By Jim Keohane, Alex Mazer & Jonathan Weisstub
Jim Keohane recently retired from the Healthcare of Ontario Pension Plan (HOOPP), where he served for 20 years as CEO and, before that, Chief Investment Officer. Under Jim’s leadership, HOOPP delivered the highest ten-year returns among global pension fund peers. While Jim was CEO, HOOPP and Common Wealth Retirement collaborated on a number of projects, including research on the value of a good workplace retirement plan.
Alex Mazer and Jonathan Weisstub are the co-founders and co-CEOs of Common Wealth Retirement.
When discussing group retirement plans with employers, one topic that frequently comes up is that of investment choice: What investment options will you provide to our employees? This is a very important question, as the design of the investment program for a group retirement plan is one of the most important factors in determining what value it will provide to employees.
Unfortunately, this is an area in which the traditional retirement benefits industry has poorly served both plan sponsors and plan members. The traditional industry’s focus on a high degree of investment choice is based on a flawed premise: that employees and plan sponsors have the desire and capacity to engage in the choosing and ongoing management of the investment of their retirement savings. If our goal is to help employees achieve retirement success in the most cost-effective way — which it should be — then a better focus should be not on choice but on simplicity.
The status quo: choice overload
Traditional providers sell their group retirement services to employers on the basis that they have hundreds of funds and dozens of managers to choose from. Canada’s major insurance companies boast of the breadth of their selection of investment fund providers, asset classes, investment styles and strategies, and so on.
Especially for smaller or mid-sized employers, there are usually four parties involved in the chain of decisions that leads from the hundreds of funds on an plan provider’s platform, to the investments that are eventually held in a plan member’s retirement savings account:
- The insurance company or bank that is providing the plan and promoting investment options through the broker
- A broker (who might have the title “advisor”) who is selling the plan to the employer and helping that employer choose a set of investment options
- The employer (e.g., the business owner, HR, or finance department) who is setting up the plan and making the final choice about investment options. Employers will be asked to choose an investment “lineup” (industry-speak for the investment products that will be offered to employees as part of their plan). There are several elements to this choice: How many funds do you want to provide? What investment managers do you prefer? What mix of different types of fund (e.g., balanced, target-date, target-risk, ETFs, money market funds, speciality funds, individual asset class funds)? What should be the default fund for employees who don’t make a choice? Do you want passively managed funds, actively managed funds, or both? Should employees be allowed to choose individual stocks or particularly narrow asset classes (e.g., Canadian small-cap growth)? It is not reasonable to expect that the expertise needed to make these difficult choices would reside in most companies.
- The employee who is enrolling in the plan and making an investment choice from the menu provided by their employer. It is not uncommon for employees with little to no investment acumen to have to be faced with a dizzying array of 30 or more investment funds, often with confusing names and technical education materials. In addition to having to choose among these many funds, employees may often be asked to allocate their retirement savings across multiple funds. It would be rare for any employees to have the educational background and knowledge of financial markets to make informed choices.
You can see why, especially during periods of stock market booms, greater choice might have been an effective sales tactic. It would seem intuitive that greater choice would be desirable. Traditional providers were racing to become supermarkets of funds, outcompeting one another for who could offer the greatest selection. But research shows that the facts are quite different.
In creating supermarkets of investment products, the traditional industry has lost sight of the main point of workplace retirement programs: to create good retirement outcomes for plan members.
Employees need and want simplicity
There is mounting evidence from some of the world’s top retirement researchers that greater investment choice leads to materially worse outcomes for plan members. Here are a few examples from the literature:
- Columbia University researchers found that offering greater investment choice led to lower participation, with workplace retirement plans offering ten or fewer options resulting in the highest participation
- Wharton School researchers discovered that streamlining investment choices could result in nearly $10,000 more in savings for plan participants over a 20-year period
- Harvard University and Yale University researchers learned that even highly educated investors can make common mistakes (like paying too much in fees) when selecting from a group of seemingly similar funds
This research confirms what social psychologists and behavioural finance experts have been saying for some time: that more choice can overwhelm people and lead to poor decisions or to indecision (see, for example, this often-cited paper). Given how overwhelming most people find the topic of retirement saving and investing to be, it is not surprising that the “supermarket” style of workplace retirement plans has led to worse outcomes.
There are a number of reasons why introducing complexity into the investment choice and management process results in worse outcomes.
- Poor asset allocation. Asset allocation — how you divide your investments between different kinds of investments and geographies — is generally regarded as the most important investment decision, driving over 90% of investment performance. Most individuals lack the knowledge to make sound asset allocation decisions if required to make these choices on their own. It is not uncommon to see individuals take too little risk (e.g., by putting long-term savings into a money market fund), take too much risk (e.g., by investing all their retirement savings in a single asset class), or fail to take advantage of what is regarded as the only “free lunch” in investments: diversification. If a workplace retirement plan involves a high degree of choice — especially if it has no default funds — individuals are likely to make poor asset allocation decisions that could cost them hundreds of thousands of dollars over the long run.
- Market timing mistakes. When individuals feel responsible for managing their own investments, they often make predictable and poor decisions when it comes to market timing. For example, during periods of market volatility, individual investors tend to try to “time the market,” hoping they will minimize their losses by withdrawing from the market when it is falling, and getting back into the market in time to reap the benefits of the recovery. However, even seasoned investment professionals find it extremely difficult to time the market in this way, and individual investors usually end up underperforming the market in these situations. Morningstar, a respected investment research firm, has found that market timing and other factors lead individuals to underperform the funds they invest in by roughly 1% per year.
- Performance chasing. Individual investors tend to choose funds that have performed well recently. While this might seem like a wise approach, funds with strong recent past performance often end up having weak future performance, in part because fund performance tends to revert to the mean. Some call this common behaviour “performance chasing,” and it is another form of investment mistake that can cost individual savers.
- Active management’s tendency to underperform. Investment choices often include actively managed funds, meaning funds that attempt to beat the market as a whole through some kind of strategy. Although these funds often involve significantly higher costs, they very rarely deliver outperformance over sustained periods of time, especially after taking fees into account. While a small minority of actively managed funds do outperform the index, it is very difficult, especially for an individual investor, to identify these funds in advance.
- The cost of complexity. A high degree of choice introduces additional costs. It is expensive for traditional providers to support platforms with hundreds of funds and dozens of managers. It is expensive to pay brokers to distribute group retirement plans and individualize investment lineups for each employer. These costs end up getting passed on to the plan member in the form of higher fees, and these fees take a big bite out of the plan member’s retirement savings.
The combination of these factors is one of the reasons why we found, in previous research that we worked on together in a collaboration between Common Wealth, the Healthcare of Ontario Pension Plan, and the National Institute on Ageing, that the ability to avoid investment mistakes is one of the five main value drivers in measuring retirement plan cost effectiveness.
It’s not just that simplicity results in better outcomes for employees. We believe it is also what most people — both employees and employers — are looking for. People live busy lives. Most are not looking to become investment experts. They are looking for their retirement plan to help them achieve retirement success in a straightforward and cost-effective way.
Likewise, employers want workplace retirement plans that are easy to set up, straightforward to manage, and will lead to retirement success for their employees.
Undisclosed conflicts of interest
Besides being overly complicated and prone to poor outcomes, the supermarket approach to investment funds is also subject to conflicts of interest.
Traditional providers are often conflicted because they have their own proprietary investment products, in addition to products from other investment managers. They make more money from a group plan if it includes insurer-provided funds as part of the investment lineup. This conflict, and the compensation structure behind it, generally goes undisclosed as part of the buying and plan setup process. Research has also shown that proprietary funds are less likely to be removed for poor performance.
Brokers also receive compensation in the form of commissions for selling group plans. Those commissions look different depending on the kind of plan they sell. Parts of the brokerage industry have fought tooth and nail to prevent these commissions from being disclosed to employers or plan members. Many employers think they are getting advice about setting up an investment lineup, when in fact they are dealing with a commissioned salesperson whose main incentive is to offer the arrangement that pays the highest commission. Even if these conflicts did not exist, many brokers lack the necessary investment management or retirement expertise to make appropriate recommendations to employers or plan members, since they must split their time amongst a wide variety of group benefits, including insurance, health, and other offerings that do not give them the time to develop the necessary specialized expertise.
The combination of high choice, undisclosed conflicts, and inadequate expertise puts both employers and plan members in a very difficult situation.
Human resources managers and other employer representatives are put in the uncomfortable position of selecting investment lineups for their employees when often they are not sure how to invest their own retirement savings, let alone be responsible for those of dozens or even hundreds of their employees. Employees, meanwhile, are often faced with a dizzying array of choices as part of a plan that was supposed to make retirement saving easier.
A common sense approach
At Common Wealth Retirement, we’ve chosen an approach to investments that we think makes much more sense for both employers and plan members:
- Use target date funds. Target date funds are an all-in-one, simple investment solution. They are tailor-made for retirement, and automatically do those things that help plan members get the fundamentals of investing for retirement right: broad diversification, rebalancing, and appropriate asset allocation that automatically becomes more conservative with age. Recent research from the Wharton School found that plan members who use low-cost target date funds could enhance retirement wealth by as much as 50% over 30 years.
- Use smart defaults. Plan members are given a default target date fund that is appropriate to their age and desired retirement date. The vast majority of members choose the default, which means that investment choice rarely becomes a barrier to people participating in the plan.
- Employers don’t have to choose. We remove the burden of investment lineup choice from the employer. We have found that most employers — particularly small and medium ones — have little interest in becoming investment experts, and some are concerned about the potential liability and risk associated with having to make investment choices.
- Favour indexing. Our target date offerings use an index-based approach, rather than using active management which tries to beat the market. Extensive evidence shows that active management tends to underperform, and that if you give people a choice among a variety of funds, they will often pick the funds with the best recent performance (if these are actively managed funds, that often means they are the most likely to underperform in the future).
- Partner with world-class providers. Rather than trying to create a fund supermarket to rival those of the legacy providers, we have worked with a select group of investment managers and annuity providers, including BlackRock, Brookfield, and Vanguard, who are global leaders in what they do.
It’s important for all of us — providers, employers, and plan members — to remember the real problem workplace retirement plans are meant to solve: helping people secure the best possible retirement outcomes for themselves and their families. When investment choice becomes the measure of success, this focus gets distorted and employers can unwittingly undermine their efforts to build their employees’ financial health, costing their employees tens or even hundreds of thousands of dollars.