INTERVIEW: Why are Defined Benefit ("DB") funds outperforming Defined Contribution ("DC") over time and how much is this related to the typically very retail nature of DC investment options?

Interviewer: David Grana, Clear Path Analysis

Interviewee: Tony Tomich, Head of Pension Investments – Farmers Insurance

David Grana: Over the last 15 years, Defined Benefit (DB) plans have outperformed Defined Contribution (DC) plans at least 75% of the time and by at least 39 basis points and on average, by 70 basis points. Why is that?

Tony Tomich: A DB plan has many structural features that aren't available in DC plans. One being that you have access to lower cost vehicles in a pension plan, such as separate accounts, which are fundamentally cheaper than mutual funds, which are the prevalent vehicle in a DC plan.

Mutual funds are much more expensive, you have to close them daily, work on marketing and regulatory work which you don't have to with a separate account.

When you see the migration of many bigger plans in the DC space to open architecture, one of the motivations is to move away from mutual funds because they are relatively expensive and if you are a big plan you don't have to use them.

Another issue is scale within the different pension plans and asset classes. With scale, you usually have lower fees.

In a pension, you have professional / institutional management which can't be understated. When you have professional management of assets you have a very thoughtful and diligent risk budgeting, strategic asset allocation that is identified and defined.

You also have disciplined re-balancing to stay in line with that strategic asset allocation and so this ultimately leads to better outcomes.

On the other side of this, when you are dealing with retail investors they can display behaviour that is very different. Sometimes they can chase returns at the top or can be fearful at the bottom of markets and so retail investing behaviours is very different to institutional behaviours.

David: Would you say education has a lot to do with this?

Tony: I don't know if I would pin education as you can have very well educated, smart people who behave in sub optimal ways in times of market volatility.

It is more about whether one is more seasoned and experienced rather than educated. If you have a seasoned, institutional investor, this person might behave differently than someone who might be very intelligent but who doesn't have the experience or expertise.

One of the main benefits of institutional investors is their patience and they understand that market volatility is a part of how the markets and the global economies work.

They know that in the long term, sticking to their strategic asset allocation is what creates optimal risk-adjusted returns.

In DB plans, you also have access to asset classes that you don't in a DC plan. You can look to collect different risk premia or illiquidity premia that just isn't appropriate for some stand-alone DC fund options.

David: An employee working 60 hours a week may find it difficult to keep a close watch of their DC plan and re-balance according to their proposed strategy. Is their anything automatic in the market that investors can rely on to solve this issue?

Tony: Target date funds do this and that is why you have seen such a growth in this product. It does rebalance for you on a periodic basis, it sets a glide path and changes risk and asset allocation as time goes by.

It is also professionally re-balanced and that is why you have seen them grow so quickly, because they do it for a retail investor.

There are other services out there like managed accounts which will help someone create an SAA and maintain it to rebalance etc. but these cost money and may be confusing for some investors.

When we converted to open architecture, we had a number of focus groups and asked people simple questions like, did they know we had a 401(k), did they know what a stock or bond was etc. and the overall theme that came out from this was that people were confused and needed help.

This is why we have a belief that structures are very important and you have to put them in place to help use momentum in a good way instead of letting it work in a bad way.

The momentum of a DC plan is a very strong factor, as once people enroll they tend to not touch it, which is why having them consider a target date fund, or something that has a structure that allows for diversification, is really important.

This is one of the reasons we simplified our plan. We got rid of the myriad mutual funds that were very confusing.

To read the full interview, go to Reports and download the Institutionalizing of DC Plans Report.