Defined contribution (DC) retirement plans, such as 401(k) and 403(b) plans, require significant re-engineering if they are to do a better job serving the millions of Americans who were exposed to unexpectedly high risks during the 2008-09 financial crisis and stock market plunge, according to a May 2010 Towers Watson report, Journey Well, Arrive Better—Redefining DC Investment.
The analysis shows that during the financial crisis employees felt the full force of investment risk. It suggests ways in which fiduciaries can improve participant trust in DC plans.
“There is no doubt that being a participant in, or fiduciary of, a DC plan is challenging, but more thinking is producing better practices," says Carl Hess, global head of investment at Towers Watson. "Indeed, many DC participants now realize that they need to better address their own investment risk, while plan fiduciaries are reviewing their investment strategies and default arrangements to redress the balance of risk and return. Against this backdrop, and with much greater awareness of and engagement with the issues, we are confident that a more robust DC proposition is emerging,” Hess adds.
Understanding Participant Behavior
“A really positive development of late is a strong move toward better understanding the uniqueness of plan participants, their objectives and likely behavior patterns, particularly with respect to investment risk,” Hess explains. “This is important for grouping those who will simply follow a default process, those who with guidance are willing and able to make small personalized decisions, and those who are able to manage their own choices.”
In its analysis, Towers Watson recommends segmenting participants according to their needs. For example, in a company where different types of work are carried out at various locations (and employees have different educational backgrounds or salary bands), segmentation by employment location would be a useful measure of ability to take risk.
Once the appropriate data has been identified and collected, a weighted sum of four risk factors can be used to measure participants' risk tolerance:
• Net wealth, including assets, liabilities and government benefits.
• Human capital, including education, prospects and job security.
• Life influences, including health, gender, age, dependents and lifestyle.
• Plan management and decision-making, including time, interest and expertise.
Taking all factors into account, the fiduciary can understand better the broad structure of participants with regard to risk. This can lead to a better design of investment options (including default investments), communications and educational outreach. For instance, in selecting target-date or "lifecycle" funds, participants' risk tolerance should be considered in evaluating the design of the glide path that moves from growth-oriented to more conservative assets over time.
A Governance Framework
Unless plan design, investment structures and communications are organized and managed in an effective governance framework, they are unlikely to deliver a successful plan, according to Hess. He notes, "governance is the essential ingredient that pulls everything together to make a DC proposition substantially more than the sum of its parts.”
The Towers Watson report contains seven articles that can be downloaded individually at no cost:
• “Journey planning—a more engaging approach.”
• “Investment governance—enhancing the value chain.”
• “Lifecycle strategies—what next?”
• “Glide path design—building a de-risking strategy.”
• “Investing for growth—creating more efficient portfolios.”
• “Managing risk around retirement.”
• “Segmentation—understanding your membership.”
Stephen Miller is an online editor/manager for SHRM.
SHRM Online Benefits Discipline