Successful Defined Contribution Investment Design. Gao Ying

I had the great fortune of working with financial professionals who immediately recognized the power of tax-deferred retirement investing. One experienced colleague told me, “If you participate in this plan, you’ll be a millionaire someday.” That’s all I needed to hear to sign up for automatic payroll deductions into my plan – a practice I have never stopped. Today, I am among the many millions of workers around the world who will fund retirement primarily with my defined contribution assets. I am very fortunate to have been advised to start saving early, and to have ignored others’ suggestions to postpone retirement savings and “enjoy being young.” I’m also lucky that I’ve had access to an employer-sponsored plan funded via automatic payroll deduction, and to have a healthy investment menu from which to choose.

      In short, I’ve spent my working years with a defined contribution (DC) pension, versus the “traditional” defined benefit (DB) pension. I believe that my personal experience, as someone who started working just as 401(k) plans came into being, has helped me understand the power and importance of “getting DC right.” In 1989, I joined Hewitt Associates in Lincolnshire, Illinois, and shortly thereafter turned 100 percent of my professional focus toward consulting to DC plan sponsors and research, including creating the Hewitt 401(k) Index to track participant reaction to stock market movements. Since that time, and in the 10-plus years I’ve spent working at PIMCO, getting DC right has not only been a personal but also a professional passion. As my career is exactly as old as 401(k) plans, this means that DC plans and I have “grown up” together.

      Part of growing up for DC plans has been the evolution toward more institutional structures, which some refer to as “DB-izing” DC. This movement includes shifting away from retail-priced packaged products, such as mutual funds and closed-architecture target-date funds, and toward collective investment trusts, separately managed accounts, and custom multi-manager structures. These shifts can be beneficial for plan participants: Using institutional investment vehicles and improving asset diversification may lower plan costs and improve risk-adjusted investment returns for participants. For example, if an investor could earn an additional 100 basis points (1 percent), over a 40-year career, this expense and return difference adds up. Indeed, for someone starting with a salary of $50,000 – and assuming annual real wage gains of 1 percent; contribution rates, including the employer match, of 9.5 percent (in the first 10 years) and 15.5 percent (for the next 30 years); and conservative portfolio returns of 4 percent per year – an additional portfolio return of 1 percent plus the reduction in expenses resulting from the shift from retail-priced products compounds after 40 years into about $210,000 when retirement starts. This extra sum may be sufficient to boost the retirement income replacement rate by 16 percent throughout retirement (that is, the extra sum can be used to provide yearly income in retirement that is equal to 16 percent of yearly preretirement pay).

      To support the ongoing transition of DC plans toward more institutional structures, in 2010 I worked with Lew Minsky, Executive Director of the Defined Contribution Institutional Investment Association (DCIIA), to launch and serve as the founding Chair of this organization. DCIIA is a community of retirement leaders that is passionate about improving the retirement security of workers by improving the design and outcomes of DC plans. DCIIA brings together professionals from across the DC market, including consultants, asset managers, plan sponsors, recordkeepers, insurers, lawyers, communication firms, and others, all working together on this common goal.

      Today, as DC plans are poised to become the dominant form of retirement savings around the world, I am inspired to provide a book to help guide the development of successful DC plans primarily for the benefit of employers and workers now and in the future. My hope is that plan sponsors, consultants, and other plan fiduciaries, by engaging with the materials in this book, will take away an empowering framework and insights to help structure and further evolve DC plan design.

      DC PLANS: BECOMING THE NEW REALITY.. NO TURNING BACK

      DC plans are a large and growing market globally, representing nearly half the world’s $36 trillion in estimated total pension assets. Over the past decade, the global share of pension assets held in DC plans in the world’s major pension markets has increased dramatically, from 39.9 percent in 2005 to 48.4 percent in 2015 – and DC assets have also grown at a faster pace than DB assets, at a rate of 7.1 percent per year compared to the slower pace of 3.4 percent per year for assets in DB plans (Willis Towers Watson, Global Pension Assets Study 2016, covering 19 major pension markets). While DC pension assets are increasing around the world, the United States, Australia, and the UK represent roughly 90 percent with 76 percent, 7.5 percent, and 6 percent of the global DC pension assets.

      In 2014, we spoke to Brigitte Miksa, Head of International Pensions (and Executive Editor of PROJECT M at Allianz Asset Management AG), about the development of retirement systems around the globe. We discussed the shift in weight among the pillars or sources of retirement income, including the first source of public pensions, such as Social Security, and the second source of occupational programs, both DB and DC. We also contrasted reliance on the different sources of retirement income and DC developments within three market segments: Anglo-Saxon countries, developed European countries, and emerging pension markets.

      Looking forward, as each market develops and DC assets grow, Miksa expects the plans in these markets will become increasingly “professionalized,” such that decision-making about asset allocation and more will shift over time to professionals, away from individual participants. (These shifts mirror the evolution toward institutionalized structures for DC plans discussed above.) She told us:

      Starting in the early 1990s, many countries initiated pension reforms and we began to see shifts in the dependency on different retirement income pillars. The initial wave of reforms focused on sustainability of the first pillar – government-funded public pensions such as Social Security. With the recent financial crisis, more pressure has been placed on reforming public pensions, and fortunately, these efforts have been quite successful in many cases. For instance, increasing the age for public pension qualification will help with the sustainability of public pensions in many countries.

      Another significant global shift is occurring in the second pillar – employer-sponsored or occupational pension schemes. We continue to see rapid movement away from defined benefit pension plans and toward defined contribution systems. This shift started in the Anglo-Saxon countries, including the U.S., Australia, Canada and the U.K., and continues to spread to other developed markets like the Netherlands and Norway, as well as to the emerging markets.

      Over the past decade, Miksa told us, more than half of the 34 countries in the Organisation for Economic Co-operation and Development (OECD) have rolled out DC programs. While the Anglo-Saxon countries continue to dominate in their percentage of global DC assets accumulated, other markets are showing rapid development; these include Denmark, Israel, Italy, and Turkey.

      As the move away from traditional DB pension plans continues, workers are increasingly reliant on DC pension schemes to build their own retirement income. Employers, too, are reliant on DC plans to both attract and retain talent, and to manage their workforce – reducing the cost and the potentially detrimental effect of retaining workers beyond their desired retirement age. Multinational corporations commonly manage their DC plans worldwide with the aim of providing a valuable retirement savings vehicle as well as local-market competitive benefits (PIMCO’s 2015 Global DC Survey for Multinational Corporations). Over a third of these organizations have a written global retirement plan philosophy, while another third say they are likely to write one over the next year or two. These employers view “the ability to attract and retain talent” as the top return on investment for offering retirement benefits – this motivation is followed by a “sense of doing what’s right.”

      SETTING GOALS FOR SUCCESS: INCOME REPLACEMENT TARGETS

      Whether you’re a multinational plan sponsor, a single market, or a public employer, we know that for a DC plan to succeed, that plan may need to deliver an old-age income stream to last 20 to 30 years in retirement – or perhaps even longer. Consultants surveyed in PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey suggest that plan sponsors set an income replacement target at 80 percent of final pay, including Social Security and other income sources. They suggest that a DC plan will need to replace 60 percent of a worker’s