Innovations in DC: Leveraging Data and Design – Pensions & Investments

As defined contribution plan sponsors continue to seek out approaches to help their employees improve retirement security, they are leveraging automation, personalization and a wider menu of products suitable for different stages of the plan participant’s journey from accumulation through decumulation. These efforts are being bolstered by legislation and regulatory guidance, particularly with regard to retirement income and the addition of more diversified investment options.

Coming off two years of the pandemic, a heightened focus on the overall financial wellness and retirement readiness of employees has led many plan sponsors to contemplate adjustments to their DC plan investment lineups. The challenges of the current macro-environment, with inflation at its highest level in 40 years and low returns forecasted to persist across asset classes for some time, have necessitated a refinement of DC investment menus. “The ultimate goal is to maintain a standard of living in retirement, and the approaches to achieve that [via DC plans] are changing. This is a good time for plan sponsors to reconsider their mix of options, both for core menus and default investments, as well as for features in their plans,” said Rene Martel, managing director and head of retirement at PIMCO.

Supported by the Setting Every Community Up for Retirement Enhancement Act of 2019, the implementation of retirement income solutions — long discussed but not acted upon by many sponsors — has now increased significantly. “The market will begin to center around income being the new outcome,” said Bill Horvath, senior managing director of corporate retirement solutions at TIAA. “We’ve come to the point where certain cohorts of participants are nearing retirement, satisfied with what they’ve saved, and they want to know what to do with it.”

The attention of many employers to the full experience of DC plan participants, to and through retirement, has led to an industry shift toward seeing DC plans as not just traditional tax-preferential savings accounts, but also as retirement income-generating vehicles, Horvath noted. The most likely way to deliver the latter aspect is by providing participants with a range of investment options that offer capital accumulation and preservation along with guaranteed retirement income, he said. And while DC investment menus have default options that work for many, they are also evolving to include personalized options that meet specific participant needs. (see chart)

Indeed, personalization is fast becoming an overarching theme in DC plans, bringing more access and flexibility across a broader suite of products to improve employee retirement readiness.

“Providing the education and guidance that participants need is critical, and the increasing use of automation, data and information will continue to accelerate” and improve that engagement, said Horvath. “Institutions have the data that can be used to assist retirement decision-making, [and they are analyzing that data] as long as it’s appropriate and not intrusive.” Plan sponsors are using participant information on age, compensation and other demographics, as well as behavioral information, to help build overall financial wellness, improved financial security and, ultimately, a prosperous retirement. “That’s where we’re headed,” he said.

The focus on personalization that is driving DC investment menus includes refinements to the qualified default investment alternative, which is the target-date fund in a majority of plans. “The most pressing opportunity for QDIA innovation is to introduce personalization that better aligns the suitability of investments with the participant’s circumstances, while maintaining the features that they appreciate the most from traditional target-date funds, such as the absence of an engagement requirement and having a reasonable cost and relatively low level of complexity. If you can achieve all those objectives with innovation and the help of technology, we believe that plan sponsors and participants will embrace personalization,” said Martel.

The industry is keenly watching regulatory guidance that impacts DC investments, whether that’s about environmental, social and governance integration or considering alternatives on investment menus.

“Over the past year, the macro impact on DC plan management has been less about the effects of the coronavirus and, going forward, it will be less about rising interest rates. The focus has been on interpreting and implementing regulatory guidance,” said Bill Ryan, partner and head of defined contribution solutions at NEPC, referring to the Department of Labor’s guidance on incorporating ESG factors as well as private market investments. “Over the past two years, the fundamental lesson that the pandemic has taught plan sponsors is to focus on what they can control.”

“While the [language of the] guidance may have seemed vague, plans are more keenly focused on its intent, which has been less about the ways to incorporate ESG and private markets, and more about the duty of care and fiduciary responsibility when selecting investments for participants,” Ryan noted. “If a sponsor can perform the proper due diligence on what’s suitable, either ESG or private markets can be offered within a defined contribution plan,” he said.

The pandemic has intensified sponsors’ sensitivity to financial insecurities, and that continues in their focus on participants’ financial wellness. “Depending on where they are in their lives and their financial priorities, participants remain concerned about debt management, student loan repayments and other needs that factor into their complete financial picture,” said Horvath at TIAA. Plan sponsors are responding to the rise in requests for help with personal budgeting, overall financial planning, saving for retirement and determining adequate cash flow in retirement, he said.

Many employers took the lead in providing health savings accounts, life insurance and managed-account offerings while at the same time exploring lifetime-income options. Now more plans have joined in, and discussions about these products have deepened dramatically because of employees’ greater demand for financial security and guidance. “Financial wellness will continue to be an area of major focus for sponsors. The COVID pandemic has also allowed employees to have a larger voice in shaping the financial wellness and retirement programs that their firms offer to attract and retain talent,” Horvath said.

“During any form of market crisis over the past two decades, DC plan sponsors have increased their participant communications. Amid COVID, digital communication channels like teleconferencing and chat platforms have accelerated and become a part of the standard business practice, strengthening the employee-employer relationship,” said Ryan. In keeping with this trend, plan sponsors have scaled up all forms of digital interactions, including one-on-one sessions with financial advisors on topics ranging from financial wellness to HSAs, student debt and other areas.

“Now participants can easily meet online with trained investment professionals without having to rely on their brick-and-mortar locations. Interestingly, we’ve found that the camera provides the right mediation for participants. They are more comfortable speaking about personal financial topics and [more open to] receiving the guidance they really need,” he said.

As part of their increased attention to employees’ overall financial security, many DC plan sponsors and their consultants are utilizing workforce data analytics to closely assess the suitability of their investment menu for their plan participants. “In the last two years, we have seen sponsors streamline their investment lineups more strategically to make sure that they have the appropriate number and lineup of offerings, and fair pricing [for those offerings],” said Bill Horvath, senior managing director of corporate retirement solutions at TIAA. “That [process] has led to new and innovative approaches, like custom defaults, which we [are seeing] more sponsors and consultants consider and implement,” he noted, referring to custom target-date funds as the default solution.

Read: A fiduciary’s guide to offering lifetime income

One example is a target-date fund approach with multiple glidepaths, starting from core investments and diverging for different individuals, depending on their situation nearer retirement, to include annuities that provide lifetime income, Horvath said. With the SECURE Act providing a safe harbor provision for offering annuities and lifetime-income options in DC plans, the implementation and integration of these options has become a high priority for many plans. “We’ll start to see income as part of a default feature, whether that’s a target-date fund or some type of custom glidepath,” Horvath said.

At PIMCO, “our primary approach to retirement income is to deliver in-plan nonguaranteed solutions, simply because that’s where the highest level of interest and advocacy is today. That’s mainly because participants tend to value liquidity and having access to their assets at any time,” said Joseph Healy, senior vice president, account manager and specialist in the defined contribution practice at the firm. “Also, sponsors want operational simplicity and portability with something that delivers what participants seek.” Healy said that he expects interest in guaranteed solutions to grow in time with the expansion of non-pension participant retirees.

Healy also pointed to additional developments in the required lifetime-income disclosure, based on the participant’s current balance, that could be refined for different investments. “Currently, it’s a single number based on one set of investment assumptions. But it would be helpful for participants to have more information [across different investments] to help decide on their investment mix and level of risk.”

Some plan sponsors have taken the approach to lifetime-income solutions as a critical component of employees’ spending-down decumulation phase. “Lifetime income is not simply a type of investment or a plan option decision, it’s a plan design decision,” said Horvath. “With nearly 80% of participants staying invested in a default option after enrollment, it’s important for sponsors to ensure that they solve not only for the accumulation of savings, but also for the retirement income part of that equation. Our approach is an in-plan annuity that offers lifetime income as part of the default structure.”

Recent TIAA research showed that more than half of participants are highly interested in an annuity that provides lifetime income if it was offered through their employer’s retirement plan, Horvath said. “In-plan annuity options as part of the default will soon become the norm, and that’s where we see the majority of assets going.”

Target-date structures are evolving via the use of artificial intelligence, automation and more advanced modeling techniques. “Personalized target-date funds could be a significant breakthrough. They require close coordination with the recordkeeping community, but there are ways to leverage technology to minimize cost and complexity, and to facilitate their construction,” said James Bentley, executive vice president and national retirement sales manager at PIMCO. “There’s a middle ground between off-the-shelf target-date funds on the one hand and a managed account on the other, and we’re beginning to leverage the benefits of both.”

A fair amount of engineering is required to structure personalized target-date funds initially, but it may not be any more challenging than other prior innovations in the DC space. “First, it’s a matter of working with a technology partner to on board the record keepers. There’s a little bit of build needed, but we’re using an existing target-date complex and we’re leveraging existing record-keeping data; we’re using what’s already available to deliver a degree of personalization,” said Rene Martel, managing director and head of retirement at PIMCO. The first iteration uses an algorithm that combines existing target-date vintages, he explained. “We’re just working on the engine to personalize it for each participant, as opposed to offering a single product for everyone in a specific age range.”

In addition, this development and application of technology to target-date products offers a framework for further innovation. “While we’re initially targeting suitability, down the road, plan sponsors will have other objectives, whether it’s incorporating ESG or taking more of an income focus towards the end of the target-date horizon. Once we’ve built that grid of personalization, those other elements can be integrated, so you’ve not only made an innovation in one area, but you’ve made future innovation much simpler,” Martel said. PIMCO helped sponsor a survey showing workers’ responses to investments in TDFs, income options and ESG options (see chart). The survey also showed improvements that workers want to see in their retirement savings plan (see chart).

Behind the innovation in target-date funds and structures is market competition and asset growth for the investment management firms that are looking at the space between TDFs and managed accounts as they try to lower the cost of access to custom or personalized solutions. “The invisible hand of economics is real when it comes to target-date funds today,” said Bill Ryan, partner and head of defined contribution solutions at NEPC. Industry competition for market share has been fierce, he noted, which has dramatically improved the sophistication in approaches to TDF construction. The focus on refining and personalizing TDF structures will continue across all stakeholders in the DC industry as they seek to improve plan participant retirement outcomes.

The current macroeconomic environment, including the upward trajectory of inflation and lower expected returns across traditional assets, has led plan sponsors to carefully assess investment menus and plan designs. Many have added some inflation protection or have diversified their offerings, while others are considering custom or white-label structures.

“To address the implications of inflation, low interest rates and potentially lower returns, a plan sponsor could take a broad approach when selecting core menu options and focus on the outcome as opposed to the traditional asset class construct,” said Rene Martel, managing director and head of retirement at PIMCO. For instance, Treasury inflation-protected securities have traditionally been the go-to asset for inflation protection. “But now, TIPS yields and their expected returns going forward, like most other fixed-income assets, are fairly low, so sponsors need to consider other inflation-protection strategies,” he said. One is a multi-asset solution that combines TIPS into a single strategy with other inflation fighters, such as real estate, commodities, emerging markets and other assets. “This can meet your objective with a better return profile than a more narrow or traditional option.”

A multi-asset approach applies to broader plan investment objectives as well. “For example, if a plan is looking for a multisector credit approach, it might look further than a constrained domestic option. To overcome the current low-return environment, you can think about broader solutions across the credit spectrum and geographies, and put more weight on diversification,” Martel said.

Inflation-sensitive assets are important for participants around age 50 or 55 who are close to beginning to withdraw from the plan, especially those within a target-date fund, said Bill Ryan, partner and head of defined contribution solutions at NEPC. But plan sponsors need to also consider the potential impact of the depth of inflation. “A time horizon shorter than one year could be hedged through TIPS or real estate, but inflation begins to work its way through core bonds and even equity if the time horizon is much longer than a year or two.”

Plan sponsors are also considering active management, particularly for fixed income, in a challenging market environment. “The active-passive pendulum will always swing to some extent but, currently, it probably needs to swing more towards active,” said Martel. While some point to few active equity managers outperforming their benchmarks, the opposite is true in fixed income. “Our analysis shows that more than 80% of active managers in fixed income consistently outperform their passive peers,” he said.

As fixed income becomes a more significant asset category toward the end of the glidepath, one strategy is to focus on higher-yielding fixed-income categories. “As rates are uncertain, guaranteed lifetime-income solutions can remove some of the market volatility by building an income floor for retirement that participants can factor into returns and their ultimate asset allocation,” said Bill Horvath, senior managing director of corporate retirement solutions at TIAA.

Most participants close to retirement are invested approximately 50% stocks and 50% bonds as they are in the default solution, noted Ryan. “That balanced allocation tends to be beneficial in today’s low-rate environment, especially with the strong performance of equities over the last two years. Alternatively, we see sponsors give more consideration to income-generating products already in the market, such as a multi-asset credit fund, stable value or a fixed-annuity solution, that can still provide yield near retirement but also smooths the volatility that we’re seeing today,” he said. In addition, retirees still have an average 20-year time horizon ahead of them, which allows them to lean on equity and dividend-producing investments that will offset the current low rates, he noted.

Asset growth, simplification of options and improved oversight are some of the reasons that plan sponsors continue to adopt custom solutions and white-label plans.

DC plans are increasingly moving to custom solutions, partly because of rapid asset growth — a $500 million plan five years ago could easily be a $1 billion or $2 billion plan today because of contributions and market appreciation, Ryan said. Today they have become “more eligible for customization from a cost perspective, and operational issues may require a custom or white-label solution because of their asset size,” he explained. For instance, if they are the sole investor in a single fund, they may need to diversify away from manager concentration risk. (See chart below).

A recent PIMCO consulting survey indicated that more than $800 billion in DC assets are held in white-label funds, said Joseph Healy, senior vice president, account manager and specialist in the defined contribution practice at PIMCO. “When you add custom target-date funds, it’s more than $1 trillion, which is obviously a significant portion of total retirement assets.”

White-label structures have several benefits, Healy said. “They simplify the menu and make it easier for sponsors to change investment managers and increase diversification, which is the main way we see them being used.” For example, a sponsor may find it easier to incorporate a portable alpha equity option that provides diversified sources of return into a white-label offering rather than providing it as a stand-alone option to participants that would be too complex to explain. Another example is a multisector income fund combined with a core investment option that can provide more robust fixed-income allocation in one stroke. “There is a lot going on in white-label solutions, but they tend to fly under the radar,” he said.

“We’ve seen significant adoption of custom defaults, and our offering can act like a target-date option within a model portfolio structure. One of the things that differentiates our programs is that the plan sponsor or consultant can choose to use a fixed annuity as part of the bond allocation. This portion of the model will provide participants guaranteed returns, reduced volatility and the opportunity for lifetime income when they retire.” said Horvath at TIAA. “But any custom solution has to be right for the sponsor and the participant, and it has to be constructed based on the attributes of the participant population and its behaviors,” he said.

Another area of interest by plan sponsors is managed accounts, particularly for participants nearing retirement, as they tend to have more complex financial situations, Horvath said. “Managed accounts tend to provide more oversight and customized investment allocations, and they are especially effective at managing lifetime-income solutions by holding a fixed annuity as a replacement for some of the fixed-income investment allocation,” he said.

Sponsors are evaluating other features as well. Those firms that have sophisticated investors and want to offer additional flexibility may add a brokerage option. “There’s also a lot of interest in alternatives, like private equity and real estate at the moment, and guidance from the Department of Labor has encouraged sponsors to take a closer look. Also, ESG is coming into better focus for some firms, and offering ESG investment options and integrating ESG factors in core investments is starting to accelerate,” said Horvath.

Extending retirement security to more employees and the focus on retirement outcomes continues to drive the legislative and regulatory agenda for DC plans. In the process, DC plans are becoming more responsive to employee preferences for environmental and social considerations.

The SECURE Act of 2019 allowed unrelated employers to band together to offer pooled employer plans and expand DC plan access with lower administrative costs. “We’ve certainly seen interest in PEPs, predominantly from small companies and startups with fewer than 50 employees, [since] providers started to bring these products to market in the beginning of 2021. But there is also interest from larger companies,” said Jamie Bentley, executive vice president and national retirement sales manager at PIMCO. Some plan sponsors have remained on the sidelines due to the simplicity of early PEP designs, with fixed investment lineups, match formulas and vesting schedules. “Over time, we expect the PEP market will allow for more flexibility while still reaching the scale that it’s trying to achieve,” he said, noting, for instance, that technology that provides personalization at the individual level could make it more suitable for different plan sponsors to use the same target-date fund provider.

“Employers that consider joining pooled or multi-employer plans should weigh a number of factors,” says Bill Horvath, senior managing director of corporate retirement solutions at TIAA. These include the level of fiduciary responsibility, the goal of the plan, its costs, administrative obligations and customizability, and how much control over the plan is ceded. “If properly built, PEPs can provide ease of administration, lower costs and lifetime-income options, but there are trade-offs around control and the fiduciary aspect,” he said.

“Pooled employer plans could be the surprise innovation coming out of the SECURE Act,” said Bill Ryan, partner and head of defined contribution solutions at NEPC. PEPs are growing rapidly across all sizes of DC plans, he said, with the larger plans interested in achieving better operational efficiencies. Additionally, features like guaranteed income and private market investments could have a role as PEPs move upscale and pricing becomes level across plan providers, allowing access to investment solutions at lower rates than what individual plans can get by themselves, he said.

Bill Ryan, partner and head of defined contribution solutions at NEPC. PEPs are growing rapidly across all sizes of DC plans, he said, with the larger plans interested in achieving better operational efficiencies. Additionally, features like guaranteed income and private market investments could have a role as PEPs move upscale and pricing becomes level across plan providers, allowing access to investment solutions at lower rates than what individual plans can get by themselves, he said.

Both plan sponsors and participants, particularly younger generations, are looking to align their investments with their values. The Department of Labor’s most recent guidance was favorable to ERISA fiduciaries in their consideration of ESG factors in investments.

“Consideration of ESG in retirement plans is changing faster than plan sponsors realize. You can no longer judge a book by its cover: You need to look past the fund name and read the investment thesis,” Ryan said. Many asset managers already apply ESG factors in their investment processes, and while ESG may not be in a fund’s name, nearly a third of retirement assets are invested with ESG principles, he noted. “Consultants need to be more articulate with plan sponsors and explain how ESG actually is being used by their asset managers.”

“In the past, sponsors may have had an ESG option or two in their plans, but now they’re thinking about it more holistically and adding it to their tiered menus, whether it’s the [qualified default investment alternative] or complementary options,” said Horvath at TIAA. “There is more discussion needed around incorporating ESG into every investment option, but it’s definitely a higher priority, equal to considerations around plan costs, performance and general asset allocation.”