus generally take more varied approaches to mitigating inflation risk than QDIAs. Recently, we have seen particular interest in multi-real-asset solutions to help hedge against inflation. This is likely driven by the desire to outsource the management of all-in-one comprehensive portfolios of inflation fighters to investment managers.
QDIA options such as TDFs often incorporate assets meant to mitigate inflation, especially for investors in retirement age. Unfortunately, in our view, many TDFs may not have sufficient allocation to inflation-mitigating assets. The average real asset exposure among the top 10 TDFFootnote1; providers ranges from about 2% for younger participants to about 9% for those in retirement. In our view, exposure to real assets in glide paths should be meaningfully higher.
Bottom line, plan sponsors should evaluate their current inflation-hedging options – both in the QDIA and core menus – and determine how well they complement participants’ existing equity, bond, and capital preservation options.
4. Help participants pursue their ESG aspirations
There is growing attention to investments related to environmental, social and governance (ESG) concerns. While a focus of institutional investors, ESG investment options will increasingly be demanded by DC plan participants and other individuals, in our view, and DC consultants are heeding that call. About two-thirds of those surveyed in our 2021 PIMCO U.S. Defined Contribution Consulting Study were considering adding ESG strategies to DC investment lineups; more than half were evaluating or already recommending ESG options. (This trend is advancing despite uncertainty with respect to the 2020 Department of Labor final rule, “Financial Factors in Selecting Plan Investments.”)
That said, implementation remains challenging and plan sponsors might still be cautious about offering ESG funds pending additional regulatory guidance. As a first step, we believe sponsors should evaluate investment managers on their ability to integrate ESG into their existing investment and research processes.
Longer term, we believe ESG options may offer solutions for plan sponsors seeking alignment with the sustainability objectives of their business, the values of their participants, and, as a means to retain and attract talent. They may also fulfill fiduciary obligations that consider material risk-return analysis, including climate and other ESG factors.
5. Introduce investment options better suited to participants in or near retirement
Plan sponsors increasingly want to reduce costs by retaining workers in-plan after retirement. To do so, many more will need to offer plan features that match the diverse and unique needs of retirees, aided by the new flexibility afforded by the SECURE Act. Indeed, many plans have recently added educational tools or begun offering distribution flexibility (see Figure 4).
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While great first steps, they will only be helpful and impactful if participants use that education and implement a decumulation solution within the plan. The big milestone is adding retirement income solutions or products, either as part of a retirement tier on the core menu or within a dual QDIA structure.
So far, it appears implementation of these types of solutions has been fairly limited – in part because of the perceived complexity and the number of elements that plan sponsors are trying to solve for when evaluating such strategies.
It won’t happen overnight, but as a first step we recommend that DC plan managers consider making it a near-term priority to introduce a relatively simple retirement income solution, or set of solutions, that can address the most basic, yet also most important, needs of both retirees and plan sponsors. That is, a solution that incorporates elements such as liquidity, capital preservation, and explicit monthly distributions – all in a package that can easily be understood by participants.
THE YEAR AHEAD
While the pandemic sent the world into rolling lockdowns over the past two years, we believe collective retirement liabilities are like approaching objects in the rear-view mirror – they are closer and larger than they appear. Yet the mission of plan sponsors and investment staff has not changed. They remain responsible for helping participants prepare for retirement in the face of a complex web of legal, regulatory and market challenges. The pandemic has been a catastrophe, but it will serve to hasten the substantial evolution of the DC plan landscape and give plan sponsors an opportunity to continue cultivating their plans and participant experience.
1 Source: Morningstar and PIMCO as of 8 February 2022. Real assets include TIPS, long duration TIPS, emerging markets debt, and real estate.Return to content↩