In 2023, Neither Defined Benefit nor Defined Contribution Plans Are Optimal.
Institutional and individual retirement investors are equally off-track

By Steve Deutsch, CFA, CFP, FRM, CAIA, CTP, SHRM-SCP, RPA

The following is an extract of a presentation to the 2023 ISCEBS Employee Benefits Symposium on Tuesday, August 22, 2023:

In practicing as an independent institutional consultant now, I am asked a perennial question: “Which type of retirement plan is better – defined contribution or defined benefit?”

In 2023, there is no theoretical debate about the way the plans are structured in the U.S. and Canada. It’s a moot point, because of the reality in which both types of plans are frequently poorly administered, regardless as well whether the plans are in the private or public domain.

Neither form is superior, as both remain hindered by significant human failings. The basic functions of running a plan or preparing people for an adequate retirement are held back by widespread financial illiteracy, including behavioral biases that affect all manner of investors.

When large sums of money are institutionalized, these shortcomings are very difficult to address. Overcome by bureaucracy and averse to addressing challenging questions, these sophisticated investors shift their focus to misguided, non-fiduciary self-preservation.

“Governance” and “fiduciary” are so overused, but seemingly not well understood. It’s fashionable to worry about artificial intelligence becoming self-aware or conscious. From observing how Boards and Committees function, whether overseeing investment plans or generally, they should beat this litmus test but don’t.

A Board should not only be diverse and representative, but they should also not be empty vessels. Most remain just automatic defense mechanisms of management or other fiduciaries. Trustees or Boards should ask fair but tough questions and anticipate concerns before they become problems. As always, and particularly when well-compensated with cash, Board members are very reluctant to hold management or administrators or consultants accountable at the correct, pre-emptive time and not the usual “locking the barn door after the horses have left.”

For example, since DC (RRSP in Canada) plans dominate retirement plan structures now, the Trustees should annually monitor how many participants are contributing, are taking the full match, are contributing to the maximum allowed, or have taken a loan from the plan. And then act, adjusting efforts to address these shortfalls, emphasizing adjusting to their diverse participant populations.

Defined benefit plans are generally equally vexed by the guideline of contributing regularly and fully. Allocating funds, there always seem to be more pressing immediate needs in the warped perspective of too many non-fiduciary trustees. They also often make the mistake that investments are primary determinants of how much money people will have in retirement, when it’s actually regular and substantial contributions or savings to the plan.

To expand this analysis, I will refer to two public plans. Privately-owned plans have the exact same opportunities and problems, just lower profile and less easy to access information. Similarly, one public plan is in the U.S. and the other in Canada, again making the observation that these capabilities and challenges are not geographically defined.

The Canada Pension Plan (CPP) is the country’s social insurance plan, with C$575 billion (U.S.$428 billion) at mid-year.

Founded in 1997, the CPP Investment Board emphasizes public affairs or a significant funding of a continuous, controlled managed message, “Nothing to look at, folks.” “Everything is under control.” “We got you covered.”

While they would prefer to be seen as a quiet success, the Investment Board has shortcomings, some considerable and worthy of addressing.

Active Management Across All CPP Asset Classes Needs a Thoroughly Researched Justification

A primary and regular consideration for the Board should be the CPP’s reliance on active management, across its entire portfolio and regardless of type of asset.

The Board is all-in on this mindset, a behavioral bias and viewpoint that developed gradually and then was fully adopted in 2006.

The missing piece of the conclusion before 2006 and that should be regularly and publicly examined now and ongoing, is the active vs. passive question assumption.

The Investment Board appears to have assumed active management adds value without providing foundational, thorough, objective research on active vs. passive that was publicly disclosed. From reviewing the annual reports from more than two decades ago, it certainly appears the Board slept-walked the very debatable assumption that lots of money necessitates active management at all times, in all asset classes.

The Board should have examined this topic to a through and publicly reported because it must. Some of the CPP’s asset allocation classes are very efficient, like Western public equities – and that implies that passive has a lot to offer.

The CPP IB does disclose and provide performance attribution in its latest annual report. The investment selection contributions of five of the six CPP asset classes are very slim. And 4.9% of the CPP’s five-year return of 7.9% through its fiscal year-end is from the passive choice of asset allocation.

To address this, the CPP IB should examine the copious academic analysis of active vs. passive and regularly reconsider the topic and whether certain CPP assets would perform just as well or better if passive management prevailed.

It’s also somewhat jarring to read in the 2023 CPP annual report that the IB employs long/short extensively in the public markets. Recalling my experience in watching the 130/30 long/short fad rise out of the market collapse of 2008, the excitement as many strategies came to market was present. It seemed so intuitive. If active managers knew what to buy and go long, they also knew what to avoid and short.

Active managers are constantly looking to find a rationale for their employment, with recent echoes in the smoldering embers of the unfulfilled promise of ESG. Long/short was the earlier overemphasized promise that faded as returns and overall performance did not deliver. There are very few managers offering long/short in 2023. The CPP IB should again closely monitor and publicly document the rationale and the reality of long/short as an investment strategy for the public markets on an ongoing basis.

Asset Allocation Provides A Lot of the Return – So It Should Get A Lot of the Effort

Another important consideration is the CPP IB’s current practice of reviewing asset allocation only every three years. Aside from the not insignificant social implications and independent valuation of private equity, the IB – like practically every Board (public/private, DC or DB) would do well to very regularly review asset allocation. While the academics debate the impact of asset allocation from 40% to 80%/90%, or 100% of an investor’s return, at the end a lot of performance is determined by this crucial choice. That means regular annual strategic reviews and quarterly tactical, using a diverse set of projections, actively discussed.

At present, the long-term return expectation for B and C-rated office commercial real estate is under a great deal of question, and in addition to real assets the CPP likely holds exposure in its other asset allocations, to some significant degree, as well. The outlook for private equity is in the same boat. Even with direct investment, a considerable amount of like-minded prudent investors are observing that many fundamental reasons for private equity’s long-run success to this point will not prevail in the future.

The Investment Policy Statement – the foundation of the CPP – could be much more solid

For core Board duties, the investment policy statement of the CPP could be much more direct in simply and cleanly stating:

the investment timeframe for the portfolios;
the long-term rate of return objective for the portfolio(s),
what are the risk parameters qualitatively (standard deviation, information ratio, VAR, duration, etc) and quantitatively (including the upper ranges for each risk measure where re-assessment for exposure has to be examined.

The annual review of investment policy statement with an open-mind should be driven by the Board. This is a basic task that again, many plans just don’t see occurring under their current “governance.”

Ensuring the Comparability Investment Results

Regardless of plan type or whether it is public or private, what all participants and beneficiaries deserve is easy comparability of investment returns. Millions of Canadians should be able to compare results on a relative basis (against peer groups and index returns) quickly and easily, without question.

For the CPP IB, with thousands of employees, some must be Chartered Financial Analysts (CFAs). The CFA Institute has had Global Investment Performance Standards (GIPS) for Asset Owners since 2020. GIPs are voluntary, ethical standards for calculating and presenting investment performance based on the principles of fair representation and full disclosure. Practically every single major asset manager follows these investment reporting guidelines worldwide: they are bedrock standards.

The CFA Code of Ethics requires investment professionals to comply with the GIPS standards when reporting investment performance. There is a fair amount of mechanics in following GIPS, like expense allocation and constructing composite returns. It would take effort for the CPP IB to adopt the standards. It is a worthwhile effort. Canadian members of the CPP would be reassured that they are comparing apples to apples.

The Thrift Savings Plan (TSP) is the defined contribution plank of the retirement coverage for U.S. federal employees and members of the military, with $767 billion (C$1.031 trillion) at May 31, 2023.

Founded in 1986, TSP oversight is provided by the Federal Retirement Thrift Investment Board (FRTIB), and focuses intently on lobbying Congress and trying to avoid any headline risk, with no political controversies.

The FRTIB may have had a purpose and added value when it was created 36 years ago, in the Reagan era.

Times and the investment industry have changed.

In this case example of pension governance concerns, I can provide additional insight as I was recruited to the FRTIB and served for most of 2020 as its Deputy Chief Investment Officer. Some may assume this colors my observations. I present any recommendations based on objective, solid evidence and the imperative of close to seven million current and former military service members and civilian public servants relying on the TSP and its oversight agency, the FRTIB.

Missing Effective Governance

At root, the TSP is surprisingly poorly supervised or governed. There is no apparent lack of governance: the FRTIB is the primary body, after Congress (the U.S. Senate Committee on Homeland Security and Governmental Affairs and the House Oversight and Reform Subcommittee on Government Operations). The Employee Benefits Security Administration (EBSA of Department of Labor/DOL) has fiduciary and auditing oversight of TSP. There is also a (federal) Employee Thrift Advisory Council.

Preceding and current FRTIB Board of Trustee members are inert. FRTIB members, in sum, seem to view this responsibility as honorary. They see their appointment as the finance or investment high-society equivalent of joining the Board of Trustees of The Kennedy Center. Occasional soft-ball questions are offered, but the monthly Board meetings function as following a well-rehearsed and frequently repeated script.

What is lacking is effective governance and fiduciary duty to the participants, reflecting a lack of purpose or direction or a basis of solid financial literacy. Board members should not be empty vessels. Conscious, asking the right questions, always emphasizing the participants and beneficiaries.

There is multiple evidence of a lack of effective governance from the FRTIB, which will be explained below: not having written investment policy statements for 36 years, mediocre relative investment vehicle performance for participants, horrible account servicing, and a mutual fund window that is incredibly expensive for participants to use.

Long Lack of Written and Up-to-Date Investment Policy Statements

For example of the offtrack governance from the FRTIB, the one TSP fund that is internally managed is the “G Fund”, which has $298 billion in AUM and is 39% of the $767 billion in total as of May 31, 2023 (the most recent month available). It is a bedrock investment vehicle for all TSP participants and beneficiaries.

In 2020, the FRTIB tried to figure out a policy response to the real potential of negative interest rates for the G Fund at the time and that involved analysis and discussions with the U.S. Treasury Department.

As the Deputy Chief Investment Officer, I surprisingly quickly determined the G Fund did not actually have a complete, recent, or regularly updated investment policy statement.

Yet, the G Fund has been in existence since 1986. A proper investment policy statement, of course, defines the time horizon, the return objectives for a portfolio, its risk parameters, how often the portfolio will be re-balanced, etc. The FRTIB merely has disparate and brief Board resolutions from decades ago as the G Fund’s investment policy statement. Their founding legislation, FERSA, calls for the FRTIB to “…develop investment policies.”

Consequently, the FRTIB has varying (and no official) benchmark indices for the “G Fund” to track its performance against, and completely ignores any peer group comparison.

Whether the G Fund is meant to serve as an investment fund or a money market/savings fund or is supposed to surpass inflation is undetermined. After 36 years, this has never been properly addressed.

Still, without ever actually reviewing any investment policy statements, each quarter for the past 36 years (until 2022) the FRTIB Trustees stated the same rote text for the public record, for all TSP fund, that they have reviewed the investment policies of the TSP funds, are satisfied with the investment performance and investment, “…and the current investment policies…are affirmed without change.”

In my written analysis and internal communications to the Office of Investments in 2020 of how to address negative interest rates if they were to transpire, I recommended writing investment policy statements in full and regularly reviewing and updating them and to include addressing scenarios including the response to possible negative interest rates.

The Chief Investment Officer subsequently stated, “Investment policy for the TSP Funds is contained in both the statutes and Board resolutions.”

Yet, at the February 2022 meeting of the FRTIB, after I had left, the FRTIB Chief Investment Officer presented my recommendation from 2020 as industry best practice and a motion was passed: “That the Board will review the TSP’s investment policies (and produce or write them for the first time) going forward on an annual basis.” After 36 years.

Mediocre TSP Fund Returns

Bearing in mind the gross and net returns the FRTIB reports for TSP funds are not industry-standard and may be incorrectly calculated, it certainly appears that despite the advantages of the bargaining chip of asset size to drive down costs, as well as further offsetting expenses through security lending, and the unicorn “G” Fund, the TSP’s core target date “L” funds are mediocre or sub-par in net returns relative to their private-sector competitors for the 2030, 2040, and 2050 vintages of the TSP L Funds, especially in recent years. That is an astounding outcome, considering the advantages the FRTIB has or had.

The FRTIB can only produce average target date and index funds, with many superior private sector alternatives available,

As of May 2023, 3.5 million or 52% of the TSP participants are at least partially invested in the TSP’s target date funds, the “L” Funds. The L funds are also the qualified default investment alternative for the TSP. That means the performance of the L Funds matters. But the TSP dropped the ball thanks to the FRTIB.

The TSP L Funds compare very poorly when the stock market is advancing. However, even in the current market, the relative mediocrity of the L Funds is still apparent. The TSP L Funds slightly outperform the average target date fund in a down market because they carry a significantly higher allocation to cash and fixed income than their average private sector peers.

And it is quick and easy to identify superior private sector funds that are consistently outperforming the TSP 2030, 2040, or 2050 target dates. I have re-run the comparative analysis at the end of many reporting periods and the results are consistent with those through June 30, 2023, presented below. The L funds are merely average default or target date funds on a net return basis in the short-term and underperform consistently in the long-term. The TIAA Index Funds are but just one example of readily available private sector choices that perform as well or often better than the L funds.

This standard type of comparative analysis should be regularly presented by the FRTIB staff to the TSP Board, monthly -as well as the TSP participants and beneficiaries I might add. But the staff of the FRTIB does not act and the Board of Trustees has similarly not asked for it.

The FRTIB mistakenly believes it still has an enormous cost advantage. The TSP’s C (common stock) fund has a total expense ratio of 0.059%. How about 0%? The Fidelity ZERO Large Cap Index is aptly named, as are the Fidelity ZERO fund equivalents to the TSP S (small cap) fund with a total expense ratio of .090% or the TSP I (International) fund with a total expense ratio of .064%. Times have changed.

Ignoring Investment Reporting Guidelines

Unfortunately (again), the performance reporting of the TSP funds is completely out of line with investment industry bedrock standards. On paper, but not in reality, the strategic mission for the FRTIB aligns with continuous improvement: “We apply best in class internal business processes to ensure secure and efficient Agency operations.” And “Optimize business processes to allow continuous improvement of TSP and Agency operations.”

In reporting to its millions of participants on TSP.gov, the FRTIB completely ignores CFA Institute Global Investment Performance Standards (GIPS).

Despite having CFA charterholders in the FRTIB Office of Investments, they were somehow blissfully unaware that their own CFA professional guidelines strongly advise them to follow GIPs or that the standards had evolved to and had been adopted by other asset owners.

The FRTIB did not (and cannot) make a clear and rational case that the ad-hoc, unique, and incomplete investment reporting of the TSP Funds at present are to the advantage and interest of millions of the TSP’s members. It is like a U.S. company saying it wants to ignore GAAP for accounting purposes. That would not be tolerated by investors or the SEC.

Yet, both the Executive Director and the Chief Investment Officer of the FRTIB varyingly stated that the FRTIB: 1) was already GIPS compliant (without citing any strong basis in fact and incorrectly); 2) was close to compliance; or 3) that it was not necessary for the FRTIB or the TSP to comply with CFA GIPS.

When questioned in 2022 as to why the FRTIB’s Chief Investment Officer either ignored and/or violated the CFA Institute’s clear guidelines to members, such as himself, namely the CFA Institute’s Code of Ethics and Standards of Professional Conduct, he replied, “The CFA Institute does not determine the priorities and policies of the United States government.”

Inferior Account Servicing to TSP Participants

A greater operational risk that the FRTIB subjected its poor participants to has been a disastrous implementation to try and deliver standard recordkeeping for their investments… This has not been “Thank you for your service.”

The FRTIB trustees approved a 30% increase in the agency’s annual budget for FY 2021, reaching a total of $500 million “…primarily due to the recordkeeping services acquisition procurement. The system in place was installed close to twenty years previously and its functionality was approximately 50% of the norm offered to private sector investors, as the FRTIB discussed internally.

What the FRTIB and its many governance bodies forgot was the precedence from the last recordkeeping upgrade – twenty years ago. It had been a disaster, resulting in congressional hearings and litigation by TSP participants. The Committee on Government Reform in 2003 found: “…a new recordkeeping system designed to improve service to Plan participants…and operate more like private sector plans…” suffered from software glitches that caused the new system to be slow and difficult for participants to access.

As was recorded at the time: “Participants still spend countless hours trying to access their accounts online….The TSP Service Center has been flooded with calls and has been unable to handle the volume…Direct management responsibilities fall on the TSP Board and its executive director, who are the fiduciaries of the plan…Conduct wider testing before launching the system…Provide adequate customer service staffing to handle enquiries…highlights the importance of properly managing outside contractors…Even the most professional and efficient contractors need clear instructions and close supervision.” Déjà vu.

And years later, it seems no one at the FRTIB, either the bureaucrats or the Board members, or any of the other oversight bodies, recalled this lesson or examined the questionable rationale of building a public sector recordkeeping system from the ground up instead of outsourcing to the private sector. The economics and trends in the private sector recordkeeping industry are instructive: industry consolidation, fee compression, and a technology arms race.

And the 2022 recordkeeping “upgrade”, meant to, “… reimagine retirement services for the digital age and improve the customer experience for the Thrift Savings Plan (TSP)…” went seriously awry as soon as it went live on June 1, 2022.

Afterwards, on August 24th, 2022, Accenture Federal Services (AFS) appeared at the FRTIB monthly meeting. AFS does not have an extensive track record in recordkeeping specifications or implementation projects and as reported by Federal News Network said:

“We got it wrong…we’ve been working night and day to fix it. …We changed almost everything about TSP delivery…”

We changed the platform, the underlying technologies, the processes [and] the way we deliver the specifics of the plans…changed all the people who deliver those processes and operate those platforms. It was a wholesale change.”

…AFS anticipated the volume of calls to TSP’s customer service center, would be about twice as high as FRTIB’s previous call record… the call center received six times the previous call record.

…Another decision … of frustration for TSP participants was requiring all users to set up a new login….

“We made that process cumbersome; it was very hard for a vast number of users… We made it overly complex…

… the average call wait time for customer service is …down from two hours on June 1.”

No Holistic or Really Any Financial education to TSP Participants

The TSP does claim that its annual survey of its participants finds high levels of satisfaction. I suggest that this satisfaction reflects rampant financial illiteracy amongst the TSP participants, unfortunately.

The TSP surveys also clearly show that participants have no clear idea if their plan has relatively high or low fees compared to their private sector peers.

Participants do not receive any substantial, regular, and frequent occurring peer group analysis of the TSP funds relative performance, risk, or fees – or any holistic financial literacy assistance or instruction of substance from the FRTIB. Years ago, the GAO recommended it, no surprise.

There is a “cottage-industry” of retired federal workers who self-publish and comment on TSP performance. A major metric of success is how many federal workers achieve a million dollars in retirement savings. They and their readers are oblivious to the fact that the discounted perpetual present value of the FRTIB’s inferior quality oversight translates to 200,000 fewer civil servants and members of the military achieving millionaire status.

A TSP Brokerage Window that is Incredibly Expensive (and Non-Fiduciary)

The FRTIB staff will argue that FERSA, the founding legislation of the FRTIB, is not specific or silent on many topics. So, the Agency, at its own discretion, is engaging in certain activities, such as allowing its external investment managers to vote the TSP’s shareholder votes/proxies on any topic, including Environmental, Social, and Governance (ESG) considerations, even though the FERSA states explicitly that no one in or associated with the FRTIB should engage in proxy voting.

At other times, the FRTIB staff will apply the reverse logic and ignore the specific written requirements of FERSA. While this is clever, the downside is significant negative consequences for the Federal civil and military participants.

For example, the Thrift Savings Plan Enhancement Act of 2009 made several improvements to FERSA and the function of the TSP, including instructing that TSP participants should have access to a mutual fund window and be able to “opt out” of the TSP investment menu on their own if they should so choose.

If there was good governance of the TSP, from any level – Congress, Board members, or staff- why would a legislative requirement be ignored for 13 years with the mutual fund window only being implemented in 2022? How is this fiduciary?

Without effective governance from anyone, the staff of the FRTIB, with a focus on the Executive Director and Chief Investment Officer, are left to drive the relaxed and soft agenda of TSP oversight, using the founding legislation, FERSA, to their personal preferences.

The Executive Director stated matter-of-fact, on several occasions, that his viewpoint was providing mutual fund choices outside the TSP line-up was unnecessary and he intended the TSP mutual fund window to be expensive.

He achieved his personal bias and ignored the fiduciary interests of close to seven million participants.

To use the mutual fund window at the TSP, the FRTIB has a $55 annual administrative fee plus a $95 annual maintenance fee and trades cost $28.75 each.

By comparison, Vanguard usually has no administrative fee. You might be charged $20 annually if you have negligible AUM with Vanguard. Trades are typically $0, but can again go to $8 or $20 per trade if you have low AUM.

Further, Fidelity charges no administrative fee and $0 per trade without any minimum AUM requirements.

A Firm Conclusion: Continue the TSP in the Private Sector and Eliminate the FRTIB

The U.S. defined contribution plan for civil servants/members of military does not need to be socialized – or run by the government in 2023 in a country committed to capitalism/free enterprise.

There is no need for misinformed, misled, willfully ignorant bureaucrats to poorly reinvent the private sector wheel using substantial effort/money/time.

The FRTIB is not adding and cannot now add value to the TSP. After 36 years, there is no more allowance -including time – for redemption.

Instead, the inevitable conclusion is that effort, money, and time are being wasted to deliver an equivalent if not inferior retirement investment plan relative to the many private sector choices.

U.S. military service members and civil servants deserve much better and should be freed of the FRTIB constraints. They may be content with the TSP, but they should not be of the same opinion of the Board or administration that is supposed to look out for them.

The Australian Superannuation Fund-type solution for the TSP should be a curated set of private-sector investment choices, two or three top tier index providers that would provide superior risk-adjusted passive sector and target date choices, with low fees, and continuing to pass through the income from securities lending to the benefit of the participants.

The menu of approved private-sector funds/vehicles, with a brokerage window, would best be curated or chosen by an effective advisory board of CFA and CFP accredited, objective financial experts who are recent retirees from the corporate world and have kept up their continuing education requirements and have or are trained in fiduciary duty.

These experts would also likely encourage new indexing methodologies, far beyond straight market capitalization indices, to be continuously evaluated for TSP participants.

TSP participant accounts should be made easily transferable or able to be split amongst the chosen private sector investment firms, to avoid multiple accounts. As at present, the TSP accounts would be jointly funded by the Federal government and by employees’ income.

The Board trustees seeking honorary positions and the FRTIB staff wanting a relaxed bureaucratic lifestyle will not act as fiduciaries and lobby for their positions to be eliminated.

Congress should be called upon by the TSP participants to again write a legislative amendment to the Federal Employee Retirement Savings Act (FERSA). I have a draft ready. When the Federal government is in record and rising deficit, it is time for this strong corrective action to the current dereliction of fiduciary duty by the FRTIB to the detriment of the TSP.