The intent of this series is to provide a brief reality check and ideas for improvement where warranted. Let’s begin with the groundwork upon which a great menu is built, including:
- The role of demographics in determining asset classes to offer;
- The importance of framing menu decisions within the bigger economic picture;
- Size matters; too few or too many menu options can hurt results;
- Accessibility tools; translating a great menu into great individual allocations;
- “Needs analysis” can make the difference between motion and action; and
- The importance of establishing and following a prudent process.
You will see that common sense and the right advice will get you where you need to be.
BTW, you may have skin in the game. Are you a plan-level decision maker? This includes having a vote on your plan’s committee. If so, you are probably a fiduciary. That’s not necessarily a bad thing. Plans couldn’t function without fiduciaries, and while fiduciaries are held to an expert standard, it is completely proper to rely upon outside expert advice.
Are you getting advice? If a vendor receives payment for giving advice, that makes it a fiduciary. But many vendors and brokers have policies against accepting fiduciary responsibility. Therefore, what appears to be their “advice” and “recommendations” are not actually advice and recommendations; they are “information” that you can use as you wish. That may be fine, but be careful about believing that they are covering your back. If in doubt, ask them if they accept fiduciary responsibility, and if so, ask them to detail it in writing. If not, consider hiring an independent investment adviser to sit on your side of the table.
Begin at the beginning. Surprise, it’s an important fiduciary obligation to tailor your plan’s investment menu to the demographics of your eligible participant population. An off-the-rack vendor menu may not fit. If your plan has been in place for years, take a fresh look today at the composition of your participant population. Has the average age gone up? [If not, what are you putting in the water cooler?] What about your participants’ education levels, computer literacy, degree of investment sophistication, language barriers, etc.? Tailor your menu to meet their needs. And remember, anyone with a balance in your plan is a participant and should be considered, even if they terminated or retired.It’s common sense that an unsophisticated population might do better with plain vanilla funds and easy allocation tools, whereas an investment savvy population could justify some more exotic options. Other demographic considerations might take more thought. For example, a participant population with many individuals approaching or beyond retirement age might justify a discussion about inclusion of more fixed income options. That’s a reasonable line of thought, but be careful how you execute!
The big picture. As fiduciaries, we are supposed to frame our investment decisions within the current economic landscape. This requires regularly stepping back and thinking about whether these are the right menu options for right now.
For example, let’s say that to accommodate the needs identified through our demographic analysis, we decided to add a bond fund. How about adding the Vanguard Long-Term Bond Index ETF? Its expenses are rock bottom, it has a 4.9% yield and the average credit quality is “A”. Sound good? Remember, we are trying to help our older participants manage risk.
By looking at the big picture, we see that we are at historically low interest rate levels now. It turns out that adding this fund would expose our participants to significant risk. Why? As interest rates rise, bond prices fall. How much? According to Morningstar, the average effective duration of that Vanguard fund is 12.9 years. All other things equal, each 1% rise in rate would be expected to lead to a 12.9% decline in value. Our safety-seeking participants could lose 25.8% of their principal if rates rose 2%. This would be partially offset by the interest they collected, currently 4.9%, but this would be minor consolation for aging participants who thought they were occupying the safe end of the investment menu.
Education is always good, and could help protect our participants from taking unanticipated risk. However, you can also see that if the plan’s fiduciaries really thought about their plan demographics and the big economic picture, better results and lower liability could have been achieved.
How much is too much choice? There’s no one-size-fits-all answer. You want enough options to cover the most important asset classes. On the other hand, studies have repeatedly shown that too much choice can cause decision-paralysis and inhibit participation. It can also cause participants to make less optimal decisions than would otherwise be the case. This is especially so when you offer multiple options within the same asset class. We’ve seen plenty of menus with 3 or 4 or sometimes even 5 options in the same asset class, which can be very confusing.
You would probably want to have a thoughtful explanation ready if you have fewer than 10 options or more than 20. If you offer target-date funds, they count as one option for the purpose of this discussion. As always, education is good, and can help participants to make good decisions regardless of menu size. Good accessibility tools can help as well.
Accessibility tools. Having a great menu doesn’t mean your participants will automatically have great results. The end game is having suitable investment allocations in your participants’ individual plan accounts. Accessibility tools can help participants to actually harness the power you have provided through the menu.
Accessibility tools commonly include age-based and risk-based funds or portfolios, and on-line “advice” services. In our experience, very few people use the on-line advice services, so let’s focus on the others. The simpler the better, and the fewer steps the better. That’s part of the issue with the on-line services.
In our experience, the most effective accessibility tools are target date retirement funds and risk-based allocation portfolios. Target date funds are simple to get into. The participant just has to select the fund that corresponds with their age. These are excellent options for auto-enrollment and other default situations. Target date funds that qualify as “QDIAs” have the added attraction of providing a potential exemption from liability. There are a lot of considerations in selecting a target date fund series, including; the glide path, management quality, cost and philosophy. Target date fund selection will be addressed in a future article.
Risk-based portfolios have the advantage of reducing “emotional risk” – the danger that a participant sells during a market drop because they experience more volatility than they can stand. In our experience, the most effective accessibility combination is a risk profiling quiz with complimentary risk-based portfolios. We use a brief, self-scoring quiz that immediately tells the participant whether their investing temperament is conservative, moderate or aggressive. They then have the option of selecting a pre-set, point-and-click portfolio; Conservative Growth, Moderate Growth or Aggressive Growth.Pie charts or other generic allocation tools are better than nothing, but extra steps or complexity will inhibit their use. For example, a tool that says a moderate investor should have 20% in Large-cap Growth, etc. requires a participant to figure out which options on their menu are in that asset class, and then to figure out how to get that allocation onto the recordkeeping system. Removing obstacles typically improves end results.
Analyze and address your plan’s specific needs. The chances are that your participant population is unique in one or more ways. Identifying and addressing their specific needs will move you in a successful direction much more quickly than following a generic path. What is your plan’s participation rate? Are participants contributing adequate amounts? Do they have diversified, risk-appropriate individual asset allocations? Are participants bailing out during market declines? How much do they really understand about 403(b)s in general, and your plan’s specific features? What continuing education topics would be relevant? In our experience, “slick doesn’t stick”. Communications need to be targeted to a specific audience and delivered in a way that engages those individuals to learn and to take positive action as appropriate. It’s the difference between motion and action.
Establish and follow a prudent process. This is too big a topic to tack on to the end of this article, but a discussion about the groundwork for building a great 403(b) menu wouldn’t be complete without introducing this topic. A prudent process, anchored by a carefully crafted Investment Policy Statement, will foster consistency and discipline in the way that you manage your plan’s investment menu. It will lead to better long-term results for participants and, if properly documented, will provide a good degree of fiduciary protection. We will cover this topic in detail in the next article in this series, as we move from the general groundwork and get specific about selecting and de-selecting investments for a great 403(b) menu.
Summarizing. You can achieve better results with lower liability if you do certain things right. Here, we addressed the broad groundwork upon which a great 403(b) menu can be built. Look at the big picture and make the right decisions for your population. Think about demographics, economic trends, menu size and complexity, tools to make it accessible, ways to educate and empower your population to make better decisions, and establishing a prudent process for carrying out your plan’s business.
Jim Phillips, President, and Patrick McGinn CFA, Vice President, Retirement Resources
Patrick and Jim have over 50 years of combined investment and retirement plans experience. Retirement Resources in a Registered Investment Advisor that helps employees retire with greater security, while helping employers manage workload, costs and fiduciary liability.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.