Monday, June 10, 2013

Asset Classes in DC Plans -- Should They be the Same as in DB?

I read several summaries of a BNY Mellon white paper entitled "Retirement Reset: Using Non-Traditional Investment Solution in DC Plans." Honestly, I would have read the whole white paper, but after searching for it on the BNY Mellon website using the exact name of the paper and having no related hits come up, I decided that I would have to stick with the summaries.

In any case, the paper attributes the limited range of investment options available in DC plans as the primary reason that participants' accounts in DC plans do not have the same performance as do DB assets. According to the author, Robert Capone, if DC plans were constructed more similarly to DB plans, participants would allocate about 20% of their assets to non-traditional strategies including real assets, total emerging markets, and liquid alternatives.

Reality check time, people!

The bulk of my readers are pretty savvy people. Would all of you choose to invest your own 401(k) money in these asset classes? Would you invest in a fund of liquid alternatives just because it was a fund of liquid alternatives?

There are a myriad of reason why participants in DC plans, on average, do not get the returns on investments that DB plan sponsors do. Here are some:

  • In theory, DB plans, have an infinitely long investment time horizon. That is, open DB plans generally do not have an accumulation phase and a decumulation phase. Sound sponsors can withstand blips.
  • In a DB plan, sponsors fight to keep asset-related fees low. They know that every dollar that they pay out in fees is a dollar that they will have to contribute. And, in fact, since PPA, it is generally a dollar that they will have to contribute immediately. In DC plans, usually, the investment management fees come right off of participants' top lines. It is human nature that plan sponsors will be seeking to get a good deal for participants, but not be as concerned as they are on the DC side.
  • DC plan participants, even if they choose to invest in non-traditional strategies, do not usually have the knowledge or the tools to develop an investment portfolio that sits on an efficient frontier.
  • DB plans don't have leakage. Whereas participants in DC plans may take plan loans or hardship withdrawals and have periods during which they are either unemployed or choose to not defer, DB plans have large pools of assets and liabilities.
  • DB plans spread those asset pools over a group of participants. The group has a liability profile and the group is diverse. In a DC plan, a participant is one unique person. That person is of a given age, and in an ideal world, one year later, that person will be exactly one year older. As the participant ages, if he follows prevailing wisdom, his portfolio should get more conservative. Are we really espousing that a 55-year old such as me should have 20% of his plan assets in non-traditional strategies? If so, should my bias be toward liquid alternatives? According to research that I did on a number of investment websites, this class has among the highest risk of all asset classes. Isn't it a little bit late in my working lifetime for me to be taking those kinds of risks?
In summary, I suspect that the BNY Mellon white paper is well-founded and well-written. But, it seems to me highly theoretical and perhaps not particularly practical advice. I have my own reasons why DC returns are not as good as those in DB plans.
  • Market timing -- many DC participants see that the markets are going up or down and move into equities after a rise or move out of them after a fall. Being behind the trend is not the way to increase investment performance. A set it and forget it strategy is generally better.
  • Target-date funds -- Target-date funds or TDFs are often the best way for participants in DC plans to have a properly diversified portfolio. However, when plan sponsors choose the family of TDFs for a plan for their employees, they typically do not do research to seek the best TDF. What happens more frequently is that they use the TDFs of their recordkeeper. As I have written many times, most TDFs are not funds of the best of the best. Instead, they are funds of proprietary funds. So, to pick on two of the largest players, a Fidelity TDF probably does not contain any Vanguard funds, and conversely, a Vanguard TDF probably does not contain any Fidelity funds. Custom TDFs are becoming more popular, but in practice, they are largely restricted to plans of large plan sponsors.
  • Lack of professional asset allocation -- A large DB plan will typically have an Investment Committee that controls its investments. That committee often has several people on it with professional training in investments. They engage outside advisers to monitor funds. They engage outside advisers to assist with asset allocation. They often pay large sums of money to see the results of asset-liability modeling. Such modeling often starts with goal-setting. On the DC side, even to the extent that a similar process is followed, it is done en masse. I'll bet that your plan's Investment Committee never asked you about your risks and your goals in developing an asset lineup for the plan in which you are fortunate enough to participate.
There are lots of reasons that DC plan returns, on average, are not as good as those in DB plans. I'm sorry to have to say it, but in my humble opinion, the lack of availability of real assets (are these different from fake assets), total emerging markets (as compared to partially hidden markets) and liquid alternatives (is this red versus white or Red Bull versus Monster) is not the answer.

I apologize for being so cheeky on a Monday morning, but I'm afraid that my parentheticals are not far from the average participant's comprehension of those asset classes.


  1. Cheekiness becomes you. :-)

    Nice article with some new insights from the usual read.

  2. Thank you "Anonymous" and thanks for reading. I'm just trying to speak what I believe to be the truth.

  3. This is anonymous II.

    Having been in the plan sponsor role for well over 30 years at four different fortune 500 employers, the fact is that the comparison is without much merit.

    Simply, these are different components in the portfolion of some of the same investors, and frankly, in many situations, the investors / participants in the plans are dramatically different. So, if they are measuring the investment performance of the same individual, comparing her DB plan investment performance with her DC plan investment performance, SHOULDN'T the investor have different investment priorities, different investment time horizons, different allocations, etc. comparing DB with DC? Simply, most of the time, the participant has a much more restricted selection of investments, compared to DB plans, ... much as they would have different objectives/priorities for other investments (IRA's, social security, etc.)

    And, I believe the data bear that out, that individuals who have both DB and DC invest differently (and have much different returns in their DC plans) than those with DC only.

    It is really more informing to note that the DB and DC participant populations are significantly different - even for the same plan sponsor. The DB plan retains as participants individuals in the annuity payout phase, while individuals in DC plans often cash out and rollover upon or after separation.

  4. Anonymous II, thanks for reading and commenting. Nice to hear from the plan sponsor side.