Defined contribution plans suffer no shortage of critics—just ask the plaintiffs’ bar.

The most strident would like to see them go away altogether, and return to the days when defined benefit pensions were the primary platform for readying workers for retirement.

That is unlikely to happen, of course. But a new survey of 20 sponsors of mega 401(k) plans that hold billions, and in some cases tens of billions, in participant assets, suggests more fiduciaries are incorporating components of traditional defined benefit portfolio management into their 401(k) platforms.

“Historical approaches to DC plans have generated decidedly mixed results, including an over-reliance on retail investment solutions, inability to integrate automation and education, and inefficiently priced products and services,” says a new paper from BNY Mellon, The DC Plan of the Future: DB Principles for the DC Generation.

Read: 401(k)s beat pensions for higher income replacement rates

Credible studies crop up every year comparing 401(k) plans’ ability to generate retirement income relative to traditional pensions.

A couple of years back, Towers Watson compared annual investment returns of 401(k)s to pensions over a 17-year period, beginning in 1995.

Read: Top 5 industries for 401(k) plans

The investment strategies of DB plans routinely outperformed returns in 401(k)s, which are not only self-directed by non-investment professionals, but also have access to fewer investment options. For six of those years, returns on pension portfolios were more than 2 percent better than 401k plans generated.

Those results go a long way to explaining why more of the largest 401(k) sponsors are actively implementing tradition DB investment strategies into their DC plans.

Here is a look at exactly how the largest sponsors are borrowing from the past as they create the 401(k) plans of the future.

#1: Creating income for life by annuitizing deferrals

Over half of the of the sponsors said providing retirement income will drive the greatest changes in plan design by 2020, more than investment product innovation, regulatory or litigation issues, or market volatility.

“In the same way that people know the monthly payments of their pension (DB) and social security, the same thing can be done with DC plans,” the study says.

While forward-thinking sponsors are addressing lifetime income needs, real obstacles are slowing the process. The financial crisis called into question the solvency of some major insurance carriers, such as AIG needing a government bailout. Some annuity products were pulled from the market during the crisis, according to the report.

Also, regulators have been slow to provide a clear safe harbor for sponsors in offering annuities, though efforts from the White House to clarify sponsors’ fiduciary obligations in selecting and monitoring an annuity provider suggest the regulatory will exists to facilitate annuities in 401k plans.

#2: Institutionalizing investment options

Of all the controls at sponsors’ disposal, the study calls the use of institutional investment vehicles the “low-hanging fruit” in the effort to reduce plan costs and implement greater control over investment outcomes.

More than one-third of sponsors said they will reduce the number of mutual funds from lineups, and 65 percent said they will increase the use of institutional investment vehicles such as collective trusts and separately managed accounts.

The average expense ratio of all CITs (including passive and active strategies) is 32 basis points, compared to 45 basis points, the average for all mutual funds.

Beyond the lower fees, separate accounts allow sponsors to customize an investment strategy. In “white labeling” an investment strategy, sponsors can leverage investment managers with proven success overseeing participants’ DB plan assets.

Sponsors said they continue to limit the number of investment options. In customizing institutional investment options, they can improve underlying diversification issues in some traditional off-the-shelf funds, while minimizing participant confusion by narrowing the range of investments to choose from.

#3: Adding a place for private equity, hedge funds and other alternatives in mega 401(k)s

Mega sponsors are warming to offering alternatives to 401(k) participants, even as some public pension funds and institutional investors pare back some alternative vehicles, such as hedge funds.

The paper suggests that by accessing the range of investments available with DB strategies, 401(k) participants could not only experience higher long-term returns, but also build in protections from volatile equity markets.

In total, 30 percent of sponsors said they are increasing alternative options (5 percent are adding hedge funds, 25 percent are adding liquid alternative funds).

Alternative investment fund manufacturers are helping the cause by providing products that don’t include the carried interest or incentive fees seen in traditional alternative investments, which have garnered significant criticism over the past several years.

Sponsors also said they are looking to include alternative funds in custom target-date funds, giving participants investment diversity while addressing liquidity issues that have harmed the case for alternatives in 401(k)s in the past.

Some sponsors indicated concern over stand-alone alternatives in investment menus, as participants may get the impression that alternatives can’t lose money.

Last year, fiduciaries of Intel’s 401(k) plan were sued for the volume, cost, and quality of the alternative investments in its platform.

Notwithstanding that case, BNY Mellon says all indications are that sponsors of mega plans see a place for alternatives in participants’ 401(k) strategies.

#4: Unbundling fees and improving transparency

Combining investment, recordkeeping, and administration fees can create inflated costs, limit transparency, and introduce potential conflicts of interest, the paper suggests.

“The DC Plan of the future will have a more transparent fee structure, particularly on the investment side,” the paper said.

The vast majority of mega-plan sponsors—95 percent—expect to see greater unbundling and less reliance on revenue-sharing agreements.

“Whether driven by regulators, lawsuits, or voluntary changes, sponsors anticipate a decreased reliance on marketing and distribution fees and related payments. Fees will become more competitive once sponsors can see what they are paying for.”

#5: Combining education and automation

The automatic-enrollment and automatic-escalation provisions of the Pension Protection Act have succeeded in expanding enrollment but have failed to ensure adequate savings rates, failed to address participants’ specific savings needs, and failed to provide income predictability in retirement, the paper says.

Two-thirds of mega-plan sponsors said they plan to increase the time invested in participant education to address the shortcomings of auto-enrollment.

“Returns are important,” notes the paper. “But successful campaigns stress the need for disciplined approach, with savings as the main engine of growth.”

Deeper analysis of the true cost of 401(k) loans is one tool sponsors are exploring to better educate their participants.

Sponsors in the BNY Mellon survey noted the need for targeted education of retiring employees. Because mega plans have such significant purchasing power, and given sponsors’ intent to reduce plan costs more with CITs and separate accounts, retirees will face potentially expansive new investment costs when they roll out assets at retirement into IRAs packed with more expensive retail mutual funds.

That raises the question of leaving assets in plan at retirement, and how that might benefit not only participants, but also mega-plan sponsors.

“Targeted communications to participants nearing retirement can highlight the fact that staying in the plan is a compelling option,” the paper said.

Moreover, “sponsors with plans where the majority of assets concentrated among a narrow group of participants nearing retirement have the added motivation of considering the potential impact that large rollovers would have on the plan.

“Defections by boomers with high account balances could significantly decrease plan assets, leading to decreased economies of scale and higher fees for remaining participants,” the paper noted.

Instant Insights /

5 strategies 401(k) plan fiduciaries are borrowing from pensions

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