Defined Contribution: Going the distance
In Australia and the US, best practice in the DC sector is to ensure participants have sufficient income throughout retirement, writes Christopher O’Dea
While the goal for the defined contribution sectors in the US and Australia today is essentially the same, the best practice menus for DC plans in each market are about as far apart as the countries themselves.
In both countries, the main objective is to ensure that plan participants’ account balances generate an income stream that is sufficient to maintain each participant’s lifestyle throughout retirement. But there the similarities end.
In the US, the focus on retirement income generation is a relatively recent evolution in the DC market, which has emphasised accumulation, broad menus of fund choices, and perhaps too much focus on big-name fund managers – all while leaving annual contribution levels, asset allocation and investment decisions to each individual. Target-date funds were a partial answer, seeking to deliver participants some measure of certainty by setting a schedule for when managers would change allocations among broad traditional asset classes. But these products still focus mainly on accumulation during a participant’s working years, rather than delivering post-retirement income.
Australia’s superannuation industry, in contrast, is rolling out a significantly more sophisticated investment proposition. Based on compulsory contributions and management of assets by defined-benefit style teams of professional investors, superfunds are now offering multiple default fund options that aim to secure a retirement income stream by tailoring investment strategies and risks to both a participants’ time to retirement and account balance – a major advance over the target-date model that only changes asset allocation every few years, and then without reference to participants’ balances or income needs.
While US DC plan sponsors remain focused on costs and the effectiveness of investment options offered to participants, the new focus on generating income in retirement is revolutionary, says Winfield Evens, who is responsible for the investment strategy and retirement research groups for Aon Hewitt’s defined contribution outsourcing business.
“Moving beyond the question of whether you’re saving enough, to a framework around retirement income adequacy that helps the average investor understand what this means – and then having the plan help pay people out, is a revolutionary step,” Evens says. “There are aspects of it out there already, but the industry is not there collectively yet.”
In the US, “DC plans historically have been very good at helping participants accumulate assets over time – save more, invest for the long term – those messages have been broadly communicated in a good and positive way,” Evens continues. “What they have been less adept at is helping participants live off their balance in retirement.”
The American tendency towards individual self-reliance can leave plan participants in search of an investment programme late in life. In US 401(k) plans, the main form of DC plan in the US, “you can keep your money in as long as you want, until you have to take minimum distributions”, Evens says, which in the US starts at age 70.5. Some employers force employees to take all their cash as a lump sum.
Innovations include planning tools that help participants with modest balances structure the withdrawal of plan assets, insurance-linked income solutions, and financial wellness programmes that help participants save as much as possible.
Financial Engines, a publicly-listed provider of workplace-based investment advice and management, offers a tool called Income+ to optimise withdrawals after retirement. HelloWallet, a subsidiary of Morningstar, is a web and mobile application for employees that partners with employers to provide independent, personalised financial guidance to employees. Aon Hewitt works with clients to include such solutions in savings plan communications, Evens says.
“Plan sponsors have found that many participants, as well as non-participants, live paycheck to paycheck, and it’s beneficial to provide employees across the income spectrum with financial planning assistance in order to alleviate the stress that can arise from concerns about financial security,” he says.
“More Americans need to not only set savings goals, but consider how their retirement savings will translate into an income stream that they cannot outlive,” says Ed Van Dolsen, president, Retirement and Individual Financial Services at TIAA-CREF. “Individuals will feel more confident in their retirement plans if they know that their basic expenses will be covered by guaranteed income,” he says.
Those concerns can last the remainder of a DC participant’s lifetime – the average American will live 20 years in retirement, notes Roberta Rafaloff, vice-president, institutional income annuities, in the corporate benefit funding segment of MetLife’s institutional retirement group. MetLife introduced a new deferred income annuity product for DC plan sponsors in May, a so-called qualifying longevity annuity contract, or QLAC;
The US Treasury last year adopted new rules that allow DC plan participants to exclude plan assets used to purchase an annuity contract from the calculation of required minimum distributions that participants must take beginning at age 70.5. That means participants can use the lesser of 25% of their account balance or $125,000 (€113,000) to buy a deferred annuity.
Australia’s QSuper focuses on default options
Other insurance companies that have launched QLACs include AIG and Principal Financial. The products could help fill a big gap in America’s do-it-yourself retirement industry. The TIAA-CREF 2015 Lifetime Income Survey found that 84% of Americans value a guaranteed monthly income in their post-career years, yet only 14% have taken steps to ensure lifetime income with the purchase of an annuity.
Providing income during retirement has long been a goal for Australian Superannuation funds. The Australian government spurred the focus on retirement adequacy with the MySuper reforms of 2011, which recognised that most employees opt for default funds, and set out required features for MySuper default products intended to make default funds relatively simple products competing on the basis of net costs and returns.
While many superannuation funds have renamed existing default options, some have been more aggressive. QSuper, for example, ran the best-performing Super fund in the year ending June 2015, with the QSuper Balanced fund posting a 12.3% return against the 9.8% return for the median growth fund, according to Mano Mohankumar, investment research manager at Sydney-based Australian superannuation consultancy Chant West.
Despite that outperformance, QSuper has seen significant assets move into its Lifetime portfolio, the new default option that replaced the Balanced fund, says QSuper’s CIO, Brad Holtzberger. In the three years since its launch, Lifetime has grown to AUD23bn (€16bn) of the AUD55bn QSuper manages, compared with AUD10bn remaining in the Balanced fund, he says.
With Lifetime, QSuper has taken perhaps the biggest step forward in the industry; instead of one default fund, the investment team manages separate strategies for eight different cohorts based on time to retirement and account balance, using asset-liability-matching principles that are standard fare for DB investment management. “We’re dealing with internal rates of return, not time-weighted returns,” says Holzberger.
“What makes us distinctive is that we also focus on age, because it’s the measure of account balance and age which creates the measure of adequacy of funding for retirement,” says Holtzberger. Returns on the eight cohort portfolios for 2014 ranged from 6% to 14.5%, he says. For those that are close to retirement or have low balances that they can’t afford to lose, “we’ve chosen to pull the risk back”, he says, to portfolios weighted toward cash. Those with many working years before retirement are in portfolios including equity, risk-parity strategies, and unlisted investments.
Holtzberger says the next step in QSuper’s evolution will be investment solutions aimed at the longevity risk conundrum. As members don’t know when they’re going to die or run out of money, the QSuper team is at work on an approach that will seek to optimise a longevity risk-sharing approach and a drawdown strategy. “We hope to be good stewards of the money,” Holzberger says. “There’s a huge moral imperative to get this right.”