Successful Defined Contribution Investment Design

STACY L. SCHAUS is an executive vice president and leads PIMCO’s Defined Contribution Practice working primarily with plan sponsors and consultants. Prior to joining PIMCO in 2006, she was a founder and president of Hewitt Financial Services, which offers DC investment consulting and research as well as brokerage and personal finance services. While at Hewitt, she co-created and launched the Aon Hewitt 401(k) Index™ to help evaluate how DC participants respond to market changes. She is the founding chair for the Defined Contribution Institutional Investment Association, serves on the executive committee of the Employee Benefit Research Institute, and served as a Financial Planning Association board member. She has 35 years of investment experience and holds an MBA from the Stern School of Business at New York University and an undergraduate degree from the University of California, Santa Barbara. YING GAO, who carried out the analytic reporting and modeling contained in this volume, is a vice president in the client analytics group in the Newport Beach office of PIMCO. Her primary areas of focus are financial modeling, asset allocation, and risk management. Prior to joining PIMCO in 2009, Dr. Gao worked with the fixed income portfolio management department at Principal Global Investors and the capital markets group at Federal Home Loan Bank of Des Moines. She has 10 years of investment experience and holds a PhD in economics from Iowa State University. She earned her master’s and undergraduate degrees in finance from Zhejiang University in China.

• Acknowledgments xv Introduction 1How This Book Is Organized—and How to Use It 3A Continuing Commitment to Meet the Need for Information 6Why Should You Read This Book? 7PART ONE DC Plans: A Cornerstone of Retirement 9CHAPTER 1 DC Plans Today 11Preface: A Career and a New Form of Pension Plan Are Born 11DC Plans: Becoming the New Reality . . . No Turning Back 13Setting Goals for Success: Income Replacement Targets 14Reducing DC Litigation Risk: Process and Oversight 16Who’s a Fiduciary? 17How to Approach Outsourcing DC Plan Resources 19Hiring an Investment Consultant 20Getting Started: Setting an Investment Philosophy and Governance Structure 20PIMCO Principles for DC Plan Success: Building and Preserving Purchasing Power 25Maximizing DC Savings: Just Do It! 27In Closing 32Questions for Plan Fiduciaries 33CHAPTER 2 Aligning DC Investment Design to Meet the PRICE of Retirement 35Begin with the End in Mind 37What Is a Reasonable Pay Replacement Target? 39Calculating the Income Replacement Rates 42Historic Cost of Retirement: PRICE Is a Moving Target 44A Focus on Income, Not Cost 47PRICE-Aware: Applying PRICE to Consider DC Assets and Target-Date Strategies 48Evaluating Glide Paths 50Tracking DC Account Balance Growth Relative to PRICE 54Summary: The Importance of Knowing Your PRICE 55In Closing 55Questions for Plan Fiduciaries 56Note 56CHAPTER 3 Plan Investment Structure 57Tiers and Blends: Investment Choices for DC Participants 60Tier I: “Do-It-for-Me” Asset Allocation Investment Strategies 61Tier II: “Help-Me-Do-It” Stand-Alone or “Core” Investment Options 67Tier III: “Do-It-Myself” Mutual-Fund-Only or Full Brokerage Window 90Considering an Outsourced Chief Investment Offi cer 91In Closing 93Questions for Plan Fiduciaries 94Notes 94CHAPTER 4 Target Date Design and Approaches 95Target-Date Structures Vary by Plan Size 100Custom Target-Date Strategies 101Semicustom Target-Date 102Packaged Target-Date 103Target-Date Selection and Evaluation Criteria 104No Such Thing as Passive 105Low Cost and Low Tracking Error Does Not Equal Low Risk 106Framework for Selecting and Evaluating Target-Date Strategies: Three Active Decisions Plan Sponsors Must Make 107Active Decision #1: How Much Risk Can Plan Participants Take? 108Active Decision #2: How Is the Risk Best Allocated across Investment Choices? 114Active Decision #3: Should Risk Be Actively Hedged? 119Tail-Risk Hedging Strategies 119Insurance 120Target-Date Analytics: Glide Path Analyzer (GPA) and Other Tools 120Global DC Plans: Similar Destinations, Distinctly Different Paths 121In Closing 123Questions for Plan Fiduciaries 124Notes 125PART TWO Building Robust Plans: Core Investment Offerings 127CHAPTER 5 Capital Preservation Strategies 129Capital Preservation: Importance 130Capital Preservation: What Is Prevalent and What Is Preferred? 131The $1 NAV: Shared by Stable Value and MMFs 132Stable Value Offers More Opportunity in a Low-Interest-Rate Environment 135Looking Forward: The Changing Role of Stable Value 138Making Low-Risk Decisions: Views from the Field 140White Labeling: A Capital Preservation Solution 143An Analytic Evaluation of Capital Preservation Solutions 144Short-Term, Low-Duration, and Low-Risk Bond Strategies 146Inclusion of Stable Value in Custom Target-Date or Other Blended Strategies 149In Closing 152Questions for Plan Fiduciaries 152Note 153CHAPTER 6 Fixed-Income Strategies 155What Are Bonds, and Why Are They Important for Retirement Investors? 157What Are the Different Types of Bonds in the Market? 158What Types of Bonds Should Be Offered to DC Participants? 161Investment-Grade and High-Yield Credit 165Bond Investment Strategies: Passive versus Active Approaches 166Analytic Evaluation: Comparing Bond Strategies 176Fixed Income within Target-Date Glide Paths 178Observations for Fixed Income Allocation within Target-Date Strategies 179In Closing 181Questions for Plan Fiduciaries 181CHAPTER 7 Designing Balanced DC Menus: Considering Equity Options 183What Are Equities and How Are They Presented in DC Investment Menus? 184Getting the Most out of Equities 190Consider Dividend-Paying Stocks 194Evaluating Equity Strategies 194Less Is More: Streamlining Equity Choices 197Shift to Asset-Class Menu May Improve Retirement Outcomes 197Active versus Passive—The Ongoing Debate 197Strategic Beta: Consider Adding Fundamentally Weighted Equity Exposure 204Currency Hedging: An Active Decision 205Observations for Equity Allocations within Target-Date Strategies 210In Closing 212Questions for Fiduciaries 212Note 213CHAPTER 8 Inflation Protection 215What Is Inflation and How Is It Measured? 216Why Inflation Protection in DC? 217History of Inflation: Inflation Spikes Underscore Need for Inflation-Hedging Assets 218Inflation Protection When Accumulating and Decumulating, and in Different Economic Environments 219Economic Environments Change Unexpectedly—and Reward or Punish Various Asset Classes 221Consultants Favor TIPS, Multi-Real-Asset Strategies, REITs, and Commodities 223How Should Plan Sponsors Address Inflation Risk in DC Portfolios? 226Implementation Challenges 228Evaluating Real Asset Strategies 229Summary Comparison of Individual and Multi-Real-Asset Blends 232Inflation-Hedging Assets in Target-Date Glide Paths 235Observations for Inflation-Hedging Assets in Target-Date Glide Paths 236In Closing 238Questions for Fiduciaries 238CHAPTER 9 Additional Strategies and Alternatives: Seeking Diversification and Return 239What Are Alternative Assets? 240A Wider Lens on Alternatives 242Consultant Support for Additional Strategies and Alternatives 244Back to Basics: Why Consider Alternatives? 247Liquid Alternatives: Types and Selection Considerations 252Important Characteristics in Selecting Alternatives: Consultant Views 256Illiquid Alternatives: Types and Considerations 259Contrasting Liquid Alternative Strategies with Hedge Fund and Private Equity Investments 261In Closing 263Questions for Plan Fiduciaries 264PART THREE Bringing It All Together: Creating Retirement Income 265CHAPTER 10 Retirement Income: Considering Options for Plan Sponsors and Retirees 267Advisor and Consultant Retirement Income Suggestions 268Why Don’t Retirees Leave Their Assets in DC Plans at Retirement? 272Retaining a Relationship with Your Employer in Retirement: An Innovative and Caring Plan Sponsor 277Mutual Benefits: Retaining Retiree Assets May Help Both Retirees and Plan Sponsors 279Turning DC Assets into a Lifetime Paycheck: Evaluating the DC Investment Lineup for Retiree Readiness 280Evaluating Portfolio Longevity 285Turning Defined Contribution Assets into a Lifetime Income Stream: How to Evaluate Investment Choices for Retirees 286Guarding Retiree Assets against a Sudden Market Downturn: Sequencing Risk 288Ways to Manage Market and Longevity Risk . . . without Adding In-Plan Insurance Products 289Living beyond 100: Planning for Longevity 290Managing Longevity Risk: Considerations for Buying an Annuity 292Immediate and Deferred Annuities: Why Out-of-Plan Makes Sense 292In Closing 298Questions for Plan Fiduciaries 298Notes 299CHAPTER 11 A Global View 301DC Plans: Becoming the Dominant Global Model 302Retirement Plan Coverage and Participation 305Investment Default and Growth of Target-Date Strategies 315Retirement Income: The Global Search for Solutions 319Defined Ambition in the Netherlands 321New Solutions in Australia and Beyond: Tontines and Group Self-Annuitization 323“Getting DC Right”: Lessons Learned in Chapters 1 through 10 326Analytic Factors to Consider: Summary by Asset Pillar 333In Closing 333Note 335Closing Comments 337Priority 1: Increasing Plan Coverage and Individual Savings Rates 338Priority 2: Moving to Objective-Aligned Investment Approaches 338Priority 3: Broadening Options for Retirement Income 341Nudging One Another along a Path to Success 341Index 343