Signed into law by President George W. Bush on August 17, 2006, the Pension Protection Act (PPA) heralded the most significant changes to the nation’s pension laws since the Employee Retirement Income Security Act (ERISA) of 1974.
The sweeping reform was designed to strengthen the beleaguered pension system by establishing new investment alternatives, penalizing companies that underfund their pension plans, and giving participants greater control over how their funds are invested.
Clint Cary
As the law approaches its 10th anniversary, we turn a critical eye toward how the PPA has impacted employers and employees — both positively and negatively — and take a look at actions that CFOs and CIOs can take to further strengthen their companies’ plans.
Over the past decade, there have been vast improvements in participant outcomes as a direct result of the PPA and employers’ response to its provisions. In particular, the massive shift toward automatic enrollment in defined contribution (DC) plans has propelled more workers to start saving in employer-sponsored plans.
Traditional DC plans required employees to proactively opt in, making it all too easy for individuals to put off saving, typically because they felt they couldn’t afford to have some of their income routed toward what seemed a long-off eventuality. Automatic enrollment has drastically increased the number of individuals participating in a retirement plan, simply because opting out requires them to take action — and basic human nature dictates that most people will leave things as-is, rather than take the extra time and effort to opt out. According to new data from Aon Hewitt, 86% of workers participate in their employer’s DC plan when they are automatically enrolled, compared to just 63% for those who aren’t.
Likewise, automatic escalation has served to increase workers’ retirement savings by routinely raising the amount directed from an employee’s paycheck into his or her DC plan. Once a year — typically when pay raises are provided or on the anniversary with the company — their contribution increases by a designated amount, without the need to take any action on their part. Over time, we believe this strategy proves effective, as employees’ retirement savings grow without direct action by the employee.
The PPA also paved the way for Qualified Default Investment Alternatives (QDIAs) — that is, investment funds or portfolios that deliver both long-term appreciation and capital preservation through a mix of equity and fixed-income investments.
The QDIA rules enabled a massive shift from core menu of investments — mutual funds, stocks and bonds, etc. — to target date funds (TDFs). Also known as lifecycle, dynamic risk, or age-based funds, TDFs employ a “glide path” approach wherein they adopt a more conservative investment strategy as retirement (the target date) grows near. A professional asset manager is responsible for making asset allocation decisions, thus eliminating participants’ tendencies to chase returns by investing in funds that were doing well, only to see them subsequently falter. The shift of the default investment from a low-yield, fixed-income portfolio — typically a stable value fund — to target date funds has resulted in a potentially greater opportunity for long-term accumulation of wealth.
Clearly, these so-called “safe harbor” protections have improved participation, increased employee contribution rates, and helped individuals financially prepare for retirement with relatively little effort on their part. In other words, the reform brought about by the PPA has been good — in the short term. Unfortunately, it’s also created a number of unintended long-term negative consequences that threaten to weaken these retirement plans if action is not taken.
Unintended Consequences
As more assets are invested in target date funds, plan sponsors have inadvertently turned their attention away from the core menu. Clearly, TDFs may provide an effective tool for participants to manage their retirement savings; however, a more balanced allocation of the resources of the plan would be more appropriate.
At the same time, assets are moving from customized portfolios in the core menu to standardized portfolios in the target date fund. While TDFs are intended to be a complete package, it’s unlikely there exists a single provider with expertise in every component. Plan fiduciaries work diligently to ensure that the core menu is constructed in such a way that best-in-class investments are available to participants. Target date funds should be approached with the same diligence and customization.
As more money flows into TDFs, the assets invested in the core menu become less as a percentage of total plan assets, leading to a reduction in buying power and fewer investment opportunities. The end result is a less effective — and possibly more expensive — portfolio for participants who wish to take a more hands-on approach to their retirement investments. This further accelerates the move to TDFs, reducing the opportunity for employees to build a portfolio that meets their individual goals and objectives.
Unfortunately, most companies are unaware of these unintended consequences. Plan sponsors made their decisions about the construction of the menu years ago, and most have not revisited them. With all the focus on health benefits, labor costs, and other talent-related matters, you can’t really lay the blame on Human Resources. Since their attention has been drawn away from the retirement plan, they may not realize there’s any need for course correction. Therefore, it is incumbent upon finance executives to help improve the structure of investments in the plan.
Identifying opportunities for improvement can be challenging, because the unintended consequences are not visible. If a 401(k) is low-cost, features recognized national brand names, and has lots of participants, it’s easy to brand it a good plan. It’s necessary to peel back the layers, however, and consider the metrics around employee retirement readiness and portfolio efficiency.
Finance’s goal must be to build portfolios that balance the needs, objectives, and goals of all participants. The core menu should be constructed in such a way that it minimizes confusion for participants. Technology has enabled a better approach by offering “white label solutions” with a focus on investment concepts — large-cap stocks, small-cap stocks, investment-grade bonds, or high-yield bonds, for example, rather than utilizing branded products.
The investment options in the core menu are essentially best-in-class combinations of investment strategies. These “building blocks” can be combined to assemble TDFs that are customized to reflect the unique characteristics of the population. Participants may allocate their own TD solutions or choose pre-allocated, dynamically managed assets. Such an approach to target date strategies may represent a great value for all participants.
Another unfortunate consequence of the PPA has been a rush to the bottom in terms of fees. If you can pay less for something, that’s great, but it’s important to remember that cheaper isn’t always better. For example, passive TDFs are a fiction: asset allocation decisions are active and are the key driver of outcomes.
It’s worth taking the time, effort, and — yes expense to build the right caliber of solutions for your specific participant set. Remember that your fiduciary responsibility extends across all plan participants, so be careful to give equal attention to all components of the plan, not just what’s in vogue at a given point in time.
Clint Cary is head of North America delegated solutions and chair of the global investment committee at Aon Hewitt Investment Consulting.
