Default Options - Failure To Choose
By: Becky J. West
The passing of the Pension Protection Act of 2006 (PPA) is being heralded as a significant new phase in the U.S. retirement industry. Its impact on Canada has been to heighten our awareness of some of the issues in our retirement system as they pertain to Defined Contribution plans. In particular, Canadian stakeholders have become increasingly concerned about default options in DC plans.
Default options not only include the choice of investment strategy, but can also pertain to the option of joining the plan and to the level of contributions. For those plan members who do not make these choices, the default will define their plan participation and activity.
The concern about default options is not new, but the passing of the PPA has acted as the catalyst to focus Canadian attention on this aspect of plan design. The PPA allows for automatic enrolment and auto escalation of contribution levels in 401(k) plans. In addition, regulators have indicated the preferred choice of default investment strategies (such as life cycle funds). In Canada, sponsors are wrestling with questions such as:
- What role should employer sponsored plans play in individual retirement planning?
- Can participants make informed, sensible choices?
- Will participants have enough savings with which to retire?
- What legal liability do sponsors face in the setting of default options?
- What fiduciary responsibilities do sponsors have in setting default options?
Default characteristics have tended to be viewed as the minimum requirement for an unengaged plan participant while the default investment strategy was designed to ensure preservation of capital. Plan sponsors expected that the default choices would be a temporary situation for a member as they formulated their retirement saving strategy.
That assumption did not turn out to be accurate. Default positions have tended to remain static unless the sponsor engaged in a time-consuming and often costly campaign (typically through their human resources department or their service provider) to contact defaulted members and attempt to engage them in a decision-making process.
The typical default positions described above (minimum requirements) are contrary to the purpose of a retirement savings plan – to provide a structure for employees to save through regular contributions for an event (retirement) that will occur at some time in the future. The time horizon is typically long term in nature and few, if any, of these plans are designed to be the sole source of retirement savings. In addition, in today’s transitory labour market, sponsors should assume that a new member has been participating in some form of retirement savings plan (unless they are new to the job market). This is an important assumption to keep in mind as it means that the retirement plan is not making up for a lack of savings in the past.
Historically, the decision-making process for determining default characteristics has been driven by the wrong factors – minimum requirements and preservation of capital.
What if, instead, stakeholders created an environment where the default options were tied specifically to the purpose of the plan?
Let’s assume that the plan is a registered pension plan (participation is compulsory). Assume that the sponsor has decided that the benefit they wish to provide through the pension plan is the replacement of approximately 40 per cent of pre-retirement income. The level of contributions (employer, employee, and/or both) would be determined to support this goal given assumptions about length of tenure in the plan and a long-term rate of return.
If a member does not make an investment strategy choice, should the default option not provide the possibility of achieving the purpose of the plan regardless of the member’s engagement? The traditional choice of a money market or guaranteed type investment is probably not going to provide this opportunity. The potential for long-term growth and inflation protection are not characteristics of these types of investments.
This should lead the sponsor to the choice of a well-managed, diversified portfolio that has a balance of investments across asset classes (equities and fixed income). Growth potential and inflation protection are achieved and the investment strategy fits into the long-term nature of retirement savings. Currently, life cycle type funds offer this solution. Perhaps as the investment industry turns more of its attention to the dilemma of retirement savings, additional strategies will be developed.
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