Investment Excellence

The right expertise to make investment decisions
L to R: O’Connor, Brookman and Hunt

The right investment lineup in a retirement plan is crucial to help plan sponsors fulfill their fiduciary duties, but even more important to plan participant success is the allocation in which a participant invests. Many plan sponsors are looking for assistance to ensure that both of those goals are fulfilled. To discuss ways in which plan sponsors can get help in outsourcing some of those fiduciary responsibilities and achieve best practices in participant asset allocation, PLANSPONSOR spoke with experts at Morgan Stanley: Ed O’Connor, managing director and head of Retirement Services; Marc Brookman, managing director responsible for the Graystone institutional consulting businesses, advisory distribution, and advisory products and platforms; and Dan Hunt, Global Investment Committee senior asset allocation strategist.

PS: What is a 3(38) investment manager, and what is the benefit of using one for a plan sponsor?

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O’Connor: An investment manager under Section 3(38) of the Employee Retirement Income Security Act (ERISA) has full discretion over a plan’s investments with the authority to buy and sell plan assets. What we’re talking about today is Morgan Stanley Wealth Management’s plan to start providing 3(38) investment management services to defined contribution (DC) plans later this year.

As plan sponsors know, they cannot completely eliminate their fiduciary responsibilities. However, by appointing a 3(38) investment manager, they are able to bring someone with investment expertise into the fiduciary boat with them. They of course have to monitor what the 3(38) investment manager does, but the plan sponsor can empower them to pick and change the investment choices within the plan without previous approval.

Now, allowing a 3(38) investment manager this level of discretion can provide a more efficient and timely process for managing the plan. And this is especially important if the 3(38) investment manager is constructing models for their participants—like custom glide path target-date solutions. And that is what we at Morgan Stanley Wealth Management are really excited about: using our investment expertise to provide customized target-date glide paths or targeted risk models to participants and then picking the investment managers to construct them.

PS: How can plan sponsors get help selecting the right manager?

Brookman: It’s a complicated situation that the average plan sponsor or participant cannot invest the time and effort to fully understand and execute. What we do at Morgan Stanley Wealth Management is sometimes package the solution with the investment managers we deem appropriate, like in a model portfolio and sometimes by providing the right consultant to advise the plan sponsor. Too often the participants are left to fend for themselves and/or the plan sponsor is provided a one-size-fits-all model.

A firm like ours, working with Graystone Consultants—our institutional consulting firm of 45 teams, consulting to about $190 billion in total assets, who speak this language and who can build these custom glide path and lifestyle funds by leveraging all the things a firm like Morgan Stanley brings to the table—will create a better outcome, and not just a higher return, necessarily, but better diversity in asset classes to focus on the right outcomes.

O’Connor: In addition to our Graystone Consultants, this new service can also be delivered by our corporate retirement directors (CRDs). They are very good in helping to design a defined contribution plan including the investment lineup. Both Graystone Consultants and our CRDs will now be able to service these defined contribution plans as either Section 3(21) investment advice fiduciaries or as 3(38) investment managers. 

PS: What is the role then of the plan sponsor in selecting and working with an adviser or consultant?

O’Connor: First and foremost, plan sponsors have to articulate what are the specific goals they have for their plans. And then pick an adviser or consultant you believe can best articulate those goals and define clear metrics for you. The specific goals and metrics will be different for each plan.

Once that has been accomplished, you should then measure your adviser by assessing how well they help you to move the needle on those metrics and if they provide great recommendations and insight going forward.

Brookman: It’s about experience, credentials and results. The market is dynamic—it moves and changes quickly. The firm does matter, because you need a lot of resources to stay on top of things.

If you’re just one person, trying to do the asset allocation yourself, the manager selections, investment due diligence, find the right recordkeeper and all that is required from a legal, compliance and risk standpoint—it gets unbelievably difficult.

A sole practitioner, even within a firm like ours, has a challenge that a team approach typically overcomes—teams have multiple people with multiple skill sets: the analytical person, the outgoing salesperson to do enrollment meetings, the asset-­allocation and portfolio construction team. Plus, if I’m a plan sponsor today, given all the challenges, working with someone with substantial resources would be important, as well. With Morgan Stanley, you can check many of those boxes.

Hunt: Sponsors should be cognizant of the relative merits of the advice they receive, and advisers should be able to communicate that to them. It’s one thing for an adviser to put a brochure in front of a sponsor that shows an asset-allocation glide path and scientific sounding probabilities of success, but that doesn’t really tell you much. Advisers should be made to demonstrate the value of the advice they provide relative to what else is out there. They should also ask the right questions.

Strong solutions are the product of clear thinking, so if you’ve got superior advice, it should lend itself to being communicated clearly and compellingly.

PS: How can a 3(38) investment manager role help plan sponsors achieve better results with their asset-allocation vehicles?

Brookman: Many risk-based funds and target-date funds (TDFs) are constructed by one provider who’s not necessarily best in class in all areas they manage. With the help of Morgan Stanley’s Global Investment Committee, we bring together a universe of mutual funds, exchange-traded funds (ETFs) and other products that are covered by an exhaustive due diligence and research process.

Then it’s not just enough to put them on a menu. How are they assembled in a plan lineup? It’s not just picking the best-performing funds, but looking at details such as security overlap and concentrations in different sectors to make sure the portfolios truly are diverse.

O’Connor: Determining the right glide path is a good example of establishing your specific goals. This is about the profile of your participant base: Do people stay a long time within your firm? Is much of your plan with retirees, or are you within an industry where people turn over more frequently? Do they have other sources provided by you for their retirement—e.g., health care? These factors will help to inform the right custom solution for your plan.

Hunt: The answer you get to a retirement problem really depends on the question you ask. Many providers frame those questions poorly. They assume the question boils down to the probability that some hypothetical investor will achieve some hypothetical level of income replacement in retirement with an equity allocation that declines over time.

But it’s a continuum of outcomes and participants we’re concerned about here. A 95% probability of hitting the 60% income replacement target of some hypothetical participant is nice, but in reality, circumstances differ from one participant to another. Furthermore, participants care about the magnitude of success or failure, not just the probability.

It matters quite a lot, for example, whether a failure to hit a 60% target means a 59% income replacement ratio or a 20% income replacement ratio: 59% is inconvenient, 20% is disastrous. But yet the question of how effective a strategy is at mitigating those 20% income replacement-type downside extremes is not even being talked about by many providers. That begs the question of how well their solutions are likely to manage those risks, which in reality are of paramount importance for participants.

Many providers create their advice essentially by trial and error, interpolating some arbitrary equity or volatility targets from high to low over a lifetime, and Monte Carlo Simulating the result. That approach puts the cart before the horse and increases the likelihood of getting the wrong answer when you don’t understand the nature of the problem.

When you actually solve for a solution rather than guessing at one, it becomes clear why a glide path makes sense in the accumulation phase of the lifecycle and doesn’t make sense in the decumulation phase. And the reason is that poor returns around retirement—what we call the “retirement zone”—lead to the worst kinds of outcomes for participants. It turns out that the strategy that best mitigates downside extremes is the one that minimizes the effect of bad retirement zone returns on outcomes. Our advice is derived quantitatively to do just that.

As Ed pointed out, there’s also the need to recognize that one size doesn’t fit all. Different plans have different circumstances, and that means a different complexion of risks for participants. A plan whose participants start saving later and leave their assets in the plan after retirement is very different from a plan whose participants are automatically enrolled and tend to annuitize. A plan whose participants retire early and have recourse to a defined benefit (DB) plan is very different from a plan whose participants retire later and are less affluent.

We’ve spent a lot of time thinking about the kinds of questions whose answers have the potential to change our advice, specifically regarding the asset-allocation modeling in our 3(38) offerings. That has led to solutions that differ from the consensus on how, typically, target-date funds have been constructed, to solutions that vary depending on the balance of risk for participants and ultimately to solutions that we believe are superior to what is currently out there. 

PS: While is the role of the 3(38) investment manager in the ongoing investment due diligence of the plan?

Brookman: Well, to recap what Ed said earlier, a 3(38) investment manager is empowered by the plan sponsor to make the buy and sell investment decisions for the plan. The plan sponsor’s responsibility is obviously to monitor them. I believe more than ever that the capabilities of a firm like ours in a 3(38) capacity is valuable.

In the last five years, the world has literally changed in this marketplace. For example, the types of products you can access today that you couldn’t just a few years ago provide a fiduciary with more ways to enhance the plan. Here’s a specific example: There’s a consensus in the marketplace that interest rates will rise sooner or later—we’ve had a 30 to 35 bull market in fixed income, and it is probable rates will eventually move to historically normal levels. How you manage through this is one critical challenge. And now plan sponsors can customize a solution with us.

Hunt: Further, to Marc’s point about being able to react to what you’re seeing in the marketplace, academic studies have demonstrated that changing equity weightings based on simple measures of valuation like cyclically-adjusted price to earnings ratios would have added considerable risk-adjusted return to retirement portfolios historically.

We agree that you can add a tremendous amount of value that way, not just with equities but across asset classes. As Marc just mentioned, we believe we’re in a rising-rate environment, and regardless, we’re certainly in a zero lower-bounded rate environment, and that has implications for prospective bond returns that are meaningful for investors. So we built into our glide path the ability to make adjustments dynamically, based on which parts of the capital markets offer the best value, something that to our knowledge is not available elsewhere. We believe this will result in substantially better outcomes for participants.

Brookman: The days of “setting and forgetting” are over. Not everyone can be a student of the market and take advantage of the things going on there, but having a firm behind you that does that is absolutely critical. It’s just the way doing business today has to be different than it was a few years ago, given the risks and situations out there.

One theme we’ve all been talking about is that Morgan Stanley is a firm that delivers “investment excellence” to our clients. That’s only two words, but to us it incorporates a lot of meaning. It’s all that makes us unique as a firm. It’s all the intellectual capital that goes into the work we do.

It’s how you get the performance—looking at the models on a risk-adjusted basis, customizing the allocation for clients, doing research on investment products where no one else goes as deep or has as large a team as we have. It’s all that and investment excellence that describes the entire offering and goes into what we can deliver down to any of our clients—from a 401(k) participant with $5,000 to our largest $10 billion institutional clients. It’s the same thinking.