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This article appeared originally in Pensions & Investments online on 27 January 2014.
“As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’”
It’s a truism that poker – and financial markets – can be unkind to those unaware of the caliber of their opponents. Some sponsors of defined contribution (DC) plans, however, may be forgetting this in their otherwise admirable quest to lower costs with indexed investments.
To appreciate the magnitude of this potential error, consider that as baby boomers begin stepping out of the workforce in droves, less than a fifth of them will be looking to a traditional pension for income. Instead, they’ll be relying on government programs, such as Social Security, and the savings they have accumulated in DC plans or individual retirement accounts (IRAs).
This generation will pioneer retirement security reliance on DC plans, and no doubt pave the way for many generations to follow. Today’s workers in the U.S. – and increasingly around the globe – will look to DC programs to replace upwards of 40% of their final pay. To reach this lofty objective, workers must save enough, and their savings need to be effectively managed.
Yet many plan sponsors, perhaps prompted by fear of litigation or signaling from regulators, have lost focus on these fundamental requirements and have engaged in a myopic search for the lowest fees possible for their DC plan.
As a result, they may tend to select market-capitalization-weighted index strategies that passively track indexes such as the S&P 500 Index and the Barclays U.S. Aggregate Bond Index (BAGG). To help keep costs low, plan sponsors may also use a purely passive target-date strategy or index-seeking managed account approach as a participant default.
So far, only about 17% of U.S. DC assets are invested in these low-cost strategies, according to the Plan Sponsor Council of America, yet a higher percentage of cash flows may move this way. If we look to the U.K., consultants report that most DC assets are passively managed, and there is concern the percentage will increase prompted by proposed government-imposed fee caps.
By contrast, if we consider defined benefit (DB) programs or foundation and endowment investment pools both in the U.S. and the U.K., the vast majority of assets are actively managed.
Patsy potential These institutions have had the winning hand. During a 17-year period ending in 2011, for instance, DB plans in the U.S. outperformed their DC counterparts more than 75% of the time by an annual average of 76 basis points, net of investment management fees, according to Towers Watson. Even over the more recent five-year period ending in 2011, DB plans outpaced their DC counterparts, albeit by a smaller margin, even though DC plans had a significantly higher equity allocation.
Over a 40-year career, this small difference adds up. Indeed, for someone starting with a salary of $35,000 – and assuming 3.5% annual wage gains, a 10% savings rate (including employer matching) and annual 7.76% portfolio returns (vs. 7.0% for a passive portfolio) – it compounds after 40 years into more than an extra $230,000. So let me ask you: Is it possible that DC participants are being set up as the market patsy?
The stakes are huge. DC and IRA participants in the U.S. held more than $10.5 trillion of savings in the capital markets at the end of 2012, according to the Investment Company Institute. By buying into index strategies, their hands are shown: They will keep buying as stock prices go up and will buy more of those stocks the more rapid their relative price growth. In the meantime, the smart money may take advantage of DC buyers by selling to them as prices escalate.
Similarly, within the bond market, buying a market-capital-weighted index strategy forces the DC participant to give more of his hard-earned savings to issuers who are borrowing the most, without regard to the yields provided or the ability of the borrowers to repay. The smart money again may try to take advantage of this constant buyer by selling holdings at prices that do not align with fundamental value – not to mention the borrowers, more than 70% government-related for the BAGG, borrowing money on the cheap. This brewing inequity and financial repression should raise concern.
Savvy hands To guard DC participants against becoming the patsy, here are a few suggestions for plan fiduciaries:
At PIMCO, we believe freedom to design a DC investment structure is best entrusted to plan fiduciaries. To date, the U.S. Department of Labor supports this as well and provides fiduciaries with duties of care, including applying prudence, to confirm the reasonableness of fees.
While U.S. regulators have debated requiring DC plans to offer at least one index fund and U.K. officials may impose “fee caps” on plans, we hope these ideas will be properly dismissed, and with good reason. Index fund or fee cap requirements in DC plans would amount to price controls with the likely unintended consequence of harming rather than helping DC participants. They would likely drive increased market-cap-weighted indexation, thereby pooling more DC participant assets and positioning participants to come up short on retirement savings.
All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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