Defined contribution plans have been around for about four decades, and have been popular with small and mid-sized companies for about 25 years.
The evolution of 401(k) plans and 403(b) plans over that time, during which they became a replacement for company-directed pension plans, points to where DC plans are headed next and what the next big thing might be.
So how have the plans evolved over the years?
The first DC plans were started in the 1980s, mostly by large companies with defined benefit plans. They paid administrative expenses directly through the investment professionals that managed their DB plans.
While DB plans contained various investments with varying degrees of risk to fund retirement for a large pool of employees, guaranteed investment contracts and other capital-conservation funds such as stable value funds were the most popular, and sometimes the only, investment option in DC plans.
Mitigating risk, these conservative investments were not appropriate for all DC participants, many of whom had years to go before retirement. GICs are less appropriate for people without pension plans, which led to ...
... the popularity of mutual funds. With a booming stock market, and retail share classes with rich revenue-sharing that paid most, if not all, plan costs, mutual funds allowed hundreds of thousands of companies to offer their employees a corporate retirement plan with limited employer costs and seemingly low risk. That perceived utopia ended with the market crashes of 2000 and 2001, leading to ...
... target-date funds. The Pension Protection Act of 2006 is largely credited with the growth of TDFs. More important was the notion that most DC participants are incapable of managing risk or portfolio construction, especially as they get closer to retirement.
TDFs, no matter how crude an instrument, are more effective for a vast majority of investors than do-it-yourself investing. When combined with automatic enrollment and automatic escalation, DC plans start looking a lot like DB plans. Leveraging technology and big data and the need for more personalization, the next big thing will be …
... dynamically managed accounts. Ultimately we will need to migrate to dynamically managed accounts that are customized for each investor based on their retirement plan liability. Technology and use of big data is available today allowing the banking, credit card and online consumer industries to make big improvements.
Pension plans managed investments based on the company's liability to fund the retirement of a pool of workers. With DC plans, every employee is managing his or her own personal DB plan. Employees need to use the same liability-driven investing concept from pensions, not just the age-based investing that's used in TDFs.
Along with how close an investor's retirement plan is to being fully funded, other factors like health, job type and location of the investor as well as his or her behavior and risk tolerance should be used to create a portfolio.
Custom TDFs, the first step toward dynamically managed accounts and popular with larger DC plans, are migrating down market through adviser groups that pool their clients' assets and are taking hold now because they do not require record-keeper cooperation.
And portfolios using participant data from record-keeping systems, as well as assets held outside the 401(k) plan, that automatically dial risk up or down depending on funding requirements are starting to become available on major record-keeping platforms.
DC plans are lagging but should catch up if advisers push clients and providers to move the 401(k) and 403(b) plans to the next phase of their evolution.
Fred Barstein is the founder and CEO of The Retirement Advisor University and The Plan Sponsor University. He is also a contributing editor for InvestmentNews' Retirement Plan Adviser newsletter.