Joe and Sally joined the same company right out of school and enrolled in the registered group savings plan. Sally was three months older than Joe and retired September 1, 2008 with a $600,000 portfolio. Joe’s portfolio was worth only $480,000 when he received his simulated gold watch a few months later.
Had they been members of a defined benefit (DB) pension plan — DB plans determine a pension usually based on a percentage of salary, with the benefit being the employer’s obligation — Joe and Sally would be drawing identical pensions, all things being equal.
They made identical contributions — with identical employer matches — to buy identical funds in the identical proportion for forty years. The difference in outcomes because of something as uncontrollable as a birth date seems incredibly unfair. Something is wrong here.
Different than DB plans
DC and RSP benefits are completely a function of contributions and the actual investment result for each employee. Employees are responsible for the outcome, not employers, and the pension amount is unknown until retirement. High costs, poor investment decision-making and lack of scale are documented problems with DC plans, which have generally experienced returns 1% lower than DB plans over time, according to a recent Towers Watson study.
DB plans need to match long- duration liabilities to pay pensions of existing and future workers, so they usually invest with a very long-term view. Mutual funds, following the objectives in their prospectuses, similarly invest with a long-term view and often a perpetual duration. As a result, establishing and rebalancing portfolios to a fixed asset allocation is popular with DB plans because short-term market variability is theoretically evened out over time. Perpetually long investing horizons always have time to make back losses. In reality, Sally, Joe and every RSP and capital accumulation plan investor has an investing time horizon that is shrinking and shortening every day, whether due to retirement or death.
Constructing a portfolio that does not recognize this fact is at best irresponsible, and at worst negligent. Yet most advisors, registered reps and educational sessions for DC plans promote the same basic strategies that were designed for DB plans: diversify, buy, hold and rebalance. The exception is the “target date fund” that automatically reduces equity exposure over time on a fixed glide path. Early generations of this increasingly popular approach have not escaped controversy, a subject we will examine next month.
DB plans invest to match perpetually long-dated liabilities, while DC and RSP investors have investing horizons that are shrinking every day. By building portfolios that have fixed-asset mixes without regard for individual requirements, the industry is ignoring what investors need. Trimming risk from a portfolio as retirement approaches is one effective tactic. A simple way to do this is to introduce ETFs to build in an increasing proportion of stable, low risk. The table “ETF investing options” on the left shows some low-risk choices that can be introduced at least five years before retirement, ranked by cost.
If returns are 1% below DB plans, using passive or indexed vehicles can help make up the difference. ETFs are appropriate to use if RSP contributions are made once a year. If deposits are made more frequently, as they often are with DC plans, the commission cost of buying ETFs may be prohibitive despite their low fees.
Buying index mutual funds and making a transfer at the end of each year to one or two ETFs is the most cost-effective approach. Claymore offers a commission-free way to buy their ETFs through certain brokers, an option worth exploring for some investors.