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Considering the duration of the experiment—workplace defined contribution (DC) plans are essentially two decades old and counting—the DC marketplace has come a long way in a short time.
Since the DC plan is now the primary American workplace savings mechanism, if viewed through a societal lens it still falls short on coverage (only about 40% of working Americans put money into a workplace plan, according to the Employee Benefits Research Institute) and on contribution rates. Simply put, not enough Americans have DC accounts, and those who do, tend not to save enough. Of course, in the New World, regardless of the savings vehicle, it was ever thus.
In the large corporate marketplace, the first problem is no problem at all; almost all employees have access to the DC plan, generally with fewer and fewer vesting requirements. And the second problem is currently being vigorously tackled. Perhaps it should surprise no one that the best DC plans from a participant standpoint are found at Fortune 500 companies. Scale, combined with investment and benefits expertise, are the difference makers. As a consequence, more and more American workers at large companies are getting access to (or, more to the point, are being defaulted into) best-in-class investment vehicles at institutional rates. Thus, aiCIO examines the best examples of latter-day DC plan design in Fortune 500 companies.
Much of the progress made in defined contribution plans this last decade has been lost in the hue and cry that has accompanied the decline of defined benefit (DB) plans. Indeed, there are flat-earthers still (many, it seems, in Washington, DC) who appear to believe that, contrary to the facts on the ground, DB plans are the birthright of long-serving employees. In the public sector, that wisdom will linger for a while, but even there, for the sponsoring institution (ultimately, the taxpayer), it will simply prove unaffordable to keep those promises. A formidable collection of interests has established itself to deny this reality, but reality it is. In time, it will assert itself.
Auspiciously, in a rare spasm of lucidity in 2006, Congress recognized this reality with regard to corporate America at least, and the passage of the Pension Protection Act (PPA) reflected this understanding. The PPA both finalized the changes in accounting standards that made DB plans too risky for most American corporations and also codified what the defined contribution marketplace was already adopting. Specifically, this meant easing the path toward an “opt-out” construct. From their beginnings, DC plans had an “opt-in” architecture, in which employees decided on whether and how much they saved, and chose their savings vehicles from the various funds the sponsor approved for inclusion in the plan menu. The net result, it was widely agreed, was very substantial growth of DC assets but poorly constructed investment portfolios for most participants. The Department of Labor (DoL) then followed the PPA’s lead by, among other things, clarifying the “safe harbors” that plan sponsors would enjoy in the choice of default investment vehicles, the so-called QDIAs (Qualified Default Investment Alternatives). Importantly, the QDIA did not include stable value, and instead focused on asset allocation vehicles.
The net result of these legislative and regulatory developments was profound: the architecture that will characterize the next generation of DC plans is now in place. Indeed, in the intervening years, a multiplicity of corporate sponsors has begun to put best-in-class plans in place.
A sine qua non for these best-in-class plans is automatic enrollment. From its start at McDonalds some 15 years ago (at that time unfortunately termed “negative enrollment”), large corporate plans have led the way in this regard. Today, according to the latest PLANSPONSOR data, 60% of plans with more than $1 billion in assets have adopted automatic enrollment. There is little excuse not to: even in those rare instances when a defined benefit plan remains open and vibrant, auto-enrollment in the DC plan is only a virtue, and plan sponsors have begun to see it that way.
Where better plans differentiate themselves from good plans is in what comes next: the default contribution rate itself, and the choice of QDIA. There is no one gold standard for contribution rates, because a corporation with an open defined benefit plan cannot be expected to establish a double-digit default contribution rate for its DC plan. But many large plans are beginning to see their way clear to moving toward double-digit contribution rates by auto-escalating participants either at every pay rise or on an annual basis, and many have also pushed the starting default rate higher, to 5% or 6% from 3%. According to PLANSPONSOR data, some 52% of mega-plans which have adopted auto-enrollment have also adopted auto-increases. Newark-headquartered Prudential is a best-in-class example of this, with an aggressive and well thought-through auto-escalation feature.
But the real crucible for best-in-class DC plans is not so much plan design, in which enormous progress has been made but where the basic parameters are now accepted (auto-enrollment and auto-escalation), but in investment choices in general and QDIA choices in particular. Here a history lesson is in order. Long before the PPA laid down its edicts, a growing group of providers had begun to promote the efficacy of target-date funds for DC participants. BGI understood this before its peers, but the mutual fund complexes, specifically Fidelity, T. Rowe Price, and Vanguard were quick to follow suit. From the outset, the mutual fund target-date funds hoovered in assets; an excess of $500 billion is now in these vehicles. While they could be criticized on a number of grounds—these were mutual funds (collective investment trusts can be cheaper for large institutions) and for the most part, they were made up entirely of proprietary asset management capabilities (at a time when open architecture was widely agreed to provide better investment outcomes)—there was no stopping their growth. In part, this was because it was widely recognized that, flaws or not, these target-date funds were better for DC participants than the status quo ante—participants doing their own asset allocation and failing miserably to construct intelligent portfolios for anything other than a roaring bull market.
Many Fortune 500 plans today still keep a Fidelity, Vanguard, or T Rowe Price target fund as their QDIA, but they are a shrinking majority. There is a new focus on cost, and also a new focus on so-called custom target-date funds. And the DoL's February 2013 paper, Target Date Retirement Funds: Tips for ERISA Plan Fiduciaries, comes closer than ever before to encouraging plan sponsors to look into and adopt custom or non-proprietary solutions.
One of the challenges facing would-be adopters of custom target funds is that most asset managers—the mutual fund complexes in particular, but even the institutional players like BlackRock and JP Morgan—deep down would prefer that their clients use their proprietary vehicles. When the Boeing pension system decided to go the custom route, it had to find both a glide path manager (it selected BlackRock) as well as a provider to pick the underlying asset managers (Russell Investments). Walmart, in a closely-watched decision, reportedly made exactly the same choice, recently with the same vendors.
Estimates of the size of the custom QDIA market vary enormously, but some are as high as $90 billion, with more than 120 large plans adopting some variant of custom QDIAs, according to preliminary and yet-unpublished research done by the Defined Contribution Investment Industry Association. Russell Investments, one of the dominant players in the custom space, reckons it has interacted with more than 50 large plans that are considering custom target-date solutions. The latest PLANSPONSOR data for mega-plans indicated that 16% of these plans have a customized target-date fund already in place, and another 30% are considering such a construct.
For many plan sponsors, however, this is a bridge too far. Some argue that it takes on too much fiduciary risk—although an alternative view which has recently been gaining currency is that fiduciary risk may decrease as control of the glide path, fees, and guidelines are uniquely managed. It also requires a real commitment of resources. Boeing, for example, dedicated considerable resources from its defined benefit-focused investment staff to getting itself comfortable with its custom QDIA decision. Most plan sponsors don't have Boeing's in-house investment expertise, but even among those that do, Atlanta-based UPS being a case in point, some choose to leave their DC plan design entirely in the hands of HR, and not Treasury.
The interest in custom is, of course, part of a bigger phenomenon: almost all large plans are looking in some shape or form to upgrade their target-date solution. As a result, better off-the-shelf solutions are emerging as well, including multi-manager and active/passive combinations. This is driven at least in part by the impact of fee disclosures and the unbundling of investment management from recordkeeping.
That said, there is a growing consensus that the custom QDIA market is inexorably on the rise, driven by demand more than supply. A growing number of sponsors are looking for control and flexibility of glide-path design and asset manager selection; others are acutely aware of cost, and are looking to use the scale of assets flowing into their QDIAs to lower fund fees. Still others—Intel is the best-known and most vocal advocate, but Verizon is also to the fore in this regard—have used an open-architecture manager selection process to get alternative asset classes, such as private real estate, private equity and hedge funds, into their QDIA.
Evolving attitudes on the part of recordkeepers are also smoothing the path toward more custom solutions. Fidelity, for one—while openly obstructionist only on occasion—tended to steer its recordkeeping relationships toward its proprietary Freedom Funds solutions. If this approach bore no fruit with its larger clients, it offered various quasi-customized index or semi-open target-date funds. Now both Fidelity and Vanguard will, as recordkeepers, accommodate custom target-date funds.
United Technologies Corporation (UTC), the aerospace and building systems multinational based in Hartford, Connecticut, is a clear example of a best-in-class approach to a QDIA. The company has won plaudits for its inclusion of a retirement income component into its QDIA (more on that later), but its approach to its target-date merits real attention. In 2008 UTC adopted auto-enrollment (the company still has a DB plan, but it is closed to new entrants), and its initial default target-date was the off-the-shelf Vanguard target-date series. In 2010, UTC switched horses when it chose AllianceBernstein as its asset allocation and glide path partner. UTC's in-house investment staff (the same group which runs the DB plan) does the underlying manager selection and due diligence. The change represented a philosophical shift, says Robin Diamonte, CIO at UTC: "We wanted more simplicity and more flexibility, and we wanted it at an even lower cost."
The net result is hard to argue with. The United Technologies DC plan now has some $19 billion in assets, of which more than $2 billion is already in lifecycle options that are predominantly custom target-date funds. The Vanguard target-date funds, which were mutual funds, cost participants about 19 to 20 basis points, Diamonte reckons. The custom funds, which are a combination of Collective Investment Trusts and separate accounts, not mutual funds, cost participants about nine basis points, in large part due to the scale of assets now in the funds. The target-date funds' underlying investment sleeves are all passive. Likewise, the plan's six core options, for those participants that choose to make their own investment choices, are all passive, and managed by State Street Global Advisors. United Technologies also offers a mutual fund window for those determined to go it alone, but less than 1% of the fund's assets have taken that route, UTC officials say.
The corporation matches up to 60% of the first 6% of employee contributions. Interestingly, UTC does not default participants into an auto-escalating structure; instead it offers an opt-in auto-escalation feature. That could change to an opt-out option this year, officials say.
Company stock is an old DC bugbear. Here UTC, as is typical for many Fortune 500 companies, is somewhat ambivalent. Participants receive frequent communications about diversification and when a participant who has more than 20% of assets in UTC stock tries to increase their allocation, they must read a specific diversification message before they can proceed. However, UTC still uses company stock in its match. "This is a difficult area for many large corporations," says Josh Cohen, the Chicago-based defined contribution practice leader at Russell Investments. "Most understand that company stock shouldn't play a significant part in their employees' DC portfolios, but that's a fight that few large plans have chosen to fight."
Stable value is another DC option with which many corporations struggle, and most are attempting to de-emphasize. Once again, UTC seems to have differentiated itself, with three fully-wrapped offerings (Prudential, MetLife, and ING are the insurers) but with 16 underlying managers, each with a different benchmark, and all picked and monitored by UTC itself. These stable value funds are valued at over $8 billion—slightly more than 40% of the plan's assets.
Where United Technologies has truly distanced itself, however, is in regard to retirement income. Some forward-thinking corporations have long understood the importance of a guaranteed income stream for their retirees, and sought to put that capability in the hands of its DC participants: IBM, which enables its participants to access an annuity product at institutional pricing at retirement, is the premier example. But UTC has gone beyond this. Working with AllianceBernstein, whose custom target-date/retirement income group is among the more innovative in the industry, UTC has put in place a shift that begins at age 48, defaulting participants already in the lifecycle option fund into variable annuity contracts that put a floor on their retirement income, insulating them from declines in market value . By age 60, their entire balance is essentially guaranteed against loss. Three insurers—Lincoln, Prudential, and Nationwide—together provide this guarantee.
However, the guarantee comes at a price: a 48-year old in the target-date fund will only be paying nine basis points, whereas a fully-insured 60 year-old will be paying 125 basis points per annum, and will have been paying some portion of that 125 basis points for the proceeding years. Of course, any participant can opt out of the lifetime income component of the plan at the outset, and—this is not the case in the retail annuity space—any participant can at any time choose to opt out and receive the entire cash value of the investment fund. "We felt we had to make it completely revocable," Diamonte says. "That was key." The lifetime income strategy was launched in June 2012, and already has $630 million in assets.
No other mega-plan has been so proactive. Russell's Cohen speculates that when it comes to retirement income, many plan sponsors are waiting for the DoL's lead. "They're waiting for a safe harbor ruling," Cohen says. "And we don't think that will come, certainly not anytime soon. "For her part, Diamonte says she has no doubt that, in time, many other plans will follow UTC's lead. She also notes that the company's determination to offer its employees lifetime retirement income in the DC era was a function of the unanimity of vision shared by HR, Treasury, ERISA counsel, and the C-Suite at the corporation. "Everyone bought in," she says. "We examined the pros and cons from every angle, and did our homework. We determined that it was the right thing to do for our employees, and we determined that it was doable at the right price."
For the next few years at least, it seems that large corporate DC plans have their role model. —CR