A report released on Tuesday by Schroders studied definedcontribution plan design in several countries to try to determinethe most effective design. While the report states thatparticipants should be able to make their own decisions about theirplans, it acknowledges that left to their own devices, fewinvestors are able to actually make decisions that lead to goodoutcomes.

“Few are interested or engaged in pension planning and many donot have the financial education or personal data to help in thesedecisions. Given this reality, members must be helped,” accordingto the report.

Consequently, one of the main solutions for improving outcomesin defined contribution plans is simply forcing participants tosave.

Misusing Mandatory Contributions

As we've seen in the United States, automatic enrollmentprograms are generally successful in overcoming workers' inertia.The report found that several countries have taken automaticenrollment to its furthest extreme and made contributions to astate or corporate defined contribution plan compulsory,disallowing opt-outs and setting mandatory limits for contribution.Singapore, Hong Kong, Australia, New Zealand and Sweden are allexamples of countries that take this route.

However, Schroders found that even where participants arecompelled to make contributions, the rates may still be too lowgiven expectations for long-term future returns. Schroders referredto a report by CPA Australia that found that country's compulsoryrate, which will increase to 12% by July 2019, “may not be highenough for Australians to retire at the current retirementage.”

Replacement ratios, returns and other retirement provisions allaffect the appropriate level of contributions. Based on an analysisfor retirement plan participants in the United Kingdom, Schroderssuggested that the combination of returns and contributions couldbe no less than 3.5% real annual return and 15% per year to get aparticipant to two-thirds of their final salary at retirement.

While compulsory contributions might improve account balances,they're not without their own complications. For example, Schrodersnoted that in Australia, one concern was that mandatory limits maydo more harm than good in low-income households.

Automatic escalation is one way to address lower-income workers'difficulty making contributions. Setting contribution limits lowerwhen workers are making less money, then raising the limits overtime as those workers' salaries increase keeps them in the planwithout putting undue burden on their income. Schroders found thatin the United States, 71% of 401(k) plans use automatic enrollmentwith automatic escalation.

“The impact of auto-escalation can be thought of as usingmembers' in-built inertia in their own favor, almost by stealth,”according to the report. “Since experience has shown that very fewmembers ever alter their contribution arrangements, incorporatingauto-escalation essentially turns the situation into one of'opt-out' rather than 'opt-in.'”

Governments that want citizens to save more for their ownretirement have to counter those citizens' preference for currentspending over future spending. “While such compulsion may seemdraconian, it is the single most effective step that governments,regulators and/or sponsors can take to overcome the inertia,”according to the report.

Inertia and Apathy

Default funds and auto enrollment go hand in hand, but the fundsnew participants are directed to need to be well-designed.“Clearly, identifying a single fund that is suitable for every newjoiner is impossible due to the varying ages, periods toretirement, earnings, existing assets/financial position and otherpersonal circumstances of each individual,” according to thereport.

The United States, Canada and the United Kingdom favortarget-date funds, Schroders found, and some U.S. and U.K.fiduciaries have begun designing target-date approaches that aremore targeted to their employees.

One point of contention is whether a fund carries a participantthrough retirement or simply to it. Schroders notes the date in a target-date fund doesn't indicate when the fund willstart winding down its risk allocation to more conservative assets.In 2012, Standard & Poor's launched indexes to track “to” and “through” funds based on the equitiesin each fund and how quickly they de-risk.

Bad Timing

Boomers who were only a few years away from retirement in 2008when the financial crisis was siphoning assets out of theirportfolios can attest to the importance of limiting losses nearretirement. Schroders found that losses suffered 30 years into aparticipants' plan are around 15% higher than a loss after only 10years of saving.

Similarly, big gains have a bigger effect on a bigger accountbalance. Schroders found that a 20% gain for a 20-year-old willincrease the account balance by 5% by the time they are 60; at age50, a 20% gain would increase the balance by 10%.

One way to avoid big losses while compounding real returns,according to Schroders, is to manage tail risk, either throughderivatives or active management.

The majority of plans will be too small for managers to designfunds for each participant, Schroders wrote. Sponsors could workwith similarly sized plans to get the same result, or tailor fundsfor larger cohorts of similar participants.

One important factor, though, is that members who are defaultedinto a fund rarely overcome the inertia that put them there in thefirst place and change. Consequently, default funds should bedesigned to take a participant all the way through theircareer.

Lack of Diversification

Retirement plans frequently stick to domestic investments forseveral reasons. They're more familiar to the participants, firstof all, but they're also frequently not allowed to invest largeproportions of the plan in foreign assets, according toSchroders.

However, Schroders noted several arguments for investing inother markets:

• Access to economies that grow at different rates than thedomestic economy
• Access to sectors that may be underrepresenteddomestically
• For small domestic markets, access to deeper and broader stockmarkets
• Overseas currencies can also provide a source of additionaldiversification

Mixing domestic and international investments can help dampenvolatility, according to the report, although it acknowledged thatit was an imperfect solution: “There will inevitably be short- andmedium-term periods during which diversification delivers poorresults. This occurred in 2011 when target-date funds in the UnitedStates had their worst period of absolute and relative returnssince 2008 as a result of diversifying into small-cap, non-U.S. andemerging-market equities. However, in most years, internationaldiversification paid off in these funds through smoother returns,higher returns or even both.”

Ignoring Life After Retirement

Retirement isn't a single event that can be planned for like avacation; it's a new phase of a person's life, one that could last20 years. How are plan participants going to live during thoseyears?

The report noted that some plans buy annuities to provideretirement income, some draw from a retirement account and someprovide partial guarantees. In a low-yield environment, annuitiesand guarantees are expensive, though.

“Improved life expectancy, a low growth environment, extremelylow bond yields in some markets and rising expectations aboutretirement lifestyles all contribute to making this a difficultproblem to solve,” the report says.

Schroders noted, too, that even though participants wantguaranteed income in retirement, they're not always willing to payextra for it.

Flexibility, then, is the answer, even though it's not a veryconclusive answer. One solution would be to “average in” to annuitypurchases, buying deferred products before retirement begins andthroughout the first few years to avoid the high cost right asretirement begins.

Of course, TDF glide paths can always be extended to carryparticipants farther into retirement, the report suggested.

ThinkAdvisor