With the shift from defined benefit to defined contribution pension plans, institutional investors like pension funds and endowments are facing new challenges in their investment policies and portfolio management. As members of the defined contribution institutional investment association (DCIIA), these institutional investors need to understand the unique characteristics of defined contribution plans and adapt their investment approaches accordingly. In particular, factors like shorter investment horizons, different risk preferences of plan participants, and the impact of cash inflows/outflows require careful consideration. When formulating investment policy statements (IPS), DC plans need to focus on offering customized target date funds or managed accounts to meet the diverse needs of participants. They also need to consider rebalancing approaches, fee structures, and ESG investing. By leveraging insights from the DCIIA and peers, pension funds and endowments can develop participant-centric investment strategies that aim to deliver retirement security.
Defined contribution plans have shorter investment horizons
Unlike defined benefit plans that have very long investment horizons, defined contribution (DC) plans have much shorter horizons depending on the demographics of participants. As employees get closer to retirement, their investment horizon shortens. This requires DC plans to adjust their asset allocation and glide paths accordingly to reduce market risks like sequence of return risk. DC plans also experience more cash outflows as employees change jobs or retire. So portfolio management approaches need to factor in liquidity needs.
Participants have varying risk preferences
With defined benefit plans, the investment risk is borne entirely by the plan sponsor. But DC plans shift both investment risk and reward to individual participants. Young participants have long investment horizons and can tolerate more risk. Older pre-retirees become increasingly risk averse. DC plans must offer options like target date funds to match the risk appetite of different demographics. Instituting default investment options can also nudge passive participants towards appropriate asset allocations.
Cash inflows and outflows impact returns
Unlike defined benefit plans which have quite stable asset bases, defined contribution plans experience regular cash inflows as employees contribute to their accounts and outflows as they withdraw money. This makes DC plan returns more sensitive to sequencing risk. If a market downturn coincides with large cash outflows, it can disproportionately hurt returns. DC plans should consider strategic asset allocation strategies that account for the size and timing of cash flows.
Custom target date funds are key investment vehicles
To meet the needs of individual participants, target date funds with customized glide paths are the most suitable investment option for DC plans. As participants approach retirement, TDFs automatically shift to more conservative asset allocations to reduce risk. Plan sponsors can design TDFs to align with their participant demographics and retirement investment philosophy. Passive TDFs tracking market indices tend to be cheaper while active TDFs may offer better risk-adjusted returns.
Managed accounts offer personalized customization
For participants who want greater control over asset allocation, managed accounts are personalized investment portfolios tailored to individual goals and risk tolerance. Investment managers tailor the portfolio to each participant’s needs. Though fees tend to be higher, managed accounts provide fiduciary oversight and professional investment management.
Defined contribution plans like 401(k)s are fundamentally different from defined benefit pension plans in their investment objectives, participant demographics, cash flows, and risk preferences. As institutional investors adapt to manage defined contribution assets, leveraging insights from associations like DCIIA and evolving investment approaches are key to overcoming these challenges and enhancing retirement readiness.