When considering Defined Contribution plan design, Kristi Mitchem of State Street Global Advisors thinks of creating a sustainable ecosystem. In this context, sustainability is defined as the average plan participant’s likelihood of achieving an adequate income replacement ratio upon retirement. Academics usually peg this ratio at 50% while practitioners say that 70% or more may be appropriate on average, especially in light of increases in projected health care costs for retirees. Whatever the appropriate target ratio, Mitchem points to three factors that influence sustainability: 1) participation levels, 2) asset allocation and 3) menu design.
Why think of an ecosystem? Because these three factors interact with each other. Furthermore, manipulation of any one of them can lead to unintended consequences. Mitchem focused her presentation on some of these issues.
Auto-enrollment is a fairly recent design feature that has had great success in broadening participation among eligible employees. Studies have shown stark differences in income replacement ratios for plans with auto enrollment vs. those with no auto-enrollment feature (60 to 67% for the former, and 9 to 47% for the latter). However, participants tend to cluster around the default deferral rate chosen by the plan sponsor, sometimes causing those who would otherwise save more without an auto-enrollment feature to accept the default. Thus, unintended per capita declines in savings rates have been associated with this innovation.
The antidote may be another innovation; auto-escalation of deferrals. Automatically increasing the participant deferral rate over time has been shown to improve income replacement ratios vs. non-escalating plans. Contrary to common plan sponsor fears, this is accomplished without adversely impacting participation rates. Mitchem highlighted a number of research findings that, in summary, indicate an initial default deferral of 6% with auto-escalation to 10% deferral, lead to optimal income replacement ratio outcomes without diminishing participation.
What about menu design? In this case, less is more. Faced with more than 16 to 18 choices, participants become confused and lower their participation rates. What’s more, they allocate inefficiently among the available asset classes. Mitchem described the tendency to make a 1/N allocation which, in the typical plan menu, often leads to an overallocation to US equities and small caps, and underallocation to international funds. Where employer stock is a choice, a typical allocation is 23%. Even if ample opportunities for diversification are available in a large plan menu, participants simply don’t know how, resulting in undue concentrations.
One way to counter this behavior is through “white labeling”. This practice combines allocations among major asset classes into a single investment choice (i.e. a single choice could contain a standardized exposure to US equities across the capitalization and value/growth spectrum). This also reduces complexity from the standpoint of the participant and may foster improved participation rates among eligible employees. Tangentially, while target date funds accomplish some of the results of white labeling, they should not be the only options available to participants. Individuals will likely wish to retain more transparency to available investment choices and be able to tailor their portfolio to individual return objectives and risk tolerances.
Finally, what ecosystem doesn’t respond to evolution? Mitchem points to exogenous developments in the broader investment landscape that have rendered a couple of typical menu options as dying breeds.
Most fixed income investment choices are benchmarked to the Barclay’s Aggregate, an index that, in recent years, has taken on greater Treasury exposure and reduced credit exposures by way of MBS and Corporates. Furthermore, International bonds are rarely available on the plan menu. A white labeling approach to fixed income that increases credit and international exposures may be appropriate here, particularly for those participants desiring higher yields. For international equities, a white labeling approach may also be appropriate for putting developed and emerging market exposures into balance, akin to an ACWI allocation.
Thanks again to Kristi Mitchem and State Street Global Advisors for their insights on this topic.