DC Plans: Which Way?

Faced with choices, DC plan members find it hard to decide.

March 17, 2015

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too much choiceIt is said that a home is the largest purchase an average Canadian will make in their lifetime.  And when most of us make that plunge into real estate, we will enter the transaction with the help and advice of professionals – from real estate agents securing the best price on the most suitable home, to home inspectors identifying potential problems or risks that the new homeowner may face.  But surprisingly (and unfortunately) when it comes to retirement savings – another sizeable and long-lived asset that Canadians rightly ought to focus on – that same level of diligence and attention is lacking.

Most of us in non-government sectors aren’t lucky enough to be part of a defined benefit (DB) pension plan.  The defined contribution (DC) pension plans that many Canadians are enrolled in shift the burden of investment decisions, monitoring and risk to the employee; in turn, the employee must select the best-suited instruments for their portfolio from a potentially bewildering array of choices, and then review and adjust that portfolio on an ongoing basis as both external conditions and their own personal circumstances evolve.

And instead of being able to solicit professional advice on a timely basis – as we might with a home inspection immediately prior to closing a real estate purchase – most Canadians are left with DC plans of the do-it-yourself variety.  A workshop or two may be offered initially to broaden members’ investment knowledge (indeed, in many cases to provide a first introduction to the discipline), but this advice is often provided far in advance of the time when it is needed or useful.

In any case, I have serious doubts about the effectiveness of these seminars, even for those members who choose to attend (and research has shown that attendance rates are in fact abysmally low).  Offering reams of material in the form of glossy brochures and thick binders also falls far short of providing meaningful guidance to individuals who have little investment knowledge, and, more often than not, little time and inclination to properly absorb the knowledge required.  As many financial and pension experts have shown, precious few members will become investment-savvy as a result of these workshops; to expect otherwise seems overly optimistic at best, and disingenuous at worst.

The economic theory of comparative advantage states that there can be a net gain to both sides in a trade if each party focuses on what they do best and if there are relative differences between the abilities or capacities of the two. To expect millions of Canadians then, each engaged in their own field of expertise, to adeptly manage their own retirement savings plan runs counter to widely accepted theory.

The multitude of investment vehicles available and the requirement that members make their own investment choices, coupled with the aforementioned widespread lack of expertise needed to do so prudently, often results in plan members making sub-optimal decisions for their savings.

In my view, it is this reliance on every member to make sound investment decisions that is the main problem with the defined contribution model as it stands today.  But don’t take my word for it.  Pension and benefits heavyweights have corroborated this belief in the past:

As Malcolm Hamilton – a well-known and respected actuary and expert on Canadian retirement savings – said, “retirement savings plans that rely on the astute decision-making of plan members are destined to disappoint. “

Jack Mintz, a world-renowned expert in the field of fiscal and tax policy and a former president and CEO of the public policy think tank C.D. Howe Institute, agrees:  “On average, investors on their own tend to make mistakes by selling assets at low values and purchasing assets at high values.  Studies in the United States suggest that poor investment strategies could cost investors 1.1% annually”

Richard Thaler, best known for his work as a theorist in behavioral finance and for a number of books on making better choices by overcoming inherent biases, believes it is a false assumption that “people … make choices that are in their best interests”

There have been entire studies – Ippolito (1992), Sirri and Tufano (1998), Frazzini and Lamont (2005) – showing that fund flows from retail investors into mutual funds are “dumb money”, because “retail investors reduce their wealth in the long run” due to decisions driven by sentiment.

Quoting Don Ezra, a widely published author in the pension fund industry and an actuary and pension investment consultant: “if we need to fly … we don’t learn to fly our own planes.  We use qualified experts. The average person will never become a doctor, surgeon, pilot, or engineer by reading pamphlets [and] the average person will also never become an investment expert that way”

With the onus of investment responsibility shifted directly to plan members (and if those members can be expected to execute poor strategies on their own) what can be done to address this problem with the DC model?  Study after study has shown that for the vast majority of plan members, the current model fails to deliver what is needed.  There have been new investment products developed in response, and in my next blog post I will introduce and discuss the various solutions for the defined contribution model.

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