DC Participants Seek Certainty - DC Dialogue
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DC Dialogue
Volume 9 | Issue 8
December 2014
Your Global Investment Authority
Defined Contribution Plans
DC Participants Seek Certainty
In this PIMCO DC Dialogue, we speak with Philip Chao
about trust and the importance of fiduciary roles for both
DC plan sponsors and consultants. He discusses the DC plan
design process, suggesting that plan sponsors start with setting
the plan’s objective and defining how to measure success.
The desire of plan sponsors and participants to increase the
certainty of reaching retirement objectives increases the focus on
retirement income as the expected destination; yet neither group
is fully grasping the trade-offs between the expectation for
performance/return and the probability of success. Plan sponsors
should select their qualified default investment alternative (QDIA)
based on the likelihood of reaching the plan’s objective in the
sole interest of participants. If a target-date fund series is used,
Philip suggests identifying the strategic (not just the equity) glide
path that is most likely to meet the plan sponsor’s conscious
This issue features an interview with trade-off between return and outcome certainty and then use
Philip S.L. Chao, CFP®, RPA®, AIFA®,
Principal and Chief Investment Officer, this strategic glide path for performance benchmarking. Philip
Chao & Company, Ltd. also suggests that constrained tactical asset allocation and a
prudent blend of active and passive asset management would
add value over time to the target-date funds. He does not
believe in a passive, set-it-and-forget-it approach in glide path
management (or none management). Managed accounts, the
least discussed QDIA option, should be evaluated on the same
Moderated by basis as target-date, target-risk and other asset managers.
Stacy L. Schaus, CFP® Finally, he encourages regulators to provide more safe harbors
PIMCO Executive Vice President and
Defined Contribution Practice Leader to plan sponsors for the retirement income and advice offerings
they make.
DC Dialogue: Can you share with us an overview of your organization and
the types of clients you serve?
Philip Chao: Chao & Company is an SEC registered investment advisory firm.
We provide investment consulting and investment management services to
organizations and individuals. Our primary focus is delivering fiduciary
investment advice to DC plan sponsors. We serve DC plans either as an ERISA
3(21) co-fiduciary investment adviser or as a 3(38) delegated investment
manager, but never both for a single plan.
We value establishing a Our DC vision is to improve plan participants’ lives by helping plan sponsors
make prudent fiduciary decisions. To that end, we strive to provide the
trust-based relationship
thoughtful analysis, educated guidance, and leadership that plan sponsors
with our plan sponsor seek to fulfill their fiduciary duties to their plan participants. Above all else,
clients that leads to helping we value establishing a trust-based relationship with our plan sponsor clients
DC participants reach that leads to helping DC participants reach their retirement goals.
their retirement goals. DCD: You noted that you act as a 3(21) co-fiduciary or a 3(38) delegated
fiduciary, but never as both for a single plan. Can you explain why?
Chao: We believe we can wear only one fiduciary hat at a time while serving
a DC plan sponsor. We want to make sure there is no real or perceived
conflict of interest. Typically we serve in a 3(21) co-fiduciary role, so we’re
working alongside the plan sponsor; they retain the final decision-making
authority. We help them with the plan design and investment selection and
monitoring. We attempt to deliver the best thinking about DC plan
management and offer the perspective of how behavioral finance affects
decision-makers and participants alike with regard to savings, investments
and outcome.
At times, our 3(21) work may prompt a client to ask whether we would also
manage investments, such as custom target-date strategies or custom risk
models. While we can fulfill this type of 3(38) investment management role, we
believe the client should first hire another 3(21) co-fiduciary to scrutinize our
3(38) services and portfolio construction through a rigourous RFP or RFI process.
Plan fiduciaries should separate 3(21) and 3(38) services to confirm those in a
3(38) role are independently selected and evaluated. Our firm can act in one
capacity or the other, but we should not serve in both for the same plan.
We also separate our work with individual investors and DC plan sponsors;
we will not take on a plan participant as an individual client if we’re working
as a fiduciary to their DC or DB plan. Again, whether perceived or real, we
avoid potential conflicts of interest. We do not want to compromise our
clients or put plan sponsors at risk.
2 DECEMBER 2014 | PIMCO DC DIALOGUE
DCD: Does your firm’s work with individuals give you a different perspective
on DC plan design?
Chao: Yes, I believe so. Working with individual investors keeps us grounded
and focused on what is important to the participant in the real world. We are To increase certainty
more aware of a participant’s perceptions, needs and vulnerabilities. To that of outcome requires
end, I believe having practiced in the financial planning field helps a great
deal. Rather than thinking only at an institutional or macro level, we’re
de-risking and not
thinking about what the participant objectives are, how participants may re-risking. Helping
respond to risk, and how to communicate in a language they grasp. For participants and
instance, we may help plan sponsors consider the returns, volatility and
value-at-risk when thinking about investment options available for individual
plan sponsors better
participant portfolio construction, whereas the participant may be more grasp the risk-return-
concerned about simplicity and gaining confidence that they can retire. outcome certainty
We may tell participants that they have a 50% chance of reaching the trade-off is a real
investment return they need to meet their retirement objective. A typical challenge. Participants
response might be, “Well, 50% doesn’t seem very high. Can you ratchet that
don’t want to take a lot
up to 80%?” Most investors equate risk and performance as a directional
dial. The naive view that dialing up the equity beta equals dialing up the of risk.
portfolio value cannot be overstated. If participants expect an average annual
return of 6%, this means there is a 50% chance they would not realize this
annual return going forward, even in the make-believe world of normal
distribution. To increase certainty of outcome requires de-risking and not
re-risking. Helping participants and plan sponsors better grasp the risk-return-
outcome certainty trade-off is a real challenge. Participants don’t want to take
a lot of risk; they want predictable (perhaps absolute) return. We demonstrate
how to reduce risk, but we also shine a light on the trade-off in terms of what
participants may give up in exchange. In today’s financially repressed, single-
digit-return world, aiming for an 8% return is perhaps too high given the risk,
but a 3% return is too low and falls short of the retirement income goal. We
emphasize the dual need to save and invest.
By working closely with individual investors, you become more aware of
on-the-ground risk perceptions and capacity. Individuals need more certainty
than institutional investors such as foundations or endowments may be
seeking. DC plans should be designed with individual perceptions and
limitations kept clearly in mind.
PIMCO DC DIALOGUE | DECEMBER 2014 3
DCD: Can you tell us how you approach a DC plan design project?
Chao: Our first step is to help DC plan sponsors understand their duties and
responsibilities as fiduciaries, as well as our firm’s role. We inform them that they
have a serious and important role for which they are personally liable. They need
to understand that before they serve as a plan fiduciary. Their only reward in
serving should be in knowing they did the right thing for the participants. We
make clear that my firm’s role as a 3(21) co-fiduciary is to help guide them in
their fiduciary duties, but that they retain decision-making authority.
We remind them that ERISA fiduciaries are subject to a set of standards under
404(a), including acting in the sole interest of the plan participants and their
beneficiaries and carrying out fiduciary duties prudently, such as selecting
investments and confirming reasonable fees, diversifying investments to
minimize risk, and following plan documents.
In the end, it’s not about being right or wrong in the design, investment
selection or otherwise. What’s important is that plan sponsors can demonstrate
that they worked in the sole interest of the participants, made reasonable
decisions, think through the issues, and developed and adhere to a prudent
process. It boils down to good governance, reasonable decisions, and orderly
process and documentation – in other words, good housekeeping.
We ask the plan sponsor DCD: How do you get started in designing the investment structure?
to forget about how the
Chao: We begin with a basic question: “What is the objective for this plan?” It
plan is designed today; is rare for us to set up a new plan; rather, we’re typically asked to advise on an
they are encouraged to existing plan. With that said, it may be surprising how much time we spend on
step back and identify the plan’s objective. We ask the plan sponsor to forget about how the plan is
designed today; they are encouraged to step back and identify what they are
what they are trying trying to accomplish. This often leads to a refreshing discussion of the DC plan
to accomplish. as a benefit program and the outcome they seek for their participants. Yet,
plan sponsors are rarely specific about the desired outcome. Instead, we often
initially hear they simply want a competitive plan, or they may tell us how a DC
plan is the only retirement savings vehicle employees have. We then work with
the plan sponsors to articulate and document the objective for the plan. Once
the objective is set, then we work on crafting the investment structure to help
meet this objective.
4
DCD: Tell us how you go about setting an income replacement target.
Chao: We consider the organization’s workforce (i.e., thinking in sole interest
of the participants) and the retirement income sources for the typical
employee. A law firm’s demographics, income distribution and other factors Selecting the appropriate
may differ greatly from a retail chain store. The law firm may have higher-paid target-date fund
workers and lower turnover. These are important considerations as we think series is of the utmost
about the median worker profile. Median is not perfect either, but it’s a start.
We consider Social Security, likelihood of the existence of other retirement
importance since the plan
plans, housing wealth, and other retirement income sources. participants will tend
In general, plans consider a 75% to 80% income replacement as the default to invest in this option
target, including Social Security. About half of that need can be covered by whether by default or
Social Security and other income sources. This leaves DC plans to fill in the choice. Plan sponsors
remaining 35% to 40% of income for the median worker over the course of
a working career. This isn’t exact and won’t fit all workers, but a general
have to get this one right.
target helps us as we consider the plan design. We ask ourselves whether the
median participant is likely to meet their income needs. We want the plan
sponsor to understand the probability of failure and whether the plan is likely
to meet the set objective. This goes beyond investment return and pulls in the
average deferral rate, employer contribution amount and other assumptions.
DCD: How does thinking about the income replacement level influence the
investment selection and overall design?
Chao: Assessing the likelihood of meeting the plan’s objective can help plan
sponsors evaluate target-date funds and other QDIAs as well as test the
balance in and portfolio construction adequacy of their core lineup. Most
plans we work with select target-date funds as their QDIA and also offer a set
of core investment choices – capital preservation, bonds, inflation hedging
and stocks. Some also offer a brokerage window.
When serving as a plan’s QDIA, selecting the appropriate target-date fund
series is of the utmost importance since the plan participants will tend to
invest in this option whether by default or choice. Most participants are the
“do it for me” type. Plan sponsors have to get this one right for the median
participant. For each plan, we consider plan participation and contribution
rates. Contribution rates are commonly the single biggest variable – more
important than return – in driving results. Yet, simply increasing the
contribution level without calibrating the risk versus return trade-offs would
be a mistake, as placing too much at risk may undermine the value of
increasing the contribution rate.
PIMCO DC DIALOGUE | DECEMBER 2014 5We work with the plan sponsor to show the probability of meeting the
income goal and to narrow the probability of failure. We know participants
care about certainty and are averse to downside volatility, so we should not
simply dial up portfolio risk in the hope of meeting their goals. Plan sponsors
We cannot take on should consider the possible sequence of returns and the risk of a sudden
excessive risk with the market decline, whether it’s a market crash tomorrow or 15 years from now.
thought that over time Depending on where participants are in their retirement savings or spending
path, a serious market correction could be a non-event or devastating to their
it’ll all work out – the
ability to retire. This issue of investment path dependency is significant. If
overconfidence bias you’re just about to retire and you experience a significant market decline,
or head-in-the-sand you may need to hold off on retirement. But we know that, due to health
approach. We need to issues, many don’t have that choice. Now, if a secular bear market begins
when the participant is 90 years old, maybe it won’t matter. Although there is
think about people’s lives nothing we can do about the “path,” such as when the market crashes or
and both the risk they when we are born (dictating when we enter the workforce and when we
can bear and how they start saving, etc.), what we can do is to be prudent with risk-taking and think
about how tail risks can be managed.
may react to risk.
Again, thinking about the path or journey is as important as the destination.
We cannot take on excessive risk with the thought that over time it’ll all work
out – the overconfidence bias or head-in-the-sand approach. We need to
think about people’s lives and both the risk they can bear and how they may
react to risk (i.e., the behavioral finance angle). Many considerations extend
beyond investment theory.
DCD: How do you help plan sponsors and participants understand risk?
Chao: We start with the plan sponsor and define risk as the failure to meet
the plan objective. Investment committee members often are at the same
level as most participants in understanding investment concepts. So we tend
not to talk about risk factors, equity beta and risk metrics. Rather, we talk in
simpler terms to help them understand the asset-allocation process, the
opportunity set, and what may happen under different market conditions. We
help them understand how a predictable retirement income stream should be
something they desire for their participants. We help them construct a
simplified and diverse core menu and, in the case of a target-date fund, seek
the strategic glide path that offers the desired level of confidence for meeting
the median income objective.
We also may show them how much loss participants could experience in a
bad year. I heard an investment professional recently suggest framing risk in
terms of a worker’s annual income. Could the median worker tolerate in a
single year a paper loss equivalent to his annual salary? Could this worker
recover from that type of loss and still retire as planned? Could he sleep at
night? That may be another frame to put portfolio risk into perspective.
6 DECEMBER 2014 | PIMCO DC DIALOGUEDCD: How would you select and benchmark target-date funds?
We prefer a blend of
Chao: We start with the strategic glide path. Plan sponsors should select a
glide path that aligns with their plan’s objective and the makeup of their active and passive
participants. Thereafter, the portfolios along this strategic glide path will serve investments where the
as the benchmark to judge the performance of the corresponding target-date passive, index-tracking
vintage. It’s critical to compare them to the selected glide path rather than to
a peer group or industry target-date benchmark, as these peer groups or
investments deliver a
fabricated benchmarks may not be relevant to the selected glide path that is low-cost beta experience
deemed most suitable for the plan participants. and the active managers
After selecting the glide path, the next two most important decisions are seek opportunities and
whether to allow tactical management (and the degree of freedom) relative to avoid risks whenever
the glide path and whether to use active, passive or a blend of underlying
possible to deliver an
managers. We believe tactical management within reasonable risk bands can
offer a better ride to the destination. We want to empower the glide path alpha experience.
manager and the underlying managers (if active) to adjust accordingly in
different markets. When available, we prefer a blend of active and passive
investments where the passive, index-tracking investments deliver a low-cost
beta experience and the active managers seek opportunities and avoid risks
whenever possible to deliver an alpha or an improved risk-adjusted experience.
DCD: You mentioned that target-date funds are most prevalent as the QDIA.
What about managed accounts?
Chao: Ultimately, managed accounts make a lot of sense. With the evolution
of big data and technology efficiencies, providers will be able to cost-
effectively tailor glide paths to individuals rather than to a median plan
participant or overall plan. While these nascent services exist today, we have
many questions that need to be addressed before we would suggest them.
Our first question is, “On what basis would we fire the provider?”
We should not hire any investment manager – and managed account providers
typically are 3(38) investment managers – unless we know how to fire them.
As fiduciaries, we need to prudently select and monitor the managers. How do
we monitor managed account providers? As with target-date selection and
monitoring, we want to know the glide path within the managed accounts.
What allocation will participants default to if the managed account provider
has no other information than the participant’s age?
We want to know how the managed account provider performed relative to
the default glide path or strategic portfolio. How was their tactical asset
allocation done? A plan fiduciary needs the answers to these questions. At
this time, information and data we need to select or evaluate managed
PIMCO DC DIALOGUE | DECEMBER 2014 7account providers is lacking. Fiduciaries need assurance that the investment
management is prudent. Other factors, such as increasing participation or
contribution rates, should not be a part of the overall success measure, as
those can be improved without a managed account approach. Fiduciaries
need to focus on the investment advice given. This is about attribution and
isolating the data so that the portfolio management component stands alone
for fiduciary selection and monitoring.
DCD: What suggestions do you have for the core lineup?
Chao: To make it easier for participants to make decisions, we need fewer
choices on the shelf. Choices should offer clear and simple diversification
opportunities. Participants do not need every box on the equity and fixed
income style chart. What they need is a thoughtful set, including capital
preservation, fixed income, inflation hedging and equity. These choices should
include access to the global markets and diversifying assets such as
commodities. The latest rage is liquid alts. We expect to see more asset
managers attempt to differentiate themselves by plugging in liquid alts. Their
success rests not on performance, but on expectation.
DCD: What about retirement income? Will the qualified longevity annuity
contract (QLAC) rules make a difference in DC plans?
Participants do not Chao: I applaud the government for its focus on retirement income issues. As
need every box on you know, we’re at the beginning of the baby boomer decumulation wave. By
allowing participants to hold longevity annuities within DC plans and IRAs,
the equity and fixed
QLAC opens the door to more retirement income flexibility and product or
income style chart. marketing innovation. There are still issues in the selection of the insurance
What they need is a providers, pricing, product portability and so on that the regulators can help
thoughtful set, including address. Plan sponsors need more direction and support in these areas. The SEC
also needs to chime in so that such product innovations are not reserved for the
capital preservation, mega DC plans, but also are available in mutual fund and variable account
fixed income, inflation formats for small plans. Nonetheless, this is a first step in the right direction.
hedging and equity.
8DCD: Do you have any comments on giving advice?
Chao: Advice is another area where plan sponsors would benefit from smart
regulation so they are not between a rock and a hard place in supporting
their participants. Unfortunately, the advice offered in the IRA marketplace
often is conflicted. Retirees are encouraged to pull out of their DC plans when
they leave or retire, and they often end up paying much higher fees for
inferior products, when they would have been much better off remaining in
the plan’s target-date funds under the care of a fiduciary and enjoying
institutional pricing and safeguard against conflicted product pushers. Plan
sponsors often are afraid to encourage retirees to retain their assets in the
plan and to offer ongoing guidance. Yet, it is the plan sponsor, as a fiduciary,
whom the retiree likely trusts most. Participants will have a much better
chance at a successful retirement if we strengthen our safe harbors and
support of plan sponsors. We need to help those who help the participants.
Investing is like our Constitution. America cherishes liberty, freedom and
individual rights. At the same time, the bedrock of protecting such freedom is
the rule of law. It is this balance between freedom and the rule of law that
keeps this nation great. Account-based, self-directed DC investing offers a great
deal of freedom to the participants and allows individuals the right to construct
their own retirement portfolio. The plan relies on individuals to take actions and
live with the consequence. But this freedom is subject to behavioral economics
and often falls short of the optimum outcome. Plan fiduciaries are gatekeepers
and establish the guardrails in the sole interest of the participant investors. Like
the rule of law, it is not set up to please everyone, but it is to provide the
counterbalance and necessary constraints to participant freedom. Saving and
investing for retirement matters not only to each future retiree but to the social
and financial fabric of America.
DCD: Thank you for your insights and inspiration.
Chao: My pleasure.
PIMCO DC DIALOGUE | DECEMBER 2014 910 DECEMBER 2014 | PIMCO DC DIALOGUE
PIMCO DC DIALOGUE | DECEMBER 2014 11
About PIMCO and Our DC Practice Contact information for
Philip Chao
Based in Newport Beach, California, PIMCO is a global investment management firm Principal Chao & Company, Ltd.
with over 2,000 dedicated professionals focusing on a single mission: to manage risks Phone: (703) 847-4380
and deliver returns for our clients. For four decades, we have managed the retirement pchao@ chaoco.com
and investment assets for a wide range of investors, including corporations, www.ChaoCo.com
governments, not-for-profits, and other organizations, as well as for individuals
around the globe.
As of 30 September 2014 our:
n Clients include more than two-thirds the Fortune 100
n Investment professionals on staff exceed 700
n Global presence includes offices in 13 locations
n Total assets under management exceed $1.87 trillion
n DC assets under management over $191.1 billion
Our PIMCO DC Practice is dedicated to promoting effective DC plan design and
innovative retirement solutions. We are among the largest managers of assets in
defined contribution plans, offering investment management for stable value,
fixed-income, inflation protection, equity and asset allocation strategies such as
target-date solutions. We also provide analytic modeling, plus can help plan
sponsors identify DC consultant resources. Our team is pleased to support our
clients and the broader retirement community by sharing ideas and developments
for DC plans in the hopes of fostering a more secure financial future for workers. If
you have any questions about the PIMCO DC Practice, please contact your PIMCO
representative or email us at pimcodcpractice@pimco.com.
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