Fiduciary risk in DC plans
Within defined contribution (DC) plans, there is a substantial transfer of risk to employees that is being heavily debated. However, it is much less clear what the implications for pension plan directors and managers are, and how their fiduciary risk is affected.
Key risks such as the investment, interest rate, inflation and longevity risk, are being passed on to members. Have risks thereby been removed from sponsors and trustees?
It would be illusory to believe that all risks in relation to investment are transferred to members in a DC plan. Of course, the actual investment decision is with the individual. However, it is a choice out of a menu presented by the plan. What menu do trustees consider suitable? How much choice?
Two schools of thoughts battle it out whether the range of investment options should be “wide” or “narrow”, and there are good arguments on both sides. One view emphasises consumer empowerment and rational decision making, while the other stresses behavioural limitations and takes a more paternalistic approach.
In practice, you can find the full spectrum extending to the extremes from “no choice” to hundreds of options. Some plans try to find a solution tailored to the needs and investment sophistication of their particular workforce, for example, three simple risk/return categories. Whichever way you approach this, it is neither an easy nor a risk-less task.
One fundamental problem is that the individual circumstances are all very different. It is not only age and salary that define a member’s position, and there are other factors that, in theory, would need to be taken into account (such as the prospective labour income, other financial wealth).
Another area of concern is investors’ capabilities in the real world. There are curiosities with far-reaching implications (eg whether you give five or 10 options seems to have an influence on the investor’s asset allocation). In the late 1990s, massive overconfidence was evident, not only in the US 401(k) plans. DC is a fertile ground for behavioural studies that find all sorts of biases in people’s decision-making.
Hindsight is another problem. Expectations of future returns (and pension projections) will, ex post, turn out to be more or less “wrong”. In recent times, the combination of weak investment performance and low interest (and annuity) rates has led to disappointment (and spurring the debate about the adequacy of DC pensions also from a macro perspective). Whatever the trustees’ decision in respect of investment options, it can be quite easily challenged in retrospect:
q Too few options (eg, one bond fund can hardly cover the full range of time horizons across the membership);
q Too many options (eg, risk of confusion by members and trustees);
q Missing or wrong asset classes (eg, which alternative assets should you introduce these days?);
q Too restrictive arrangements (eg, domestic versus international, variety of investment styles, currency hedge or not, etc);
q Bad options (eg, only one fund manager, underperforming funds, fund closures);
q Too expensive funds (eg, is charging structure competitive?).
Many DC plans offer default funds out of necessity: the contributions need to go somewhere. Inertia is also an issue: it takes a lot of resources to get members to make active investment decisions. In practice, whatever the default fund given, often 70% or more people are in it, and stick to it. This puts decision-makers under pressure: Which default fund? Own company stock (as a matter of “commitment”), cash (“the safe option”), bonds (“bonds are pension-like”), equities (“long-term out-performance”), balanced (“diversification”), with-profit, have all been tried. As useful as such guidance may be in practice, it can quite easily be disputed. The consulting industry thought it had found the Holy Grail in the form of life-cycle funds (shifting from equities into bonds and cash when approaching the retirement age). Such automatism designed for a “typical member” has its advantages. Nonetheless, people are already starting to realise a number
They range from the technical (e.g. how and when to make transitions) to the practical (e.g. when will the individual really retiring?) and the conceptual (eg does the risk of equities really fall over time? What happens in case of long bear markets?).
Whatever the solution found, it needs to be actively monitored and regularly reviewed. Unfortunately, the matter often falls off the trustee agenda, once the DC investment framework has been set in place.
Georg Inderst is an independent consultant based in London. E-mail: firstname.lastname@example.org