Global Opportunities: The Next Leap Forward for Defined Contribution Investment Menus

Under ERISA, fiduciaries are obligated to ensure plan menus provide diverse investment options to help minimize the risk of long-term losses in account values. Global, non-traditional equity and fixed income options are sorely lacking in Defined Contribution (DC) plan menus. These options can offer both lower correlation to U.S. markets and potentially strong returns, which participants increasingly need given the uncertainty surrounding Social Security’s future benefit levels.

Amid the transition away from defined benefit plans, some analysts warn against overreliance on defined contribution plans for retirement security. They point to low median account balances, little guidance on asset allocation and often limited investment options, which too often include inadequate exposure to overseas markets. They are valid points. Yet each one of them is a manageable challenge, obligation, and opportunity for plan sponsors, fiduciaries, and advisors to improve the odds of a secure retirement for U.S. workers.

Many DC plan consulting firms expect the biggest changes coming to plan menus will include more global or non-U.S. equity and fixed income funds, as well as dedicated emerging-market equity options. Such changes to investment menus are a necessary evolutionary step in DC plans.

DC retirement plans have been steadily gathering assets, becoming, alongside Social Security, a key pillar of the U.S. retirement system. Given the increasingly shaky finances of Social Security, the critical importance of DC plans for Americans’ retirement security will only grow. After all, Social Security’s solvency for today’s younger and middle-aged workers appears increasingly precarious. According to the latest projections in Congressional Budget Office’s (CBO) 2014 Long-Term Budget Outlook,1 the CBO now expects Social Security’s trust fund to be tapped out by 2030. An aging U.S. population means that government outlays for Social Security, along with other entitlement spending on Medicare, Medicaid, and subsidies provided in health insurance exchanges would, under current law, “grow much faster than the overall economy.”2 Keeping Social Security solvent beyond 2030 will require substantial payroll tax increases, scheduled benefit cuts, or a combination of both.

Fortunately, since its inception in the early 1980s, the 401(k) and other DC plans, such as the 403(b) and 457 plans, have become “the dominant private-sector retirement savings vehicle in the United States,” according to the Investment Company Institute (ICI), the American Benefits Council, and the American Council of Life Insurers.3 At the end of March 2014, nearly 75% of full-time private sector workers had access to employer-sponsored retirement plans, and about four-fifths of them were participating, the U.S. Department of Labor’s Bureau of Labor Statistics (BLS) reported.4 Not including Social Security benefits, DC assets amounted to $6 trillion or 26% of total U.S. retirement assets at the end of the first quarter of 2014, up from $4.4 trillion in 2007.5 According to the ICI, the median 401(k) account balance at the end of 2012 stood at $17,630.6 While small, it should be seen in the broader context of retirement resources that may include homeownership, Individual Retirement Accounts (including rollovers of DC accounts from previous employers); other financial assets; and Social Security benefits. Moreover, the advent of automatic enrollment of new employees and auto-escalation (gradual rises in employee contribution amounts) has been generating sharp rises in account balances in recent years. A study by the ICI and the Employee Benefit Research Institute (EBRI) found auto-enrollment significantly increases the participation rate among eligible employees to 92% from 66%.7 Of course, the higher the rate at which contributions are automatically set and escalate, the greater the potential accumulation over time.

Allocation Matters

Another critical consideration is investment allocation. Retirement account returns compounded over many working years may be far less than they could be if an employee’s DC default investment is a stable value or money market fund. At the end of 2012, 69% of participants in their 20s had zero exposure to equity funds in their 401(k) accounts, while 51% of all participants had none, according to the ICI and EBRI study.8 An account invested in a sensible mix of stock, bond, and stable value funds, with periodic rebalancing for age-appropriate exposure to each along the way, has a much better chance of growing substantially and weathering the inevitable market downturns during retirement.

Retirement income as a percentage of average annual income over the last five working years—known as the median replacement rate—can vary dramatically depending on pre-retirement contribution levels and investment choices. The replacement rate for the lowest-income quartile with a 3% contribution defaulting into a money market fund is 37% for workers turning 65 between 2030 and 2039, according to a model in the ICI/EBRI study. If the contribution is 6% and the pre-set investment is a life-cycle or target-date fund, which allocates between stocks and bonds and periodically rebalances over time to focus less on growth and more on income, the outcome is much better, with a replacement rate of 52%.

Allocation funds generally come in three flavors: the traditional “balanced” 60/40 equities-to-fixed income mix; “target risk,” which typically range from an aggressive allocation with heavier equity exposure to conservative allocation with more fixed income exposure; and target date or “glide path” funds. The use of allocation funds has grown dramatically in recent years, as they enable plan sponsors and participants, who may know little about investing, to rely on conventional financial planning and investing techniques for retirement.

At the end of 2013, 40% of all participants in Vanguard DC plans were invested only in an allocation program or managed account advisory service, nearly doubling the 22% at the end of 2008. Among new participants entering the plan for the first time in 2013, “three-quarters were solely invested in a professionally managed allocation.”9 In its annual “How America Saves” survey for 2014, Vanguard also notes that, “because of the growing use of target-date options, we anticipate that 58% of all participants and 80% of new plan entrants will be entirely invested in a professionally managed allocation by 2018.” More and more plan sponsors are also using target-date funds (TDFs), with 86% offering them at the end of 2013, versus 13% in 2004, according to Vanguard. It noted that 58% of participants using TDFs had their entire account invested in a single target-date fund at the end of 2013.

While the growth of TDFs is an improvement over default contributions into money market and stable value funds, plan sponsors, fiduciaries, and their advisors should closely examine the investment components within TDFs and DC menus more generally. They may not offer an optimal balance between capital protection, return potential, and risk diversification. That’s because many allocation funds and plan sponsor investment options exhibit “home bias,” only offering funds with a relatively heavy exposure to U.S. markets and securities. Unless they are custom designed with global fund components, too many TDFs fail to offer exposure to overseas markets, where economic growth and development of capital markets have opened up immense opportunities for U.S. investors.

Going Global

A few data points tell the story. While the U.S. still boasts the globe’s biggest economy and deepest capital market, the world has rapidly evolved over recent decades. Back in 1970, the U.S. share of global stock market capitalization stood at a towering 66%, according to MSCI. At the end of June 2014, its share amounted to just under half the total. Meanwhile, the U.S. share of global economic output stood at 26% in 1980, while that of emerging markets and developing countries was 25% and China’s just 2.8%.10 Fast forward to 2014, and the U.S. share has shrunk to an estimated 23%, while emerging markets and developing countries now account for some 39% of world gross domestic product, while China’s economy has since grown almost five-fold to 13% of global GDP.

Little wonder, then, that MSCI first launched its MSCI Emerging Market Index back in 1988. “Strong economic growth combined with the development of financial markets has led to the expansion of investment opportunities in emerging markets and has reshaped the equity universe,” MSCI notes in its description of the index, on which approximately $1.3 trillion in assets are benchmarked.11 Wrapping in both emerging and developed country markets, the MSCI All Country World Index ex-U.S. Investible Market Index sports 6,062 constituents covering approximately 99% of the global equity opportunity set outside the United States, the index provider notes.

The growth of overseas capital markets, especially in emerging markets, is hardly surprising, given GDP growth differentials. While the IMF expects the United States to grow 1.7% this year and 3% in 2015, it forecasts emerging-market and developing-country growth of 4.6% this year and 5.2% next year. Even China, which is now slowly moving to rebalance its economy toward more consumption and less investment, is still poised to grow more than 7% through 2015, according to the IMF’s July 2014 update of its World Economic Outlook. In terms of world trade volumes, emerging market and developing country imports are projected to rise 4.7% this year and 6.4% next year, outstripping advanced economy imports, which are forecast to rise 3.5% in 2014 and 4.6% in 2015.

As globalization gives rise to deeper overseas capital markets and a growing share of global GDP among emerging markets, U.S. workers would do well to have access within their retirement accounts to these overseas opportunities, which can offer important return and risk diversification benefits. But within many DC plans, they have little direct exposure to foreign equities or debt, the global pool of which has also deepened profoundly in recent times. The global debt market rounded $100 trillion by the beginning of 2014, of which U.S. Treasuries comprised less than one-tenth. “Similar to stocks, the composition of the global bond market has shifted and is currently 35% U.S. and 65% rest of the world,” reported Portfolio Evaluations, Inc. in a recent paper.12

Yet U.S. workers generally have limited overseas and global investment opportunities. According to Vanguard’s “How America Saves” survey, just 27% of the record-keeper’s DC plan clients have emerging market equity funds in their menus, and only 8% of participants used them. And while 97% are offered international equity funds, just 26% of participants invested in them.

The numbers are even worse for international and global fixed income options. Among Vanguard DC plans, 98% offered bond funds, but only 24% of participants actually used them. Just 7% of Vanguard DC plans offered international bond funds, while a minuscule 2% of participants with access invested in them. The presence of speculative grade “high-yield” bond funds was also sorely lacking: just 18% of plans offered high-yield options, and only 6% of participants took advantage of them. Global strategic income funds have virtually no presence.

What about the international or global exposure among the growing regiments of allocation funds? It also appears woefully inadequate. According to Morningstar, target-risk funds with an aggressive allocation had a small 21% allocated to non-U.S. equities, with the category’s share dedicated to emerging market stocks a paltry 2.2% and that of foreign bonds a mere 1.8%, at the end of July.

TDFs aren’t much better. To illustrate, for the 2036 through 2040 segment, the allocation to foreign equities stood at 26%, with that going to emerging markets at just 3.4%. Its non-U.S. bond allocation? 1.6%. Among the bunch, only world allocation funds come remotely close to allocations that reflect the new global era in investing, though with a non-U.S. equity allocation of 33% and a foreign bond exposure of less than 10%, they, too, still fall short of optimal.

Beefing Up the Menu

If DC plans are fast expanding target-date options, many still have not moved on beyond the typical menu comprised of roughly two-thirds equity offerings and about one-third fixed income choices.13 Apart from an implicit message of greater equity allocations, choices usually lack in global stock and bond exposure. As seen in Figure 5, equity choices often involve various U.S.-focused style and market capitalization funds, perhaps with a single non-U.S. equities option. The fixed income allocation is even more limited and is dominated by a “core” offering that is heavily weighted with very low-yielding U.S. Treasury and agency debt, and low-return stable value or money market funds. Critically, global strategic income funds, which can be much higher yielding and far less correlated with U.S. markets, still aren’t widely available. They certainly should be, especially given the outlook for rising U.S. interest rates in 2015 and the attendant reinvestment risk affecting core bond portfolios.

Some may argue that U.S. investors can obtain overseas economic exposure simply by investing in U.S. funds focused on companies within the S&P 500 Index, as roughly half of their revenues come from foreign markets.14 But are DC plan participants getting sufficient exposure to overseas growth and diversification benefits through investing in U.S. large-capitalization stocks? DC portfolios can better derive such benefits, including lower potential correlation with U.S. markets, through dedicated global equity, international value, international growth, and emerging market funds, as well as strategic global fixed income funds.

Education for Enhanced Allocation

DC plans have evolved rapidly over the last three decades, and the rise of automatic enrollment and auto-escalation plans have become key factors in the retirement security equation. Balanced funds, particularly TDFs, have certainly helped workers save for retirement more than default investments into a capital preservation plan. But DC plan participants should today have the ability to take advantage of opportunities across the globe, not be effectively limited to those at home. It’s more than likely to happen, given the compelling reasons for more overseas and global investment options, which DC plan advisors have already identified as areas on which to focus.

A recent survey of 49 DC consulting firms included a question on which added asset classes would bring the most value to the core line-up: 75% said they expect global or non-U.S. equity, while 60% listed global or non-U.S. fixed income and 46% suggested adding emerging market equity funds.15

Plan sponsors would clearly do well by participants in examining their menus and drilling down into the components of their target-date and other allocation funds. Many may find they should broaden out and balance their investment line-ups to reflect today’s global opportunities. If plan sponsors and their fiduciaries include more non-U.S. and global debt and equity options in plan menus, custom TDFs and managed accounts can then be designed to use those funds so participants gain suitable access to a broader array of asset classes that are currently lacking in most pre-packaged TDF series.

Yet revising plan menus isn’t enough. Plan advisors and fiduciaries can add enormous value with the development of education policy statements and programs that incorporate the importance of global investment, given the risk diversification and potential return benefits. It’s noteworthy that the number of investment choices alone doesn’t have much influence on participant choices: in Vanguard’s survey, participants on average had approximately 18.2 distinct plan investment options, but on average choose only 3.1.

As the long-term outlook for Social Security darkens, the effectiveness of DC plans for retirement security is becoming ever-more critical. n

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