Education Versus Advice In CAP Plans
By: Warren Laing
If current education efforts are either not reaching or not enabling the majority of Defined Contribution pension plan members to feel confident about managing their retirement assets successfully, is the alternative offering them investment advice? Warren Laing, of Open Access Ltd., makes the case for doing so.
Historically, group retirement plan members have been left on their own to make crucial investment decisions, decisions that will affect their financial security during retirement, without adequate training or experience. Very few plan members understand the basic principles of investing, yet they are being asked to select investment options that range from GICs to aggressive small cap equity funds with often disastrous results.
When plan members realize that the assets in their plan are woefully inadequate to support their expected lifestyle during retirement, they will be forced to adjust their spending accordingly and it will be a financial crisis for them. When they realize this crisis is due to poor investment results, you can bet the farm some of them are going to look for someone to blame, someone with deep pockets – probably the plan sponsor. This will be the catalyst that introduces the golden age of pension class-action lawsuits.
Conventional plan sponsor wisdom has been to avoid providing plan members with investment advice, as the perceived liability for below benchmark investment returns was thought to be excessive. Instead, sponsors and their service providers undertook to give plan members the investment tools and education that would enable the member to earn the investment return required to retire comfortably. In effect, as sponsors moved from Defined Benefit to Defined Contribution retirement plans, they transferred the investment responsibility to the plan member on the assumption that the member could assume the responsibility. Unfortunately, there is a growing body of evidence indicating that most plan members are ill-equipped to manage their own retirement assets successfully.
Growing Body Of Evidence
Examples of this growing body of evidence include:
- A study called ‘DC Pension Plan Members: Needs & Knowledge,’ found 58 per cent of survey participants indicated they have time to learn, but 52 per cent admit they do not use the educational support provided, and only 10 per cent strongly agree that plan education gives them confidence to independently make good investment decisions
- In a survey entitled ‘The 2003 Pulse on Plan Members,’ members were asked: “When it comes to making investment choices for your company retirement plan, please rate your level of knowledge?” and 53 per cent of plan members thought of themselves as less than knowledgeable
- A survey of 800 DC plan members conducted by John Hancock Financial Services showed that nearly half say they have little or no investment knowledge and have never made any changes to their investment allocations. The conclusion of this study was “The theory was that if you offered the right combination of investments and educational tools, participants would take on the challenge of investing responsibly to achieve financial security by retirement. The reality is that this has never happened, we’ve had more than a decade of educational efforts and investing experience, including a full boom and bust market cycle, and most participants are no more knowledgeable, nor any more engaged today than they were in 1991.” Strong words.
Richard Deaves, the chair of finance at the DeGroote School of Business has done extensive work on psychographic profiles of DC retirement plan members. In a paper called ‘DC Pension Plan Members: Psychographic Profiles,’ plan members were divided into the five attitudinal groups, each with a different psychographic profile. The following is a brief summary of the characteristics of each of the psychographic groups and their percentage representation within the sample.
- Smart Guys (13 per cent) – The most knowledgeable, but also often the most overconfident.
- Participators (24 per cent) – Knowledgeable, but want more knowledge.
- Seekers (22 per cent) – Worried, have an insatiable appetite for education and advice.
- Needy (26 per cent) – Currently inactive, but desire advice.
- Disengaged (15 per cent) – Inactive because of time constraints and/or lack of interest.
Only the Smart Guys, which made up 13 per cent of the sample, were comfortable that they had the knowledge and all the information required to make competent investment decisions in their retirement plan. The remaining 87 per cent were uncomfortable, and wanted more knowledge. Of these, 63 per cent either needed or wanted someone to advise them on which investment options they should select.
Clearly current education efforts are either not reaching or not enabling the majority of plan members to feel confident about managing their retirement assets successfully. Some believe that more extensive educational efforts are the answer, while others believe that plan members need someone to make the investment decisions for them, such as discretionary investment management services specifically tailored for CAP members.
In a Capital Accumulation Plan (CAP), should a sponsor offer plan members investment advice? What are the advantages and disadvantages that accrue to the sponsor and to the plan member? What risks does the plan sponsor assume by doing this? Do the advantages outweigh the disadvantages?
For the plan members, the answer is relatively simple. Survey after survey has indicated that plan members are poorly equipped to take on the responsibility of managing their own retirement assets and need someone who is properly qualified to do it for them. This is an optimal solution for the plan members provided the investment manager periodically verifies the plan members’ investment needs and ability to assume investment risk through an updated know-your-client form.
For the plan sponsor, the answer is more complex. Obviously, a responsible sponsor wants to ensure that the retirement assets of plan members are properly managed and most sponsors would accept that professional investment management produces superior investment returns compared to investment education. However, what are the risks of providing professional investment management services compared to the risks of not providing it?
The Canadian Association of Pension Supervisory Authorities (CAPSA), consisting of the insurance, pension, and securities regulators across Canada, introduced the CAP Guidelines, which came into effect at the beginning of 2006. The guidelines define a CAP as a tax-assisted savings plan where plan members have more than one investment option to choose from. This includes group RSPs, DC pension plans, and deferred profit-sharing plans.
The CAP Guidelines include a section suggesting that a plan sponsor may choose to refer plan members to a service provider that can provide investment advice.
During the consultative process, prior to the publication of the final version of the guidelines, a number of submissions were made requesting a ‘Safe Harbour’ provision similar to ERISA 404(c), for plan sponsors. However, such a clause was not included in the final version, indicating that CAPSA believes that plan sponsors should bear some responsibility for plan member investment results.
ACAP sponsor acts as a fiduciary and if plan members are offered an array of investment options and education, the sponsor must assume responsibility for the options offered and the education provided. The fiduciary liability cannot be transferred to a service provider. These are significant responsibilities that should be carefully reviewed and fully understood before being assumed by the sponsor.
To properly select the investment options offered, the sponsor should determine whether properly qualified investment professionals are available within the organization or whether outside professional advice should be retained. Furthermore, if outside investment professionals are retained, a periodic reassessment of the options offered is advisable, as what is an appropriate investment option today may not be an appropriate option tomorrow. An example would be where the investment management team of one of the investment options offered quits and moves to a competitor. If the sponsor did not review the appropriateness of this fund, potential fiduciary risk might escalate.
Leaving the selection of the investment options up to the recordkeeper, who may or may not have a conflict of interest, does not relieve the sponsor of potential fiduciary liability.
Secondly, the quality of the education provided to plan members is the sponsor’s responsibility. The studies quoted above indicate that employees do not take advantage of education, that it does not equip them to make better investment decisions, and does not give them confidence that they can manage their retirement assets successfully. This can make educating plan members a high risk endeavour for a CAP sponsor. If the plan members’ investments rise in value, everything will be fine. However, if they decline in value, the plan members can always sue saying that the quality of the education given was inappropriate and/or inadequate. It is difficult to prove that the education provided was appropriate and adequate in light of poor investment results. Furthermore, courts tend to side with the employee, particularly with regard to preparing financially for retirement. If one employee sues, there is always the risk that this will escalate into a class action lawsuit. A lawyer’s dream come true!
If a CAP sponsor decides to offer professional investment management services rather than an array of investment options and education, the sponsor only assumes fiduciary responsibility for the selection of the investment manager. The investment manager is responsible for the quality of the investment results and since only a professionally managed investment product is offered, there is no need for plan member education. Professional investment managers are fully aware of the risks of providing investment management services to plan members, and will do everything in their power to ensure that the results compare favourably to an appropriate benchmark.
In addition, they will maintain properly balanced portfolios with good diversification by asset class and investment style, document every investment decision thoroughly, be properly licensed in every jurisdiction, have a competent team of professionals, have the appropriate policies and procedures for an investment manager, and ensure that no conflicts of interest exist. On this basis, it would indeed be difficult for an employee lawsuit to be successful. However, it would be prudent for the sponsor to monitor the investment manager on a regular basis to verify that the above elements remain in place.
In a White Paper published by the Boston office of Mercer Investment Consulting, entitled ‘401(k) Plans: Are Employers Taking on More Risk by Providing Investment Advice to Participants?,’ Scarlett Ungurean recommended “In this time of financial uncertainty, complex markets, and retirees with long time horizons, it is in the best interests of plan sponsors to offer well-structured advice programs to 401(k) plan participants. Offering an advice program should improve retirement readiness for participants and minimize a plan sponsor’s concerns about the advice versus education dilemma. At this time, the risks of not offering advice are greater than the risk of offering advice.” The lack of ‘safe harbour’ provisions in Canada’s CAP Guidelines makes this recommendation even more critical for Canadian plan sponsors.
Under the CAP Guidelines, providing discretionary investment management services can improve plan member investment returns and reduce the fiduciary risks for the plan sponsor. Obviously, the guidelines have brought about a significant change in the group retirement plan industry in Canada and those sponsors who adjust accordingly will avoid the cost and damage of potential employee lawsuits.
Adapt or perish!
Warren Laing is chairman and chief executive officer at Open Access Ltd..
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