State Street: DC plans better by default?

After seeing more than a decade of change in the role of defined contribution plans in the US, the pace of innovation will continue unabated as funds look to diversify their investment approach and improve fund structures, State Street Global Advisors predicts.

More than 50 million Americans currently save for their retirement using defined contribution (DC) plans, and Kristi Mitchem (pictured), global head of State Street’s defined contribution business, says the most effective way to improve the DC system is to improve the default options employees can be auto-enrolled in.

Mitchem says that up to 80 per cent of default options are target-date funds, and she predicts the focus of innovation will be on how to make these funds work better to meet the diverse needs of members.

Most members who are enrolled in default options end up staying within those plans. Mitchem sees an increasing trend in the US towards asset managers finding ways to make this “inertia” work for plan participants.

“When I say we have to spend time making sure we get the defaults right from an investment perspective, that means that innovating inside the structures that members are, by default, investing in,” Mitchem says.

“One of the ways to do this is more and better diversification within the glidepath; the second is consider alternative approaches to asset allocation, which involves mixing what we have seen as traditional modern portfolio theory with concepts such as risk parity; and thirdly, building in some sort of income stream.

“So these accumulation funds need to be connected with these other phases of income, and I think one of the big innovations that we are going to see in the US is the incorporation of distribution strategies into target date funds – and ultimately, the incorporation of longevity insurance.”

Mitchem says this longevity insurance may take the form of either deferred annuities, advanced life annuities and actual longevity insurance.

Along with these innovations, Mitchem is also noticing an ongoing move by defined contribution schemes towards more sophisticated investment structures that were previously the territory of many defined benefit (DB) schemes.

Along with sharing similar asset managers to DB schemes, Mitchem says DC schemes will look to alternative asset classes to drive returns in a low returns environment.

While high volatility and a low-returns environment remain the biggest challenges for DC funds, State Street has seen a recent surge in interest in inflation protection, Mitchem says.

Mitchem says State Street is working on investments that can help hedge inflation risk using combinations of Treasury inflation-protected securities (TIPS), commodities, natural resource stocks and REITs that aim to maximise returns but have a volatility that is similar to the US TIPS markets.

State Street says investment products and fund structures will have to adapt to the more sophisticated needs of members, which have moved beyond the traditional paradigm of accumulation then decumulation of retirement savings.

Mitchem says there are three stages of retirement planning: a growth-focused stage; a stability of asset return and income stage; and a final stage, where what is really important is that a member’s own mortality risk is managed effectively.

“There are products and approaches to asset allocation that will be suitable for people at these three different phases,” she says.

“So, key to our role as an asset manager and institutional leader in the asset management space is to help develop products and solutions that service individuals in these three distinct phases of retirement and execution.”

Mitchem predicts that there will be a lot of product innovation tailored to people who are in the advanced stage of their retirement cycle, who are in their early 60s and beginning to think about how they can best “distribute their balance”.

“This is a huge departure for us in the US, because previously, most employers actually wanted people to exit the plan at retirement,” she says.

As part of this better management of the transition between each of these retirement phases, Mitchem is seeing more transparency by 401(k) plans around the amount of income plan participants may have in their retirement.

She cites the recent move by the Federal Employer Retirement System, a 401(k) plan in the US, to place on all of its statements an annuitised conversion of the account balance.

“We are going to see more solutions that focus on income and change the lexicon from one that is around a balance to one that is around monthly income,” Mitchem says.