CAPs: When less is more
Why DC plan sponsors should limit plan member investment options.
March 16, 2015
In the 1970’s and early 1980’s, defined benefit (DB) plan members clamored for the purported free lunch and portability provided by converting their DB plans to defined contribution (DC) plans. Cagey CFO’s, encouraged by the financial institutions, could not believe their good fortune in being able to off load financial risk associated with DB plans while not having to fully compensate members for the risk they appeared willing to assume. Unfortunately, this enthusiasm has waned over the years: the majority of capital accumulation plan (CAP) members are not up to the challenge of managing investments while sponsors realize CAP members will likely fall short in terms of adequate pension incomes. The administrative and fiduciary challenges of CAPs and the potential financial and legal risks are also a concern for sponsors. Part of the problem lies in the fact that CAP programs are overly complex so a simpler approach benefits all stakeholders.
CAP members need to have a basic understanding of investment and risk concepts usually reserved for investment professionals. Coming to grips with styles, asset classes, diversification, risk (in various forms), benchmarking, risk profiling, retirement funding, and time vs. timing, requires far more time and effort than most CAP members can handle. In addition, CAP members must often contend with 15-25+ investment choices, which may include life cycle and balanced funds; large and small Canadian, US and foreign equity funds; bond, mortgage and real estate funds; daily interest and money market funds; and, GICs. Whew! While record keepers provide education, decision making tools and communications, it is not surprising that CAP members struggle, and are often overwhelmed, with this mass of concepts and information. This situation begs simplification.
The majority of CAP members are unsophisticated and inexperienced investors. Forcing them to choose from multiple options is akin to giving a teenager a bottle of vodka and the keys to the family car. Sponsors providing a large number of investment options likely do this under the misconception that it improves diversification and/or returns. Under the CAP Guidelines, however, a sponsor is only required to provide sufficient options to ensure an adequate degree of diversification. The Pooled Registered Pension Plan (PRPP) regulations also offer some insight on the issue: only six investment options are allowed in a PRPP, including a default Fund. There are knowledgeable investors who argue that a “one fund” approach using a balanced fund, or a series of asset allocation funds, would provide a sufficient choice. Catering to a very limited number of CAP members who think they need a lot of investment choices should not drive the selection of investment options: the sponsor should focus on the needs of the vast majority of the CAP members. Reducing the number of investment options is therefore an obvious way to make a CAP simpler and less costly but still effective.
Taking simplification a step further, a sponsor could also consider using passive investment options in combination with fewer investment choices. There are several advantages in using a passive approach from both a fiduciary and CAP member perspective. A limited number of passive investment options, covering the major asset classes, would likely provide an effective CAP investment framework for most organizations.
Simplifying the CAP investment platform has many advantages from a fiduciary perspective as well from a pension committee and CAP member perspective. Having fewer and simpler investment options:
- Reduces the education and communication requirements in terms of time and costs;
- Simplifies communication and education processes;
- Simplifies performance monitoring;
- Lowers administrative costs; and,
- Simplifies manager searches and reduces the time required and costs.
In addition, if a passive approach is also used
- Volatility of returns vs. the benchmark is minimized; and,
- Investment management fees will be significantly lower.
Given the range of demographics and circumstances in most CAPs it would be difficult to argue that the sponsor had not acted prudently if a suite of passive asset allocation funds plus five stand-alone investment options covering the major asset classes were available to CAP members. Using a simpler approach will not eliminate the issue of CAPs generating insufficient pension incomes but it will make a CAP program more “friendly”, effective and less costly for all stakeholders