U.S. retirement system vulnerable to financial disruptions: Morningstar

Although the retirement system in the United States appears to be stable, the system is actually quite vulnerable to financial disruptions and economic shocks. This is according to the inaugural Retirement Plan Landscape Report produced by Morningstar.

Loss of thousands of plans yearly

The report findings indicate the retirement system loses thousands of plans and billions in assets each year and depends on the creation of new plans to balance out those losses. Between 2011 and 2020, the U.S. defined contribution plan system lost 380,000 plans, almost all from plans with fewer than 100 participants, which accounted for 93 percent of plan terminations and 97 percent of newly created plans, the report said.

Cash-outs, IRA roll-outs reducing assets

During that time, $4.61 trillion flowed out of plans in the form of rollovers to IRAs and cash-outs, and the retirement system was able to retain just $395 billion of those outflows through roll-ins and shifts to other DC plans. A reduction of plan assets can impact the ability of plan sponsors to negotiate favorable fee structures, the report said.

The pandemic did not dramatically impact retirement security, although more plans were terminated in 2020 than in previous years and fewer plans were created, the report said. But policymakers and plan sponsors should be aware of the potential for financial disruptions and economic shocks to destabilize overall retirement security, Morningstar said.

2,000 employers cover half the population of DC participants

“The retirement system relies on a few thousand employers to cover most people saving for retirement,” said Brock Johnson, president of Morningstar Retirement Services. “An economic downturn or even a systemic shift to different kinds of employment could mean even fewer people have the opportunity to save for a secure future.”

According to the report, 2,115 companies cover half the population in terms of DC participation. This dynamic has made mega plans – those with more than $500 million in assets – more important to the retirement system over time. In 2011, mega plans covered 34 percent of participants, but by 2019 that percentage was closer to 43 percent. Not only do many trends originate with these larger players, including fee contraction and target-date fund defaults, but many plan innovations must gain traction within the large plan segment in order to succeed broadly. These include lifetime income options and more customization in default investments, the report said.

Not only small plans pay more fees, but their participants do too

A less surprising but equally important finding of the report is that most small plans carry higher investment fees than their larger counterparts, Johnson said. People who work for smaller employers and participate in small plans pay around double the cost to invest as participants in larger plans. Congress recently established pooled employer plans (PEPs) to help give smaller companies access to institutional pricing but so far those plans have not gained much traction, the report said.

In addition, the fee spread among the smallest plans is wider than among larger plans, which means employees in small plans are much more likely to pay higher fees than those in large plans. However, the report found that plan assets drive costs more than the number of participants. With more assets, plans can negotiate lower fees and are more likely to offer institutionally priced investment options, the study said. As a result, benchmarks that use the number of plan participants are therefore often inappropriate when estimating the likely plan fees for smaller plans.

Rise of less-regulated asset types

The study also found that larger plans have shifted away from mutual funds as their investment vehicle of choice in favor of collective investment trusts, which now represent about 45 percent of large plan investments. These pooled trusts are similar to mutual funds but are less regulated and often less expensive.

Overall, CITs have grown from 19 percent of assets in DC plans in 2011 to 33 percent of assets in 2020, demonstrating the increasing appeal of the CIT structure to plan sponsors. During that time CIT assets more than quadrupled from $370 billion to $1.76 trillion in 2020, while DC plan mutual fund assets doubled from $1.32 trillion to $2.92 trillion in 2020.

Despite the benefits, plans with fewer than $500 million in assets have not shifted to using CITs in their investment lineups. The study speculated that the CIT minimums might be too high for smaller plans and sponsors may feel less comfortable with the plans or work with consultants, advisors and providers that have less incentive to offer them.

Plans of all sizes continue to invest the majority of their assets in actively managed funds, with smaller plans typically holding more assets in active strategies. Across all plans, the study found that 58 percent of DC plan assets are invested in off-the-shelf target-date funds.

Decline of DB plans

Finally, the report found that although their overall importance in the retirement ecosystem is declining, defined benefit plans continue to contribute meaningfully to retirement security, accounting for nearly one-third of distributions in 2019. Total DB plan distributions continue to rise as more participants reach retirement age.

Employers are shifting DB plans to DC plans through soft freezes – not allowing new employees to join – or hard freezes – stopping accruals for all participants. Both strategies create complexity around helping participants figure out how much to save in new DC plans and adjust for inflation. Personalized advice will be important to facilitate these transitions, said the report.

Kristen Beckman is a freelance writer based in Colorado. She previously was a writer and editor for ALM’s Retirement Advisor magazine and LifeHealthPro online channel. She also was a reporter for Business Insurance magazine covering workers compensation topics. Kristen graduated from the University of Missouri with a degree in journalism.