When Verizon Communications Inc. announced the freezing of its $42 billion defined benefits (DB) retirement plan for active management employees in December 2005, the company used the historic juncture to make changes to its 401(k) plan, as well. Like most major employers focusing on their defined contribution plans after downsizing or eliminating a DB plan, Verizon moved first to increase its corporate contribution to the plan–to a 100% match of the first 6% and a new discretionary match of another 3%, based on company performance, from 100% of the first 4% and 50% of the next 2%.
But was that enough? Verizon Investment Management Corp. (VIMCO), overseer of the company's DB and 401(k) plans, also wanted to address problems the company's employees were having when it came to designing a portfolio mix suitably customized to each worker's age and risk appetite. Although Verizon offered four lifestyle funds, Verizon discovered that some employees were making bad choices: For instance, young employees were picking conservative lifestyle funds that were more appropriate to workers on the verge of retirement, than one at the start of a career. "In lifestyle funds, people have to identify their own risk tolerance, which is often a difficult thing for many employees to do," says David Wray, president of the Profit Sharing /401(k) Council of America, a national, nonprofit association of companies with profit-sharing and 401(k) plans. "Target date funds remove that obstacle."
VIMCO decided to assemble its own group of target date funds, using asset managers of its own choosing. Based on the target retirement date of the participant, these funds would automatically rebalance the asset mix from aggressive, when participants are young, to conservative as they near retirement. "We wanted the 401(k) savings plan to be goal-oriented," says Michael Riak, VIMCO's director of savings and affiliated plans. "Target date funds put that out in front of people and show them goals they can aim for."
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With this approach, Verizon and VIMCO addressed one of the biggest concerns of large plan sponsors when it comes to both DB and DC plans: Do participants and sponsors really understand the risks associated with retirement plans and are they structuring an investment strategy to address them? Part of what is driving this concern is fear of future class action suits from disgruntled baby boomer retirees with insufficient means to sustain themselves; just offering great investment options, good education and active participant communication may not be enough. The new bottom line for employers like Verizon is: Are employees constructing investment portfolios with a chance of meeting their retirement needs? And if not, what can they do to help?
For Verizon employees, VIMCO wanted to construct its own proprietary target date funds, rather than choose an off-the-shelf solution. This would allow the funds to include a broader gamut of investment options, such as hedge funds, real estate holdings and commodities, along with traditional equity and fixed income assets. Also, VIMCO planned to use many of the same asset managers from its DB plan in a structure that would give institutional pricing to the DC plan participants.
But first, it had to build the funds. After interviewing a half-dozen investment advisers, VIMCO picked Russell Investment Group, which assists pension plans in structuring multiple manager portfolios, to help it construct its 10 proprietary target date funds. VIMCO was attracted by Russell's "glide path" methodology, which uses optimization algorithms to construct a precise slope of equity to fixed income assets that maps out a participant's glide path toward retirement. While other target fund providers employ glide paths, Russell claims it is the only one to use mathematical optimization in deriving its path.
While virtually all glide paths have equity asset allocations which go down over time, glide paths can vary widely, remarks Mark Ruloff, director for asset allocation at Watson Wyatt Investment Consulting. Some target date funds end up with an equity allocation as low as 20%, while others may be as high as 60%. The reason for this difference lies in the model participant that you test for. "If you take the model participant, who saves the right amount, spends wisely and doesn't live past the average lifespan, you get one set of glide path results," says Ruloff. "But if you look at the typical participant–one who 'undersaves,' does not spend wisely and lives too long–then you get a different set of [glide path] results," since the model will be skewed toward a more aggressive stance of investments to compensate. This is the case especially with off-the-shelf funds, which are aimed at their average participant. A best practice is to take a customized approach to creating a glide path for a specific population. "Another reason to take a customized approach would be to be able to use best-in-class asset managers."
VIMCO is also attempting to address the longevity risk in its target date funds. The glide path calls for a 43% equity allocation upon retirement–relatively high compared to other target funds. "But," says David L. Beik, VIMCO's chief operating officer, "it's appropriate because of the longevity factor." VIMCO is exploring offering an annuity option for a portion of the payout.
Russell's model for funds emphasizes a human capital model that treats a participant's future stream of savings similar to a bond. When an employee is young, his future earnings potential represents his real wealth. That human potential is similar to an illiquid bond: It's relatively safe, so you can be aggressive with the liquid wealth as represented by your 401(k) savings plan. But as you get older, your human capital diminishes; your real wealth is tied up in your 401(k) plan, which needs to be rebalanced in favor of fixed income assets. Russell calls for a 100% equity exposure, gradually reducing that exposure and increasing the fixed income portion of the asset mix to generate income upon retirement.
Russell's glide path is not fixed in stone. Russell has the authority in consultation with VIMCO to alter it. "Changes to the glide path will be infrequent because of valuation issues," Beik says. "If there were shifts in risk premiums or capital market conditions, then [Russell] might rerun their models and shift things. But those are expected to be few and far between."
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