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Testing DC Members: Can They Make The Grade?

By: Peter Gorham

More than two-thirds of respondents to a recent survey believe that fewer than 60 per cent of their plan members are qualified to make investment choices. Peter Gorham, of Morneau Sobeco, examines the concept of testing plan members to determine their ability to make financial decisions.

hould we allow our Defined Contribution (DC) plan members to make investment decisions when we know, or maybe ought to know, that they are not sufficiently knowledgeable? In a recent ‘60 Second Survey’ of employers conducted by Morneau Sobeco, over two-thirds of respondents believe that fewer than 60 per cent of plan members are qualified to make investment choices.

The results are not too surprising when you consider that many plan sponsors report between 20 and 30 per cent of DC plan members do not attend seminars (unless forced), do not read material, and do not respond to surveys. Since we cannot find out very much about this group, it is hard to know what level of expertise they possess. If I were forced to bet, I’d guess they are among the least knowledgeable of DC plan members.

Furthermore, the investment information provided through DC providers is generally aimed at an average employee. Targeting an average will mean that the lower and upper range of employees do not receive the information they need or want. It is that lower range about which we should be particularly concerned.

Member’s Responsibility

The April 2003 draft Guidelines for the Administration of Capital Accumulation Plans (the CAP Guidelines) suggest that providing education targeted at an average employee is sufficient. It is recognized that it is the member’s responsibility to obtain any additional information to meet their individual needs.

This is good news for a plan sponsor worried about possible liability. Until recently, the sponsor had no guidance about how much is enough. It makes sense that a plan sponsor should not be required to baby sit plan members or spend inordinate resources to help members manage their retirement savings.

That said, we still have a large group of plan members who simply do not have enough knowledge to make good investment decisions. Can we, and should we, be doing more to assist these plan members? The CAP Guidelines, as well as business common sense, suggest that there is a limit to what we should be expected to do.

I suggest that a plan sponsor can do more with little additional effort and I believe it would be prudent for sponsors to give serious consideration to doing this little bit more.

‘Little Bit More’

This ‘little bit more’ involves employee testing. There will be some major hurdles before there is any hope of widespread acceptance of this idea. I suggest a voluntary test, but a test nevertheless.

Here is how testing could be put into place.

A DC plan member would be given a choice of having all plan assets invested in a fund selected by the plan sponsor or of personally selecting the funds from those provided under the plan. To select investments personally, the member would have to successfully complete an investment knowledge test. This should be a simple test, aimed at determining whether the person understands the basics.

When plan sponsors initially made the move to investment choice, it was often in response to member requests. Even so, many sponsors were relieved to be rid of their responsibility for selecting and managing the plan’s investments. This proposal’s use of a default fund will not sit well with them. Recent developments in the DC industry, including the CAP Guidelines, suggest that sponsors actually did not get rid of their responsibility for monitoring funds when they gave investment choice to members.

It is generally acknowledged that a sponsor should monitor the appropriateness and performance of all funds offered under a DC plan. Having accepted this, there is little additional responsibility to manage a single ‘default’ fund.

For long-term retirement savings, most pension consultants believe that a balanced (or diversified) fund is the most appropriate investment choice for the majority of plan members. This could be the default fund for members who are uncomfortable with investment decisions and who know little about the subject. That suggests conservatism to me. So, for most sponsors, it would simply be a matter of selecting a reasonable balanced fund which is managed on a conservative basis.

The choice becomes potentially easier when we consider the availability of Manager of Manager funds (see Sidebar).

Sponsor’s Reaction

In the ‘60 Second Survey,’ sponsors were asked how they felt about testing for investment knowledge. Not too surprisingly, only 11 per cent said that testing would be a good idea without any reservation. More interestingly, only 15 per cent replied that they would never require employees to pass a test. Of those who expressed an opinion, the largest group are prepared to consider the idea, but only if it becomes a widespread practice in Canada.

The results of the survey did not differ materially by size of organization or the type of pension arrangements organizations currently have in place.

It is becoming increasingly clear that giving unfettered investment choice to members is not the great idea originally thought. Without realizing it, sponsors responded to the vocal minority of employees who were clamouring for choice. Now, the silent majority are quietly making it clear that they are confused and are uncomfortable with all of the choice. They want direction and some confidence that someone more knowledgeable than they are looking after their retirement savings.

These two groups represent the extremes of plan members. They are the ones who can likely be trusted to make an intelligent choice between a sponsor-monitored fund and individual choice. The middle group are the issue. They may be enamoured of the double digit investment returns others are (or claim they are) getting, and believe that it should be easy to replicate such success. I believe that it is this group that pose the biggest risk to a plan sponsor for future litigation.

Sponsors need to set up plans which allow members to save for retirement, but without creating significant additional work or liability for the sponsor. In my view, that framework can be provided by offering a single conservative investment fund, likely based on a manager of managers approach, coupled with investment choice for members who demonstrate through a test (or a waiver) that they can manage their own investments.

Peter Gorham is a partner at Morneau Sobeco.

1. While this statement probably applies to most newlycreated plans over the past decade or two, the author recognizes that “assisting employees with savings” may not be the main reason behind a DC plan created as a conversion from a Defined Benefit (DB) plan.

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