Before evaluating investments for inclusion on a defined contribution (DC) plan fund lineup, plan sponsors need to decide what types of investments they want to use.
An article from Willis Towers Watson, “Moving the Needle on Defined Contribution Plans,” suggests that the purpose of the plan will help sponsors define the pieces of an investment lineup.
Evaluating Participant Demographics
David O’Meara, director, investments, Willis Towers Watson, says the first task in determining the purpose of a plan is framing who the end user of plan is—understanding its participants and how to unlock more value for them. He notes that there’s been an evolution in the DC plan industry over the past 20 or so years from offering an abundance of choices to offering more simplification, because DC plan participants have a hard time processing all those options and making good asset allocations with that amount of complexity.
“Plan sponsors need to know their plan demographics and the investment sophistication of participants,” says Michael Welz, president and chief investment officer (CIO) at USI Advisors. “If they have an unsophisticated participant base, it may not be viable to offer some investment options, such as sector or region funds, multi-sector or high yield.”
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Welz says the age of participants matters as well. If the population is mostly young and has time to grow assets, the investment lineup can focus more on accumulation. But investments that help participants create income for retirement are also a key consideration for DC plan investment menus.
Plan sponsors can also track how many participants are using investment education tools provided by recordkeepers or advisers. If many are using these tools, it might give plan sponsors more flexibility in what investment options to offer.
In its article, Willis Towers Watson says one thing that can simplify investment lineups for participants is leveraging multimanager funds, which can help reduce style bias by any one manager relative to a fund’s benchmark.
“A lot of individuals will sell yesterday’s losers and buy yesterday’s winners, and, over time, that will detract from investment outcomes,” O’Meara says. “We find packaging multimanagers into single funds and white labeling them to be a more efficient way to build better investment choices for participants so they can maintain expected outperformance at lower investment risk. It is also better to put managers with different investment styles together to help participants avoid overtrading portfolios.”
Welz says if plan sponsors define the purpose of their plans, it will provide direction for the plan investment lineup. He adds that the plan’s purpose could be dynamic and change over time.
One purpose of DC plans is still to help participants grow their assets. For this objective, Welz says, plan sponsors should look for return-seeking investments.
Welz says target-date or target-risk funds are appropriate for the majority of participants because participants typically don’t know how to invest, and these accounts are tailored for them. “When combined with auto-enrollment, a target-date or target-risk fund as the QDIA [qualified default investment alternative] works very well,” he says.
However, he notes that every plan has a population of “do-it-myself” participants who put a fairly aggressive asset allocation into play. He adds that in addition to core equity and fixed-income options, plan sponsors should consider offering a brokerage window, depending on participant demographics.
Welz says there are so many different target-date fund (TDF) products that the chances are high that an off-the-shelf one will work for the vast majority of plans. However, he says, plan sponsors should go through a prudent process for selecting TDFs.
“For example, an in-depth process will take the population that uses TDFs—their income, contribution rates and account balances—and model it out to age 65. Then consider how on-track for a successful retirement they will be with the age-65 balance plus Social Security,” Welz says.
Regarding QDIAs and TDFs, specifically, investment experts fall into different schools of thought about what plan sponsors need to provide for participants. But O’Meara suggests that if a plan sponsor determines it wants to provide the very best investment solution it possibly can, that might involve not using an off-the-shelf QDIA.
“Sometimes it can only be done with a truly open architecture investment program,” he says. “This can open up doors to investing in asset classes not typically available in off-the-shelf solutions, namely alternative assets used by other institutional asset owners, such as real estate, private equity and hedge funds.”
With regard to custom TDFs, Welz says it takes a level of sophistication for committee members to understand the various benefits and drawbacks of them. He adds that some plan sponsors are reluctant to use custom TDFs because of the lack of a public benchmark or because of higher fees and the threat of excessive fee lawsuits. However, he says that when considering custom TDFs, plan sponsors should use the same in-depth process he suggests for off-the-shelf products.
Another aspect of reimagining investments is considering what role DC plans have in being a true retirement vehicle, considering the decline of defined benefit (DB) plans, O’Meara says.
“DC plans have been pretty good at helping participants save and invest money, but not so good at helping them turn accumulated savings into a sustainable income stream,” he says. “So many plan sponsors are now thinking about the purpose of the plan and whether it is to provide a seamless transition for participants to retirement so they can stay in the plan. Plan sponsors are asking, ‘Can we deliver something better than participants can get on their own, or is it our job to get them to and not through retirement?’”
Determining the purpose of the plan and the role the plan sponsor wants to have post-employment can open the door for different solutions to meet the needs of former employees, O’Meara says. He adds that solutions can be any number of things from an annuity or some type of investment with a guarantee to educational resources with a suite of services and funds that help participants better understand their needs in retirement and options for using DC account balances to meet those needs.
“We’re seeing more plan sponsors thinking about what to do to deliver something, whether DB-like or other tools to leverage the plan’s scale and economics to meet participants’ needs better than what they can get on their own,” O’Meara says.
“Over the last 10 years, if we asked clients ‘What is the purpose of your plan?’ in 99% of cases, it would be ‘to help participants grow assets,’” Welz says. “It’s only been in last few years that decumulation—providing income in retirement—has become a purpose.” He says this is historically how most DC plan investment lineups have been based—and why they have been dominated by equity funds.
“In general, most plans are underdiversified in fixed income,” Welz says. “I think the industry is looking to bridge the gap between accumulation and decumulation, so depending on which provider a plan sponsor is using, it might provide an annuity-based product or another type of investment product allowing quarterly or annual distributions.”
Thinking of the DC plan investment lineup in this way would mean including investment options to help pre-retirees de-risk their portfolios.
“DC plans tend to be growth-heavy, and not a lot of participants are in fixed-income funds,” O’Meara says. “If there will be people of advanced ages in the plan, the plan will need additional lower risk investment options or other diversifying investments that may help to build a more efficient, more robust, sustainable portfolio for retirees.”
ESG and D&I
Plan sponsors have also been thinking more about incorporating diversity and inclusion (D&I) efforts into their benefits programs. O’Meara says a plan sponsor wanting to make diversity and inclusion part of its DC plan’s purpose should think about who the investment lineup is developed for.
“In general, investment lineups benefit those who have the ability to save and those more comfortable with investment decisions,” he says. “So, plan sponsors should be thinking about those not able to save as easily to help them with that, and, for those less highly educated and less comfortable making investment decisions, plan sponsors should create ways to engage those participants and simplify the investment selection process. This could lead to better investor behaviors across the participant population.”
Welz says participants are requesting environmental, social and governance (ESG) investment options more frequently than in the past, and plan sponsors are asking consultants about them. “The demand is there, but I think there will be more willingness to add ESG investment options when the regulations are more clear,” he says.
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