One Militia Drive
Lexington, MA 02421
781-860-7320
|
|
LANDMARK STRATEGIES One Militia Drive Lexington, MA 02421 781-860-7320 |
This piece and the accompanying slides were developed to remind those involved with defined contribution plans why a well-structured plan needs an option offering both principal stability and a good rate of return. Landmark hopes that plan sponsors and others in the DC community will feel free to use the material. A computer file containing the slides in Powerpoint format can also be obtained from Landmark.
Why Stable Value
Revisiting Participant Investment NeedsIt’s not fashionable to talk about stable value funds these days or why they are important for defined contribution plans. Investment professionals and the pension media have focused on the need for new 401(k) options and education programs to help participants understand them.
Slide 2
Ironically, these highly worthwhile discussions seem to have come at the expense of an equally important issue for the 401(k) world - understanding participants’ primary investment needs and making sure that the plan is structured appropriately to meet those needs. After performing that analysis it becomes clear that a stable value fund is virtually essential for a well-structured plan.Slide 3
This discussion will focus on three aspects of understanding participant investment needs that are often neglected:
- the differences between DB and DC investment risks
- several 'forgotten' participant groups with large plan balances; and
- the diversification superiority stable value offers participants relative to other fixed income investments.
Understanding the differences between defined benefit and defined contribution plan risks.
The standard asset allocation theory used by all investment professionals was developed for defined benefit plans. Before applying it to defined contribution investors, it’s critical to understand the differences between the types of plans and the inherent limitations of the theory for the defined contribution arena.
Slide 4
As a practical matter, the only substantial risks faced by the institutional or defined benefit investor are asset risks. A DB plan is established and regulated to be independent of its funding sponsor, so that any profitability problems of the corporation don’t affect the financial soundness of the plan. Liabilities are typically so highly diversifiable that simply ensuring a basic level of cash flow to meet expected payments is usually adequate risk protection.Slide 5
The picture is very different for the 401(k) investor, however. The individual participant has absolutely no way to diversify the benefit risk. Moreover, the risk of needing to draw upon the plan assets - whether for retirement or basic contingencies long before retirement - is totally linked to the financial status of the investor.A focus limited to asset risks is clearly inadequate for a defined contribution plan. Contingency risk is an major risk for the 401(k) participant, yet it is rarely discussed as a matter of defined contribution asset allocation. The participant’s finances external to the plan also play a critical role, as does the level of job security.
Slide 6
Moreover, it is quite clear that the overall risk level is higher for the DC participant than for the institutional investor. The inability to diversify benefit risks like the timing of retirement needs increases the risk level, as does the presence of possible financial emergencies posing pre-retirement contingencies. Many participants also have a major concentration of their assets in company stock. Analysis has shown that the volatility of a single stock in the S&P 500 is roughly double that of the index as a whole. Generally the presence of more risk argues for a more conservative asset allocation strategy to handle that risk.The "forgotten" participants with a real need for principal safety
Slide 7
Once one recognizes the real differences in defined contribution risks, it’s a pretty small step to realizing that most plans have many participants for whom the risks of needing funds over the near-term are acute: those lacking contingency reserves outside the plan, retired participants and those near retirement, and participants of all ages who have possible secondary uses for plan assets. A huge number of plan participants fall into one of more of these categories, but their needs are seldom discussed in the pension literature. The fact that these people have a real need for principal safety has been literally forgotten, at least by the theorists.Slide 8
Far too many 401(k) participants have no savings outside their plan assets. Data from the 1995 Consumer Finance Survey of the Federal Reserve Board shows that households in the income group of the typical participant have about $12,000 in financial assets (excluding physical assets like home and car), while the median amount invested in retirement accounts (for the roughly fifty percent of the group who had them) was $10,000. It doesn’t take a financial genius to conclude that the 401(k) balance is a huge part of the total money assets of the average participant. Financial planners normally recommend that at least six months’ salary be invested in savings-type assets without any market value risk before it is prudent to take on investment risk. For the average participant, that amount is roughly $17,000. Clearly this group of participants has a need for a high-yielding 401(k) option with principal safety. Stable value meets that need the best.Slide 9
Defined contribution attitude and risk tolerance surveys are almost always limited to active participants, yet the number of inactives is growing rapidly and their asset balances are becoming very large. Inactives were 8.3 percent of defined contribution participants in 1992, the most recent year for which the 5500 forms have been compiled. That is a 60 percent increase from their share of the DC participant population in 1980.Not surprisingly, since those with the larger plan assets would be the most likely to leave them in the plan when they retire or terminate, inactives’ share of DC assets is even larger. According to a recent survey of 171 plans by John Hancock, nineteen percent of defined contribution assets belong to inactives, and most of this is presumed to belong to retirees. Retirees also have a definitive need for an investment option with little principal risk and deserve a good rate of return on those assets. Once again we have a "forgotten" group of plan participants with a need for better returns than a money market fund offers.
Slide 10
Most people also tend to forget that older workers tend to have larger plan balances than their younger colleagues. They’ve had longer to accumulate their funds, they tend to be earning higher salaries, and they contribute a larger share of their salary on average. Those over 50 are only 18 percent of all active participants, but they own 29 percent of actives’ assets. This group too has an increasing need for a high-yielding conservative investment option as their retirement nears.Together these two surveys indicate that more than 40 percent of the assets in defined contribution plans belong to those 50 and older. Again, this isn’t something that gets a lot of attention in the pension press. The importance of this age group, however, means that a plan sponsor must pay careful attention to the type of conservative option offered by the fund, to ensure the highest returns consistent with principal safety.
Slide 11
And younger participants don’t always have as long an investment horizon for their funds as their retirement date would indicate. Many DC participants also have secondary uses in mind for the funds, in addition to retirement saving. In fact, surveys consistently show that participants would contribute smaller amounts to their 401(k) plans if they couldn’t tap the funds for contingencies, home purchase, education, etc. Over one-third of participants between the ages of 25 and 45 think that they may need to use 401(k) assets to fund education; twenty-two percent of those aged 25-34 may use their balances to help purchase a home. Many "life-cycle" fund options fail to take these nearer-term financial needs with their more conservative investment implications into account.Choosing the best fixed-income diversification option
Slide 12
In addition to satisfying basic participant investment needs, 401(k) funds should offer the potential for good diversification of investment risk. Indeed, providing adequate risk diversification within and across investment options is one of the basic requirements of the Department of Labor’s 404(c) regulations for prudent plan design. Fixed income options are usually considered to be good diversifiers of equity investments. In defined benefit plans, this is partly because they provide a more predictable income stream than common stocks. However, the standard for DC diversification is usually just to find asset classes with low correlations of expected returns. The ideal is to find an asset type that is performing well when another has negative performance.Slide 13
Surprisingly, over the last twelve years the bond and stock market have been very highly correlated in both bull and bear markets. Intermediate bond funds actually had a .69 percent correlation of annual returns with the S&P 500 over the period 1983-95, meaning that returns of stocks and medium-term bonds moved in the same direction 69 percent of the time. This is hardly diversification. On the other hand, the principal protection provided participants in stable value funds made them very good diversifiers for equities over the same time period. A stable value fund comprised of 5-year contracts (implying a duration of roughly 2 1/2 years) had returns that were negatively correlated with the S&P500 index on the basis of annual data over the same time period.Not only do stable value funds provide a haven for participants anxious to escape falling stock prices, they permit participants to invest a larger share of plan assets in equities without increasing downside risk. Substituting a stable value option for an intermediate-term bond fund to diversify the 401(k) portfolio means that the participant can substantially raise the equity component of her portfolio without increasing the risk of expected losses.
Slide 15
The participant could move from an investment mix of 60% stocks and 40% medium-term bonds to one of 71% stocks and 29% stable value with no increase in portfolio volatility and a 0.6%/year higher return. Participants in plans with stable value options can be expected to earn more than their peers who have only bond and money market funds as the conservative 401(k) choices.Summary
Careful consideration of participant demographics for both active and inactive participants shows clearly that there can be significant need for a defined contribution option offering principal safety among all age and many income groups. Stable value's unique ability to offer participants principal safety with returns like those of a bond fund make it an ideal choice for the conservative option for a DC plan.
~ Slides ~Title Slide
Slide 2
Slide 3
Slide 4
Slide 5
Slide 6
Slide 7
Slide 8
Return to Landmark Articles and Speeches Return Home
