Many corporate defined benefit plans did very well last year, thanks to rising interest rates that reduced plan liabilities. The funded status for the largest plans increased to 111.2% through November 2022 from 98% at the end of 2021.
MFS Investment Management’s “2023Retirement Outlook,” an annual assessment of how defined benefit and defined contribution (DC) plans are doing and what the year ahead might have in store for them, highlighted this silver lining in an otherwise tumultuous period for investments. The study also looked at the expanded benefits under the Secure Act 2.0 and the strong interest plan participants have in ESG.
The study noted some small hiccups with target-date funds, however, and misunderstanding about what happens to assets after participants retire, specifically the role of defined contribution plans when it’s time to unwind assets.
“Advice is really going to be critical here to help participants sort through what are the right products that make sense for them in retirement. Maybe it’s a target-date fund with an annuity, maybe it’s a managed account, maybe it’s something else depending on their circumstances,” said Jonathan Barry, a managing director and head of client solutions at MFS in Boston. “And we do caution plan sponsors and others about trying to find that one magic product that’s going to do the trick. We don’t think it exists.”
MFS’s data was gathered from more than 1,000 U.S. employees actively contributing to a DC plan. Its takeaway was that far too few DC plan participants who choose a target-date fund as their plan option actually understand how these vehicles work.
The target-date funds have been very successful in attracting assets, as they are now the dominant vehicle in the DC space, the outlook said. More than 60% of new assets now go to these funds, which hold 31% of total DC assets.
And most participants do understand that target-date funds get more conservative the closer the participant gets to retirement (something acknowledged by 78% of those in the survey) and that the funds offer real diversification with one investment (something acknowledged by 82% of those surveyed). However, more than 75% of the participants thought these funds provide a guaranteed stream of income in retirement; 68% believe they provide a guaranteed rate of return, and 63% think they invest in cash or low-risk assets once participants enter retirement.
“Target-date funds [are] pretty much the standard way of accessing 401(k) benefits, but we’ve never really told participants how they really, really work,” Barry said. “The focus for the last 10 years has really been on accumulation. We haven’t forced participants to think about decumulation, so when you start to ask the question, ‘How well do you understand this thing we’ve never explained to you?’ you’re going to get these answers.”
The Whole Picture
The financial industry has to get a lot better at explaining the whole picture of how investments work, he said. At the same time, because a gap is emerging between accumulation and decumulation, some target-date funds are starting to address post-retirement with annuities or guaranteed lifetime withdrawal benefits, the report showed.
In addition, target-date funds that morph into managed accounts, called dynamic qualified default investment alternatives (QDIAs), are also starting to emerge.
“We’re in the very, very early days of these next-generation features,” Barry said. “They’re out there, but right now there’s a low uptake across the industry.”
That’s good news for financial advisors, the report assured, as “even with guaranteed income features, [target-date funds] may not be a single-source retirement solution for the majority. The data also suggest that advisors will be a key piece of the puzzle in figuring out the role target-date funds will play in retirement.”
For example, only 14% of baby boomers (those age 55 to 73) and 19% of Gen Xers (those age 39 to 54) say they expect to keep all their assets in a target-date fund.
There’s been an increasing trend in which plan sponsors retain the assets of retirees, which potentially keeps them out of the control of a retiree’s financial advisor. However, the people who do this are still in the minority, as only 15% of contributors to a DC plan said they planned to leave their assets with their employer’s plan upon retirement.
If a defined contribution program is going to be a “destination plan” instead of just an accumulation plan, its sponsors need a desirable investment lineup, tools and services, and a plan design that lets participants access their money. It’s this last factor that keeps adoption low, Barry said.
“A lot of 401(k) plans have distribution provisions that are antiquated. ‘Take your money, here’s your lump sum.’ It’s very simplistic,” he said. “Those would have to evolve.”
And that evolution has a long way to go.
“On the accumulation side, participants are homogeneous. They all need to accumulate assets in the same way,” Barry said. “But when they are getting close to retirement, everyone is very, very different.”