DC Plans Learning Lessons from DB Investing

December 17, 2013 (PLANSPONSOR.com) – Defined contribution (DC) plans have already taken some lessons from defined benefit (DB) plans.

The trends of automatic enrollment, automatic contribution escalation, and automatic investing—in the form of target-date funds and managed accounts—have already taken hold. But now, DC plan sponsors are starting to take some lessons from the DB investment approach.

“Institutions have modernized their approach to creating long-term financial security, and individuals are trying to catch up,” explains P. Brett Hammond, managing director and global head of index applied research at MSCI, who co-authored a research paper with Juliana Bambaci, senior analyst for index applied research at MSCI, titled “Bringing the Best of DB to DC Fund Options.” Hammond tells PLANSPONSOR, “There is a need for modernization in investment choices/fund selection and asset allocation to catch up with successes institutions have achieved.”

Hammond contends that individuals often suffer from fund lineups that have too many similar funds or do not include the full investable universe.

The paper says, “defined contribution (DC) plans and wealth management advisers are turning to lessons from institutional investing, including its emphasis on low expenses, long-term returns, appropriate funding levels, and liability driven investment (e.g., income replacement), in an effort to significantly improve outcomes for individuals.” According to the paper, plan sponsors and advisers are doing this by adopting a global investment framework, in which they select a global index to guide asset allocation and construction of the core investment menu for DC plans as well as target-date funds used.

Hammond explains that traditionally, DC plans may have started out with a domestic stock fund, a domestic bond fund and perhaps a stable value fund, then tacked on investments thought to be missing, such as international funds and small cap versus large-cap equity. He and his coauthor suggest moving in the opposite direction. “If you keep bolting things on, you don’t know if you are covering the whole opportunity set,” he says. “Start with the opportunity set and create the lineup. That way you can make sure there are no gaps and no overlaps.”

As an example, Hammond suggests plan sponsors can find an index that represents the global investment set; for equities, that would include large cap, small and mid cap, domestic and developing and emerging markets. Plan sponsors would select funds for their core lineups that would add up to the whole index. There may be three or four funds that would do this.

The research paper suggests plan sponsors and advisers can also use indexes to monitor and evaluate funds. “Like other institutional investors, plan sponsors and advisers can set investment goals through the use of clear, explicit benchmarks and then compare each individual fund choice against its benchmark,” it says. “Further, since performance and fees vary by mandate—as represented by a benchmark or index—sponsors and investors can better compare funds that compete to offer a specific mandate.”

Plan sponsors already regularly review their fund lineups, so they should now take a look at their lineups and ask providers and advisers for help in deciding if the lineup conforms with a global perspective or if it still kind of bolts things on, Hammond recommends. “Talk about the next opportunity. Should you do an RFP [request for proposals]? Once you start doing that, create a policy benchmark that will represent a global investment perspective. That makes it much easier to have a discussion about how to identify mandates or funds.”

According to Hammond, the trend of implementing a global investment approach isn’t as far along as auto enrollment and auto escalation of contribution rates, but it is starting with plan sponsors that also have DB plans. He contends the trend will move to standalone DC plans.

“I think this is an exciting time for DC plans. There has been a lot of criticism of DCs over the last 10 to 15 years about not helping long term savers in the same way DB plans have been able to do over time. We’re seeing a transformation going on—a change with many approaches being used, including auto features and new investment lineups. We will see a trend toward improved plans that help individuals meet long-term savings goals, and a global investment perspective is very much a part of that.” Hammond concludes.

The MSCI research paper is available here.