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When Does A DC Plan Become A DB Plan?

By: Jim Helik

There is a growing realization that Defined Contribution pension plans, though a popular choice with plan sponsors, have some serious short-comings. Yet some of the solutions that are being proposed to fix these problems make us sit back and ask important questions such as ʻwhy we have DC plans at allʼ and ʻwhen does helping plan members save for their future cross the line into making key investment decisions for them.ʼ

Many of the problems of DC plans have been noted in past columns here (see ʻInattentive Portfolio Managers, ʼ June 2006, and ʻWho Is Irrational Now?ʼ September 2005). The list is a long one, but it boils down to individuals failing to make their own wise investment choices. Members, for example, often fail to sign up for plans when it would be in their best interest to do so. Once in a plan, they typically fail to diversify and make sub-optimal asset allocation decisions to begin with and fail to make necessary changes as they grow older.

Suggested Solutions

The suggested solutions fall into four areas:

• Change the ʻdo nothingʼ option in DC plans so that members are automatically enrolled unless they opt out. This is the opposite of many DC plans that require a member to actively make the decision to join the plan. Participation rates, not surprisingly, increase when members have to ʻopt outʼ rather than ʻopt in.ʼ
• Change the default asset allocation decision. In many plans, a member who is part of a plan, but makes no investment decision, finds that their funds end up in a low yielding, but safe, money market account. Some have suggested changing this ʻdefaultʼ option to a fund of funds or a balanced fund, potentially increasing investment returns over time.
• Make automatic changes to asset allocation as people age. Typically, plan members seldom adapt their asset allocations to their circumstances. Lifecycle funds can do this automatically for members as they progress through their working careers.
• Have the amount of savings automatically increase over time. Individuals tend to contribute less than they should to their DC plans. It has been suggested that automatic withdrawal programs can be established where an individualʼs contribution rates will automatically increase over time, with smaller automatic savings when an individual is young but with plenty of debt, and an automatic increase as they get older and reach their peak earning years.

Single Active Decision

If all of these programs were implemented in one plan, you could end up having a plan member selves enrolled in a plan and investing in a balanced-type fund that changes over time, with an increasing amount of money automatically taken out of their pay cheque. And all this happens without a member having to make a single active decision at all.

This sounds like a Defined Benefit plan to me – but with one important exception. At the end of the day, if there still isnʼt enough money for a DC plan member to retire on, the plan sponsor can say “Sorry, this isnʼt my problem, itʼs yours, since you made the investment decisions.”

Donʼt get me wrong, I have nothing against any of the above ideas taken individually. Getting people to save for their retirement is a good thing – for them, their employer, and society at large. Products and procedures that encourage savings should be welcomed.

But at some point, you are no longer merely helping people. You are stepping over the line to do the investment work for them, but without the real risk and responsibilities that come with a DB plan. Guiding employees down the path of least resistance (for ʻtheir own goodʼ), can give way to doing the walking for them.

Making Things Too Easy

At some point, making things too easy actually works against the interests of some plan members. As just one example, plan participation tends to decrease as the number of investment choices increases, since some plan members find all of the choices too confusing. Limiting investment choices may increase overall plan participation, but at a cost of providing few real choices for the above-average investor.

The same holds true when offering employer stock, which is often a bad move for the undercapitalized novice investor, but may be a fine option for the more sophisticated plan member with wider holdings both within the DC plan and outside of it.

If members of DC plans are ultimately responsible for their retirement savings, they must be free to make some bad decisions as well as some good ones. We can, and must, help, educate, and nudge them in the right direction, but we canʼt do it all for them.

Jim Helik is co-author of ʻEnergy Markets Risk Management,ʼ a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto.

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