While many would argue that comparing the returns of DB and DC plans is not an apples-to-apples analysis, a new report examines the plan performance gains that DC plans have made against DB plans.
CEM Benchmarking’s report, “Defined Contribution Plans Have Come a Long Way,” finds that while DB funds have outperformed DC plans from 1998 and 2005, the performance margins have decreased considerably in the last 10 years, largely as a result of changes in asset mix, plan design and better default options.
For the 1998-2005 period, DB funds outperformed DC plans by 180 basis points, but that margin narrowed to a level of 46 basis points from 2007-2016, with a 10-year average DB return of 5.36% compared to 4.89% for DC plans, according to the report.
CEM Benchmarking’s findings were based on 1,967 observations in its U.S. DB database and 1,647 observations in its U.S. DC database, which in 2016 was comprised of total participant assets of $3.6 trillion from 168 U.S. DB funds and $1 trillion from 147 U.S. DC plans.
So what changed since their last report in 2006? Plan sponsors offering target-date funds, implementing automatic enrollment and making TDFs the main default option helped reduce the net return differential, the authors suggest.
DC Plans’ Asset Mix
A main driver in the improvement of DC plan performance is because allocations to lower expected return asset classes — such as cash holdings and stable value funds or an undiversified asset, as in the case of company stock — have decreased, according to the report.
In 1998, these assets represented on average 44% (26% company stock and 18% stable value and cash) of the holdings in the DC plans, but by 2016 their percentage dropped to 25% (10% company stock and 15% stable value and cash). In addition, the eight-year (1998-2005) average holdings of cash, stable value and company stock was 41% for DC plans, compared to a corresponding 1% for DB plans over the same period.
The authors explain that these allocations have mainly moved to TDFs and balanced funds, providing a more diversified asset mix. Emphasizing the explosive growth in TDFs, the report shows that in 2016, 87% of the plans in CEM Benchmarking’s DC database offered TDFs, compared to 46% in 2007.
Plan Design Changes
In addition, plan sponsors have taken advantage of the role inertia plays in behavioral economics by offering automatic enrollment in both primary plans (DC plan is the sole retirement vehicle) and supplemental plans (DC plan is in addition to a DB plan).
The report shows that automatic enrollment in U.S. DC plans has increased substantially, from 62% in 2007 to 80% in 2016 for primary plans, and from 51% in 2007 to 70% in 2016 for supplemental plans.
More plan sponsors have also implemented a QDIA, according to the report. In 2016, only 5% of DC plans did not have a default option, which is down from 21% in 2007. Not surprisingly, TDFs were found to be the most popular, with 84% of plans choosing them as their default option, compared to 30% in 2007.
The authors note that the biggest asset mix improvement was for plans that previously had a default option that was in the category of GICs/stable value/cash. According to the report, only 1% still had this asset category as their default option in 2016, down from 21% in 2007.
Finally, the report suggests that costs for DB plans “have risen primarily because they are increasingly adopting more sophisticated investment strategies including a higher allocation to more expensive ‘alternative’ private market strategies such as private equity, venture capital, and hedge funds.”
For U.S. DB plans, combined policy weights for real assets, private equity and hedge funds increased from 14% in 2007 to 23% in 2016. By comparison, the report states that less than 1% of DC plan assets were directly invested in ‘alternative’ assets in CEM Benchmarking’s 2016 database.