By Mark Olsen, Managing Director at PlanPILOT
This article offers insight into the complex topic of the various risks defined contribution (DC) participants face. It also challenges traditional thinking about risk, which often oversimplifies risk as a single category and underestimates the impact various risks have on retirement outcomes. We believe plan sponsors would do well to deploy time toward “risk literacy” and understand the various risks their participants face as they make critical plan oversight decisions. Risk literacy will help committees prioritize the way they spend time and inform key decision-making.
Risks Defined
Risk comes in many forms that sponsors have to take into consideration for participants in plan oversight—market volatility, downside risk, shortfall risk in retirement, inflation risk, interest rate risk, and participant behavioral risk, to name the primary risk factors.
Traditionally, the most common form of risk that committees focus on is volatility, which captures the ups and downs of market events relative to a benchmark. While volatility risk is an important risk, it is not the only risk. In fact, consider that upside really is not a risk; it is a reward. Solely focusing on this single risk factor will unfortunately overlook other critical risks that have a material impact on key decisions and retirement outcomes. As a start, below is a summary of the primary risks DC plan participants face.
- Volatility risk: The risk of a change in market value of a portfolio (up and down) as a result of changes in the volatility of a risk factor
- Downside risk: An estimation of a portfolio’s potential loss in value if market conditions precipitate a decline in that portfolio’s value
- Shortfall risk: Probability that a portfolio falls below some specified threshold level (e.g., a shortfall in retirement)
- Inflation risk: The risk that purchasing power will be reduced if the value of your investments does not keep pace with inflation
- Interest rate risk: The risk that changes in interest rates may reduce (or increase) the market value of a fixed income asset
- Participant behavioral risk: The risk that participants will make decisions at inopportune times (e.g., selling when the market drops, buying when the market is at a high, not saving enough, borrowing from their DC account, investing misaligned to long-term goals—100% in a risk asset or asset that is too conservative)
Impact on DC Plans
The way these various risks impact investments, savings, and ultimately retirement outcomes in DC plans varies considerably. Plan sponsors who take the time to understand each risk and the impact on the choices they make on behalf of participants will be in a position to establish a hierarchy of risk prioritization to guide their work, leading to more informed decision-making. In the open, we acknowledge that the topic of risk in DC plans is highly complex. Our objective is to identify key risks at a high level and offer considerations for committees as they navigate plan decisions. We have provided a list of considerations below. By no means is this list intended to be fully comprehensive. Rather, we hope to instigate deeper thinking about risk and expand the conversation over time.
Key Committee Considerations
- How does each risk impact the QDIA (Qualified Default Investment Alternative) of your plan? Ask your consultant/advisor for a thorough review and analysis of the impact each risk has on your QDIA and consider this compared to plan objectives.
- Has your committee historically focused only on benchmark relative returns when assessing options (particularly for the QDIA)? Ask your consultant/advisor to expand the discussion from the perspective of downside risk/deviation and short-fall risk for a more well-rounded perspective.
- How will our bond offerings hold up in a rising interest rate environment? Should you consider increasing diversification or other offerings? Ask your consultant/advisor for a review of your bond options.
- Does your lineup adequately address inflation risk? What are alternatives to consider to tackle the issue? Ask your consultant/advisor for an inflation education session complete with various opportunities for evaluation and consideration.
- Have you studied the pattern of participant behavior (deferral rates, borrowing, trading activity, investments, etc.)? Consider a deep review of these patterns and establish a communication and engagement strategy to combat areas of concern, as well as encourage better decisions.
We’re Here to Help
We hope this article has prompted the beginning of deeper thinking about the topic of risks connected to DC plan oversight. In our view, this is particularly important in a market environment that is unpredictable and at the precipice of arguably laying out all risks at once for sponsors to navigate. Today’s market environment means it is more important than ever to expand thinking about risk and be very clear about the way all risks impact committee decisions and, most importantly, participant retirement portfolios.
Want to learn more? Reach out to us today by calling us at (312) 973-4913 or emailing mark.olsen@PlanPILOT.com.
About Mark
Mark Olsen is the managing director at PlanPILOT, an independent retirement plan consulting firm headquartered in Chicago. PlanPILOT delivers comprehensive retirement plan advisory services to 401(k) and 403(b) plan sponsors. Drawing on more than two decades of experience, Mark provides institutional retirement plan consulting to 401(k), 403(b), and defined benefit plans. His specialties include plan governance, investment searches, investment monitoring, and plan oversight. Mark is recognized as a leader in the industry and speaks at national conferences, including those organized by Pensions & Investments, Stable Value Investment Association, and CUPA-HR.