Successful Defined Contribution Investment Design: How to Align Target–Date, Core, and Income Strategies to the PRICE of Retirement

An innovative tool for building DC plans

Successful Defined Contribution Investment Design is the DC plan guidebook for structuring and implementing a 401(k) or other defined contribution (DC) pension plan for the needs of today′s employees. Action–oriented, cohesive coverage gives you the knowledge and practical tools to help improve retirement income security for your employees by creating an objective–aligned DC plan. Specifically written as a step–by–step resource for plan sponsors and facilitating professionals, this innovative research takes you through its unique framework for designing a plan, complete with tested methodologies and analytic techniques for streamlining plan monitoring and management. Keep this illuminating volume at your fingertips to:

Design a DC plan from scratch with the assurance of a tested framework for evaluation and structure Apply leading–edge methodologies for evaluating fund choices during selection and ongoing assessment Get an inside perspective on how leading companies and consultants around the world approach DC planning

Workers have only one chance to save for retirement help them get it right with Successful Defined Contribution Investment Design.

Acknowledgments xv

Introduction 1

How This Book Is Organized and How to Use It 3

A Continuing Commitment to Meet the Need for Information 6

Why Should You Read This Book? 7

PART ONE DC Plans: A Cornerstone of Retirement 9

CHAPTER 1 DC Plans Today 11

Preface: A Career and a New Form of Pension Plan Are Born 11

DC Plans: Becoming the New Reality . . . No Turning Back 13

Setting Goals for Success: Income Replacement Targets 14

Reducing DC Litigation Risk: Process and Oversight 16

Who s a Fiduciary? 17

How to Approach Outsourcing DC Plan Resources 19

Hiring an Investment Consultant 20

Getting Started: Setting an Investment Philosophy and Governance Structure 20

PIMCO Principles for DC Plan Success: Building and Preserving Purchasing Power 25

Maximizing DC Savings: Just Do It! 27

In Closing 32

Questions for Plan Fiduciaries 33

CHAPTER 2 Aligning DC Investment Design to Meet the PRICE of Retirement 35

Begin with the End in Mind 37

What Is a Reasonable Pay Replacement Target? 39

Calculating the Income Replacement Rates 42

Historic Cost of Retirement: PRICE Is a Moving Target 44

A Focus on Income, Not Cost 47

PRICE–Aware: Applying PRICE to Consider DC Assets and Target–Date Strategies 48

Evaluating Glide Paths 50

Tracking DC Account Balance Growth Relative to PRICE 54

Summary: The Importance of Knowing Your PRICE 55

In Closing 55

Questions for Plan Fiduciaries 56

Note 56

CHAPTER 3 Plan Investment Structure 57

Tiers and Blends: Investment Choices for DC Participants 60

Tier I: Do–It–for–Me Asset Allocation Investment Strategies 61

Tier II: Help–Me–Do–It Stand–Alone or Core Investment Options 67

Tier III: Do–It–Myself Mutual–Fund–Only or Full Brokerage Window 90

Considering an Outsourced Chief Investment Offi cer 91

In Closing 93

Questions for Plan Fiduciaries 94

Notes 94

CHAPTER 4 Target Date Design and Approaches 95

Target–Date Structures Vary by Plan Size 100

Custom Target–Date Strategies 101

Semicustom Target–Date 102

Packaged Target–Date 103

Target–Date Selection and Evaluation Criteria 104

No Such Thing as Passive 105

Low Cost and Low Tracking Error Does Not Equal Low Risk 106

Framework for Selecting and Evaluating Target–Date Strategies: Three Active Decisions Plan Sponsors Must Make 107

Active Decision #1: How Much Risk Can Plan Participants Take? 108

Active Decision #2: How Is the Risk Best Allocated across Investment Choices? 114

Active Decision #3: Should Risk Be Actively Hedged? 119

Tail–Risk Hedging Strategies 119

Insurance 120

Target–Date Analytics: Glide Path Analyzer (GPA) and Other Tools 120

Global DC Plans: Similar Destinations, Distinctly Different Paths 121

In Closing 123

Questions for Plan Fiduciaries 124

Notes 125

PART TWO Building Robust Plans: Core Investment Offerings 127

CHAPTER 5 Capital Preservation Strategies 129

Capital Preservation: Importance 130

Capital Preservation: What Is Prevalent and What Is Preferred? 131

The $1 NAV: Shared by Stable Value and MMFs 132

Stable Value Offers More Opportunity in a Low–Interest–Rate Environment 135

Looking Forward: The Changing Role of Stable Value 138

Making Low–Risk Decisions: Views from the Field 140

White Labeling: A Capital Preservation Solution 143

An Analytic Evaluation of Capital Preservation Solutions 144

Short–Term, Low–Duration, and Low–Risk Bond Strategies 146

Inclusion of Stable Value in Custom Target–Date or Other Blended Strategies 149

In Closing 152

Questions for Plan Fiduciaries 152

Note 153

CHAPTER 6 Fixed–Income Strategies 155

What Are Bonds, and Why Are They Important for Retirement Investors? 157

What Are the Different Types of Bonds in the Market? 158

What Types of Bonds Should Be Offered to DC Participants? 161

Investment–Grade and High–Yield Credit 165

Bond Investment Strategies: Passive versus Active Approaches 166

Analytic Evaluation: Comparing Bond Strategies 176

Fixed Income within Target–Date Glide Paths 178

Observations for Fixed Income Allocation within Target–Date Strategies 179

In Closing 181

Questions for Plan Fiduciaries 181

CHAPTER 7 Designing Balanced DC Menus: Considering Equity Options 183

What Are Equities and How Are They Presented in DC Investment Menus? 184

Getting the Most out of Equities 190

Consider Dividend–Paying Stocks 194

Evaluating Equity Strategies 194

Less Is More: Streamlining Equity Choices 197

Shift to Asset–Class Menu May Improve Retirement Outcomes 197

Active versus Passive The Ongoing Debate 197

Strategic Beta: Consider Adding Fundamentally Weighted Equity Exposure 204

Currency Hedging: An Active Decision 205

Observations for Equity Allocations within Target–Date Strategies 210

In Closing 212

Questions for Fiduciaries 212

Note 213

CHAPTER 8 Inflation Protection 215

What Is Inflation and How Is It Measured? 216

Why Inflation Protection in DC? 217

History of Inflation: Inflation Spikes Underscore Need for Inflation–Hedging Assets 218

Inflation Protection When Accumulating and Decumulating, and in Different Economic Environments 219

Economic Environments Change Unexpectedly and Reward or Punish Various Asset Classes 221

Consultants Favor TIPS, Multi–Real–Asset Strategies, REITs, and Commodities 223

How Should Plan Sponsors Address Inflation Risk in DC Portfolios? 226

Implementation Challenges 228

Evaluating Real Asset Strategies 229

Summary Comparison of Individual and Multi–Real–Asset Blends 232

Inflation–Hedging Assets in Target–Date Glide Paths 235

Observations for Inflation–Hedging Assets in Target–Date Glide Paths 236

In Closing 238

Questions for Fiduciaries 238

CHAPTER 9 Additional Strategies and Alternatives: Seeking Diversification and Return 239

What Are Alternative Assets? 240

A Wider Lens on Alternatives 242

Consultant Support for Additional Strategies and Alternatives 244

Back to Basics: Why Consider Alternatives? 247

Liquid Alternatives: Types and Selection Considerations 252

Important Characteristics in Selecting Alternatives: Consultant Views 256

Illiquid Alternatives: Types and Considerations 259

Contrasting Liquid Alternative Strategies with Hedge Fund and Private Equity Investments 261

In Closing 263

Questions for Plan Fiduciaries 264

PART THREE Bringing It All Together: Creating Retirement Income 265

CHAPTER 10 Retirement Income: Considering Options for Plan Sponsors and Retirees 267

Advisor and Consultant Retirement Income Suggestions 268

Why Don t Retirees Leave Their Assets in DC Plans at Retirement? 272

Retaining a Relationship with Your Employer in Retirement: An Innovative and Caring Plan Sponsor 277

Mutual Benefits: Retaining Retiree Assets May Help Both Retirees and Plan Sponsors 279

Turning DC Assets into a Lifetime Paycheck: Evaluating the DC Investment Lineup for Retiree Readiness 280

Evaluating Portfolio Longevity 285

Turning Defined Contribution Assets into a Lifetime Income Stream: How to Evaluate Investment Choices for Retirees 286

Guarding Retiree Assets against a Sudden Market Downturn: Sequencing Risk 288

Ways to Manage Market and Longevity Risk . . . without Adding In–Plan Insurance Products 289

Living beyond 100: Planning for Longevity 290

Managing Longevity Risk: Considerations for Buying an Annuity 292

Immediate and Deferred Annuities: Why Out–of–Plan Makes Sense 292

In Closing 298

Questions for Plan Fiduciaries 298

Notes 299

CHAPTER 11 A Global View 301

DC Plans: Becoming the Dominant Global Model 302

Retirement Plan Coverage and Participation 305

Investment Default and Growth of Target–Date Strategies 315

Retirement Income: The Global Search for Solutions 319

Defined Ambition in the Netherlands 321

New Solutions in Australia and Beyond: Tontines and Group Self–Annuitization 323

Getting DC Right : Lessons Learned in Chapters 1 through 10 326

Analytic Factors to Consider: Summary by Asset Pillar 333

In Closing 333

Note 335

Closing Comments 337

Priority 1: Increasing Plan Coverage and Individual Savings Rates 338

Priority 2: Moving to Objective–Aligned Investment Approaches 338

Priority 3: Broadening Options for Retirement Income 341

Nudging One Another along a Path to Success 341

Index 343

Stacy L. Schaus is an executive vice president and leads PIMCO′s Defined Contribution Practice working primarily with plan sponsors and consultants. Prior to joining PIMCO in 2006, she was a founder and president of Hewitt Financial Services, which offers DC investment consulting and research as well as brokerage and personal finance services. While at Hewitt, she co–created and launched the Aon Hewitt 401(k) Index to help evaluate how DC participants respond to market changes. She is the founding chair for the Defined Contribution Institutional Investment Association, serves on the executive committee of the Employee Benefit Research Institute, and served as a Financial Planning Association board member. She has 35 years of investment experience and holds an MBA from the Stern School of Business at New York University and an undergraduate degree from the University of California, Santa Barbara.

Ying Gao, who carried out the analytic reporting and modeling contained in this volume, is a vice president in the client analytics group in the Newport Beach office of PIMCO. Her primary areas of focus are financial modeling, asset allocation, and risk management. Prior to joining PIMCO in 2009, Dr. Gao worked with the fixed income portfolio management department at Principal Global Investors and the capital markets group at Federal Home Loan Bank of Des Moines. She has 10 years of investment experience and holds a PhD in economics from Iowa State University. She earned her master′s and undergraduate degrees in finance from Zhejiang University in China.