CAPs have turned out to be more complex and challenging for sponsors and CAP members than expected. Keeping it simple is an effective and efficient approach for all stakeholders.
In the 1970’s and early 1980’s, DB plan members clamored for the purported free lunch and portability provided by converting their DB plans to DC plans. Cagey CFO’s, encouraged by the financial institutions, could not believe their good fortune in being able to load financial risk associated with DB plans while not having to fully recognize and compensate members for the numerous risk they appeared to be willing to assume. Unfortunately, this enthusiasm has waned over the years: the majority of CAP members are simply not up to the challenge of managing investments and pension. Sponsors realize that many CAP members will likely fall short in terms of adequate pension incomes.
The administrative and fiduciary challenges of CAPs and the potential financial and legal risks are also a concern for sponsors. Providing accurate effective communication and education to program members however is a one of the most difficult and costly challenges of CAP programs.
Part of the problem is that CAP programs are often overly complex: a simpler approach (KISS) benefits all stakeholders.
Governance - the key to minimizing risk
The key for employers and sponsors to minimize the financial and legal risk inherent in pennsion programs is a comprehensive governnce process. Most sponsors claim to have a governance process in place. Many DC plans many sponsors assume their recordkeeper or platform admistrator is responsible for over seeing the plans. However, it is sponsor who ultimately is accountable and responsible for over seeing the plans and the administrator(s).
The many cases the governance is piece -meal at best, poorly documented and not followed. This combination is a worse case scenario from a legal perspective. In many situations the sponsor is not aware of what should be included in a governance process. The results of a governance audit tend to leave the organiaztions CFO feeling very uncomfortable and demanding immediate chnages. There-in lies the value of a DB or DC plan governance audit.
Many areas need to be considered and documented as part of a governance program.
CAP Members - the challenge
CAP members need to have a basic understanding of investment and risk concepts usually reserved for investment professionals. Coming to grips with styles, asset classes, diversification, risk (in various forms), benchmarking, risk profiling, retirement funding, and time vs. timing, requires far more time and effort than most CAP members can handle. In addition, CAP members must often contend with 15-25+ investment choices, which may include life cycle and balanced funds; large and small Canadian, US and foreign equity funds; bond, mortgage and real estate funds; daily interest and money market funds; and, GICs. Whew!
While record keepers provide education, decision making tools and communications, it is not surprising that CAP members struggle, and are often overwhelmed, with this mass of concepts and information. This situation begs simplification.
The majority of CAP members are unsophisticated and inexperienced investors. Forcing them to choose from multiple options is akin to giving a teenager a bottle of vodka and the keys to the family car. Is there a “message” in the number of choices available? For example, if there 12 options including a bond fund, a money market fund and a CIA and nine equity options is there a subliminal message about where to invest?
In addition, unlikely that members, nor the sponsors, get all the relevant performance information needed to manage in a long-term investment horizon.
How manuy options is too many
Sponsors providing a large number of investment options likely do this under the misconception that it improves diversification and/or returns. Under the CAP Guidelines, however, a sponsor is only required to provide sufficient options to ensure an adequate degree of diversification. The PRPP Regulations also offer some insight on the issue of diversification vs. the number of investment options: only six investment options are allowed in a PRPP, including a default Fund.
There are knowledgeable investors that argue that a “one fund” approach using a balanced fund, or a series of asset allocation funds, would provide a sufficient choice. Catering to a very limited number of CAP members who think they need a lot of investment choices should not drive the selection of investment options: the sponsor should focus on the needs of the vast majority of the CAP members. Reducing the number of investment options is therefore an obvious way to make a CAP simpler and less costly but still effective.
Taking simplification a step further, a sponsor could also consider using passive investment options in combination with fewer investment choices. There are several advantages in using a passive approach from both a fiduciary and CAP member perspective. A limited number of passive investment options, covering the major asset classes, would likely provide an effective CAP investment framework for most organizations. Investment communications and education to member, a difficult task, is also much simpler.
Investment Options - KISS
Simplifying the CAP investment platform has many advantages from a fiduciary perspective as well from a pension committee and CAP member perspective. Having fewer and simpler investment options:
· reduces the education and communication requirements in terms of time and costs;
· simplifies communication and education processes;
· simplifies performance monitoring;
· lowers administrative costs; and,
· simplifies manager searches and reduces the time required and costs.
In addition, if a passive approach is also used
· volatility of returns vs. the benchmark is minimized; and,
· member management fees will be significantly lower.
. CAPS are risky that DB plans:there are more things that can go wrong in a CAP. You have to question whether there is any significant benefit for sponsors or CAP members in having complex CAP investment platforms. Given the demographics and lack of member investment sophistication in most CAPs it is easy to argue that the sponsor is acting prudently by simply providing a suite of passive asset allocation funds plus a few stand-alone passive investment options, covering the major asset classes. Using a simpler approach will not eliminate the issue of CAPs generating insufficient pension incomes but it will make a CAP program more “friendly”, effective, easier to communicate and less costly for all stakeholders.
Having a sound governance process in place is the key to mininizing financial and legal risks regardless of the type of plan.
Gerry Wahl
Managing director, The PensionAdvisor