Here’s a quick recap (see also Building a Great 403(b) Menu Part 1, the Groundwork):
- Demographics — Consider the age, sophistication level and other relevant characteristics of your employee population when deciding upon suitable asset classes to offer;
- Big picture – Frame your decisions within the broader economic and market context;
- Menu length – Excessive choices can cause confusion, which can lead to sub-optimal decisions, including the decision not to participate. Keep the menu relatively concise;
- Accessibility tools – A great menu is only a starting point. Most plan participants are not investment experts, and have trouble building an individual allocation on their own. Provide them with effective education, and offer risk-based and/or age-based portfolios that they can easily opt into;
- Needs analysis – Every plan and every employee population is unique. Perform a needs analysis to identify ways in which you can improve your plan’s results.
With these structural guidelines in mind, let’s move on to discussing the actual process of populating a great investment menu. As we discussed in Part 1, plan-level decision makers are fiduciaries, so it follows that selecting investments for the menu is a fiduciary function. Fiduciaries are held to a Duty of Loyalty and a Duty of Care. The former dictates that all fiduciary decisions must be solely in the best interests of plan participants and the latter holds them accountable to a prudent expert level of operation. What are the implications?One could argue that the Duty of Loyalty requires fiduciaries to build the best menu they can for participants, not just the best they can do within a limited universe of options offered up by a particular vendor. What does this mean? You can create a great Investment Policy Statement (IPS), and you can define a great prudent investment process, but you won’t be able to build a great 403(b) menu if your provider’s platform doesn’t offer great options from which you can pick. It may be incumbent upon you to negotiate harder with your current provider for the inclusion of additional “outside” fund options, or to consider other platforms.
An Investment Policy Statement can be a fiduciary’s best friend or worst enemy.
Let’s address the scary part first. A poorly worded IPS can create a great deal of liability. How? By creating obligations that won’t or can’t be fulfilled. We’ve seen some horrible IPSs, some provided by big name firms. If you have an IPS, check it for “will,” “shall,” and “must” statements – you can be certain that a plaintiff’s attorney will be checking if a disgruntled participant ever chooses to wage war against you. Some examples: “the Committee will meet quarterly,” “an investment option shall be replaced if…,” or “a fund manager must have a five year record.” Why create inflexible mandates that can paint you into a corner? There’s no rule that you must have an IPS, and it is certainly better to have no IPS than a badly worded one.
On the other hand, since fiduciaries have to conduct the plan’s investment business at the level a prudent expert would, a well written IPS can help to make that happen. It can provide structure and continuity for the Committee, especially as the composition of the committee changes over time. It serves as the backbone of the prudent investment process that will help you to achieve better results with lower fiduciary liability.
A demographic study and needs analysis will help you to decide which asset classes should be on your menu. Once that is determined, you want to populate each slot thoughtfully. The age-old debate between the proponents of actively managed and index funds rages on. It’s beyond the scope of this article to resolve this debate, so suffice it to say there’s room for both on a typical menu. Because we want to keep the menu concise, we typically limit the number of asset classes in which we offer both active and passive (index) options.
In selecting active funds, we look for certain characteristics. Past performance is never a guarantee of future results, but we would be crazy to not examine all of the available data on each contender, including historic risk and performance. Depending upon a plan’s structure, the investment options may include mutual funds, separate accounts and ETFs, so we’ll use the term “fund” for simplicity.
We look for funds with records of delivering above average, net, risk-adjusted returns over relevant timeframes. And, we look for consistency.
Let’s break this down:
- Above average – Better than the 50th percentile, ranked against the fund’s peers;
- Net – Investment expenses are an important consideration. Fiduciaries are not required to select the cheapest funds, but they are obligated to understand all the costs and to determine whether they are reasonable in relation to the benefits received. Some types of investments tend to be more expensive than others, such as international and small-cap, so we factor that in as well. By comparing competing investment options, on a net basis, after the expenses have been deducted, we have a level field;
- Risk-adjusted – What’s better, an investment returning 9% or one returning 10%? The answer is that it depends. We wouldn’t make that decision without knowing more. One of the most important things to understand is the investment’s risk level. You should consider risk measurements such as standard deviation and beta. For income funds also consider duration and credit quality. There are widely available measurements of risk-adjusted returns, two of which are alpha and Sharpe ratio. (A future article will discuss these measurements and how to use them.)
- Relevant timeframes – This ties into “manager tenure”. Index funds are robotic, but actively managed funds have individuals or teams that make the security-by-security buy and sell decisions that determine a fund’s performance. You can see that manager tenure is a key piece of information. If a fund’s manager has held that position for only 16 months, we are going to eliminate it from consideration, or at least to significantly discount the fund’s 5-year and 10-year performance numbers, because the current decision makers had nothing to do with prior performance. We also want to see how a manager has performed during different market cycles in the past – Bull and Bear, and rising and falling rates;
- Consistency – We touched on this above, but there’s more to it. A manager can change their style over time, and this isn’t necessarily good. There are ways to measure “style consistency” and they should be part of the decision process. For example, if we are searching for a Mid-cap Blend manager, we want to see that they have stayed in that style box and that they haven’t drifted frequently into the Large-cap or Small-cap space or drifted from Blend to Value or Growth.
This article addresses building a great menu. Maintaining the menu is equally important and incorporates many of the same principles. Other aspects of on-going menu maintenance will be addressed in a future article.
Summing it up, building a great 403(b) menu takes deliberate actions, but one can be constructed for any plan. If you don’t have the time or in-house expertise, you can join the large number of large plans that use the services of an outside adviser. If you already have an adviser, this article may help you to carry on a discussion with them that may lead to better results. If you don’t have one, choose carefully. Tips on adviser selection will be the topic of another future article.
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.