Administration January 3, 2022

DC Plan Design Can Be Creatively Used to Get Participants Back on Track

Dr. Shlomo Benartzi says the pandemic is a perfect time to use plan design features that tap into behavioral science.

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Many individuals didn’t have a choice but to lower their defined contribution (DC) plan savings rates, stop contributing or take loans or withdrawals out of their plans because of the economic impact of the pandemic, noted Dr. Shlomo Benartzi, professor emeritus at the University of California, Los Angeles (UCLA) Anderson School of Management and senior academic adviser at Voya Financial, during a Voya podcast.

The podcast, “Plan Designs During Challenging Times,” hosted by Bill Harmon, chief client officer, and Heather Lavallee, CEO of wealth solutions at Voya, addressed what employers can do to help participants get back on track with their retirement savings after events like the pandemic or economic recessions.

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Benartzi said thinking about how legislation to encourage more people to save for retirement was passed shortly before the pandemic, but when the pandemic hit America, legislation was passed to make it easier for people to take money out of their retirement plans, shows that there is a need to help individuals plan for the long-term as well as tackle issues along the way.

At the point when an individual is struggling and considers lowering or stopping his retirement savings is a good time for plan sponsors to capitalize on the behavioral economics theory of present bias—where individuals focus on the present benefits of something rather than on the future, said Benartzi. Plan sponsors can offer these employees a path back to savings, he said.

“Plan sponsors can say something like, ‘We understand you have to stop saving today, but how about we set it up so you start saving again at the same rate a year from now, and we’ll set you up for automatic escalation,’” Benartzi said. “That can be an extremely effective way to address both the present need to stop contributions or take a loan from the plan and the future need to get savings back on track.”

Benartzi took some time to talk about default savings rates, saying the industry standard of 3% that many plan sponsors adopted after the Pension Protection Act (PPA) was passed in 2006 is “way too little and won’t get people to the finish line, while creating an illusion of safety because people think if the employer set it up that way, it must be the right thing.”

He noted that years after the passage of the PPA, a paper suggested plan sponsors could push the default savings rate up to 6% and employees wouldn’t opt out, “That tends to work best for people who aren’t inclined to save,” Benartzi said. “Very often it lifts the savings rates of minorities and other groups who don’t save much. It works to close gaps in savings.”

Benartzi said he was among researchers who did a study pushing savings rates up to 6%, 8%, 10% and 11%. The study found that as rates were pushed higher, not only did employees not opt out of the plan, but many engaged with the plan and if they felt the savings rate was too high, they lowered it themselves. In addition, Benartzi said, the study found 7% worked better than 6%, and it really worked well for people who were thinking they would save 5%. “If it was suggested they save 7%, it actually pushed them to do more,” he said.

“The very important take away for plan sponsors is that when you set the default don’t be too conservative. It’s ok to be aggressive,” Benartzi said. “Employees won’t opt out, but they’ll adjust the rate lower if they need to. So, there’s not much downside to suggesting they save more.”

He added that he thinks in the future, default savings rates will be more personalized.

Re-enrollment and Stretch Match Can Help in Tough Times

Benartzi said re-enrollment has a really important role during the pandemic to help people build wealth.

As background, he noted that some plan sponsors think it is too aggressive to keep re-enrolling employees into their DC plans periodically. However, globally it is actually a common practice. In the UK for example, employers have to re-enroll every employee every three years, Benartzi noted.

“The data I’ve seen from other countries shows that among employees who opted out of one re-enrollment, about half forgot they opted out and would like to be in the plan, so they stayed in the plan the second time they were re-enrolled,” he said.

Benartzi said people have been shaken by pandemic, making it the best possible time to think about resetting employees back into the plan. One caveat he noted is that plan sponsors should make opting out easy. “We are not in the business of tricking people to save if they don’t want to, so keep in mind that opting out should be easy,” he said. “And as long as it is, I think re-enrollment is the No. 1 action item plan sponsors should take to get employees back on track.”

Implementing a stretch match formula is also very timely given the pandemic, Benartzi said. It helps motivate employees to save more and can also defer matching costs to the future, to help struggling employers.

He noted that employees in general are not very sensitive to the match rate; there are plans with dramatic variations in rate from 25% to 100%, and employees don’t react to that. Benartzi said he thinks that is in part because people who are not in the retirement plan business don’t understand what a good match rate is. However, people are sensitive to the savings cap on the match, as most don’t want to leave free money on the table. “That’s why a stretch match works to help employees save more,” he said.

The way a stretch match can help struggling employers, Benartzi explained, is that if it is implemented during the pandemic or during a recession, not everyone will bump up their savings to the cap. “It might take a couple of years for employees to react, which actually helps shift match costs from now to 2023 or later,” he said. “So, I think now is a great time to rethink match formulas.”

Benartzi added that plan sponsors need to consider that a stretch match formula works well with auto escalation, because lower-income employees can’t save up to the match cap, but auto escalation can help them get to it. “When employers design a plan, they have to think about the different components of the puzzle and how they work together,” he said.

Benartzi said the Setting Every Community Up for Retirement Enhancement (SECURE) Act’s provision sanctioning an auto escalation cap of 15% makes sense when one thinks about how people started saving late and didn’t save what they should have. He also noted that the increase in job turnover means it is not only important to set a high savings rate, but to get there faster. “Using a design with a 3% default savings rate and auto escalation of 1% per year, it would take more than seven years to get to the cap, and by that time, some employees have changed jobs and are started over at 3% by their new employer,” Benartzi said. “My recommendation is to start with a 7% default savings rate and auto escalate at 2% every year up to 15%.”

The Need for Emergency Savings

Outside of plan design, both employers and employees are realizing that individuals need emergency savings.

Benartzi said he and other researchers are trying to make it easier for employers to make it easier for employees to have emergency savings. “When bad things happen, employees tap into their retirement savings, and we’ve seen some actually cash out their entire account when they don’t need that much,” he said. “Having emergency savings is one way to avoid that behavior.”

Benartzi said he is working on research now about the best way for employers to offer an emergency savings opportunity for employees. He expects results in six to 12 months.

“I’ve been working with an employer that offers an emergency savings opportunity, and one-third of its employees are using it,” he said. “The demand is there. We just have to make it an attractive option for small and mid-size employers to offer.”

Episodes of Voya’s “Hire thru Retire: A Health and Wealth Podcast,” are available through all podcast platforms including Spotify and Apple.

Investing January 3, 2022

Considerations for DB Plan Investing in 2022

Protecting funded status, addressing inflation, adding value and more—all should start with setting objectives.

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Plan sponsors should think about their purpose and key objectives when managing investment portfolios, says a paper from Willis Towers Watson.

While the paper addresses investment considerations for both defined benefit (DB) and defined contribution (DC) plans, it says DB plan sponsors should understand what their return needs are relative to their desired objectives. “For example, we have seen some plans de-risk too quickly with a capital allocation glide path, leaving the plan with insufficient returns necessary to reach its goals,” the report says.

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Sweta Vaidya, North American head of solution design at Insight Investment in New York City, says what DB plans should do in 2022 will depend on what happened to the specific plan in 2021. “Many plans have seen a funded status improvement,” she says. “Regardless of whether a plan is open, closed or frozen, any gains earned should be protected.”

Vaidya says open plans can probably continue to hold some risk because they will need growth to meet obligations that are continuing to accrue. Still, they have an incentive to take some risk off the table to protect funded status.

The funded status means something different for frozen plans than it does for open plans, says Vaidya. For example, because an open plan will continue to accrue benefits, even if it is 100% funded, it will need to hold some risk. However, fiduciaries of a frozen plan could probably decide the plan only needs a 5% buffer over full funding to protect against volatility. “It would depend on the objectives of the plan sponsor plus any constraints on cash,” she says.

Willis Towers Watson says it believes investors require an expanded return-seeking opportunity set to make portfolios more resilient in the face of an inflationary environment. “Specifically, the uncertain policy environment associated with stimulus being withdrawn, corresponding rate rises and inflation risk will require traditional portfolios of equities and investment-grade credit to be scrutinized under these scenarios,” the firm says.

For DB plans, the volatility of rates is expected to impact both liabilities and assets, “with credit and Treasury bonds expected to perform poorly due to rising inflation risk premia and secularly low-starting yields,” Willis Towers Watson says. Plan sponsors need to understand how their existing portfolios will respond to different inflation scenarios and identify new sources of income that are typically more resilient to inflation.

In 2022, Vaidya says, it will be important for DB plan sponsors to de-risk in both fixed income and equity.

“For growth assets, diversify out of equities, because we feel like they are overvalued and we expect a correction,” she says. “Plan sponsors should consider real assets, private equity, infrastructure, hedge funds or multi-asset class strategies, as well as private credit. Over the years, we’ve seen plan sponsors start to gravitate toward these.”

On the fixed-income side of the portfolio, yields are low, and credit migration risk will add a wrinkle if defaults or downgrades affect assets differently than liabilities, Vaidya says. “It’s difficult to perfectly hedge liabilities, but plan sponsors are looking into emerging market debt, structured debt, private debt, fallen angels and bank loans,” she says.

While inflation could be a good thing for corporate DB plans in the U.S. because it might decrease costs, the Federal Reserve’s reaction to it could have an effect on how DB plans should invest, says Vaidya.

“All else being equal, it’s probably not a big issue,” she says. “Corporate DB plans don’t usually offer COLAs [cost of living adjustments] for retirees, and some plans are holding real estate and infrastructure investments, which will keep assets growing. But plan sponsors are concerned that the Fed might quickly raises rates, dampening returns on fixed-income portfolios. Sponsors will need to look at their strategies for managing interest rate risk.”

Addressing Inflation

Willis Towers Watson says private assets, particularly private loans with floating rate coupons, as well as real assets, which have a natural inflationary component, may become more relevant tools for plan sponsors to weather future inflationary pressures.

With a more than 5% annualized inflation rate through the end of May in the U.S. and increasing inflation fears, Morningstar Indexes studied 2021 year-to-date index returns. The results suggest that value stocks, commodities, real estate and Treasury inflation-protected securities (TIPS) can be inflation buffers.

“The past few months have presented a unique opportunity to test the performance of various asset classes in an environment of rising inflation and inflation expectations,” says Dan Lefkovitz, strategist, Morningstar Indexes, in Chicago. “Notably, value-oriented stocks have responded well to economic growth and a concurrent rise in interest rates. And ‘real assets’ such as commodities and real estate—traditional inflation hedges—have been true to form. And, on the fixed-income side, TIPS are a great hedge to inflation, as returns are tied to the U.S. Consumer Price Index [CPI].”

“Inflation has a devastatingly corrosive impact on purchasing power and the current bout of higher prices is a real-time reminder for investors to remain ever vigilant,” says Mark Carlson, senior investment strategist- FlexShares at Northern Trust Asset Management in Chicago. “Maintaining a strategic allocation to real assets such as a broad selection of natural resources, real estate and infrastructure assets has the ability to provide durable long-term inflation protection for portfolios.”

Other Investment Considerations

Willis Towers Watson says the expansion and extension of funding relief for DB plans via the American Rescue Plan Act (APRA) has provided plan sponsors with increased flexibility in pursuing their objectives, as the potential for higher contributions has been reduced. It says this could allow some plan sponsors to pursue a more aggressive investment strategy that can ignore some of the bumps in the road that might have previously triggered a cash contribution. Alternatively, plan sponsors that are looking to take on less risk might be content with a longer time horizon on their path to achieving their goal.

But, Vaidya warns, the funding relief might give plan sponsors the urge to re-risk. “I can see that happening with poorly funded plans, which could create a lower likelihood of achieving fully funded status,” she says.

Willis Towers Watson also suggests that plan sponsors consider active management and more high-conviction portfolios that can add value. “The individual manager volatility can be offset with a multi-manager structure, with monitoring relative to objectives and/or a benchmark occurring at the aggregate or total structure level,” it says.

More specifically, Willis Towers Watson says DB plan sponsors should consider extending their high-conviction investment strategies into potential return-generative ideas—for example, credit and real assets—other than equities. And the consultant warns plan sponsors not to “lend where it’s crowded. Instead, evaluate where you lend and aim to reduce corporate lending risk, given overlap with your equity portfolio.”

In addition, Willis Towers Watson suggests that DB plan sponsors consider integrating investment themes into portfolios, such as environmental, social and governance (ESG) investing. “An area of focus that investors will likely need to embed within their programs is management of climate risk and its potential impact on asset returns,” the report says. “Having a more explicit focus on climate risk throughout your portfolio could lead to alpha opportunities and/or more sustainable cash flows.”

On a similar note, the consultant says diversity, equity and inclusion (DE&I) has never been more top-of-mind for the asset management industry. According to the paper, DE&I evaluation “requires a holistic assessment that goes beyond simply looking at ownership. We believe that ownership is an easily attainable metric that fails to integrate diversity across different functions within an organization. We believe that the only way to have more diverse-owned investment firms is to first have diverse investment leaders and teams. By measuring diversity across these three levels, we believe the resulting evaluation helps provide a more robust and relevant picture of diversity.”

Willis Towers Watson says its beliefs are backed by its research, which shows that investment teams that are more diverse result in greater investment returns.

On a final note, Vaidya says there’s a risk of plan sponsors being unprepared. For some, the funded status improvement came quickly and they adjusted their glide paths, but others don’t have glide paths in place. “Teams in general should ask what their goals are and whether they are prepared as they get closer to their goals to take action and make changes to their portfolios,” she says.

The full list of issues Willis Towers Watson says retirement plan sponsors need to consider in 2022 is in its paper, “Investing With Purpose in 2022.”

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