There seems to be no argument that defined benefit (DB) plans, with the administrative burden or the expense they allegedly add, yield better participant outcomes in retirement.
And it’s not just because the company pays. DB plans consistently outperform defined contribution (DC) plans by close to 1%, according to studies such as the Callan DC Index—which, compounded over a working career, can be a big boost toward retirement readiness.
DC plans have already adopted some of the best practices that put DB plans ahead for participant outcomes—automatic enrollment, professionally managed investment options, and for a few, access to solutions to annuitize plan withdrawals. DC plan sponsors have also begun seeing the value of outsourcing and leakage control.
Institutionalization of DC plans has actually been proceeding, in somewhat of a piecemeal, accidental fashion, since passage of the Pension Protection Act of 2006 (PPA).
Still, some plan sponsors may be unaware of the possibilities, concerned about fiduciary risks or afraid to make a sweeping change. Whatever the hesitation, experts believe sponsors have much to gain from exploring what institutionalization, including institutionalization of investments, could do for their DC plans.
“There are other institutional pools of money that have been managed a certain way for a lot longer than DC plans,” observes Holly Verdeyen, director, defined contribution investments, Russell Investments, referring to charitable foundations, endowments, executive compensation plans, and defined benefit plans in particular.NEXT: The institutionalization mindset.
But more than a list of solutions, institutionalization must become “a mindset,” a philosophy, guiding everything to do with the plan, from design to enrollment and withdrawals, to investments, fees and advice—even applicable in small and mid-sized plans, says the Defined Contribution Institutional Investment Association (DCIIA) in “Institutionalizing DC Plans: Reasons Why and Methods How.” And each decision should further the goal of maximizing participant savings.
When it comes to plan investments, Verdeyen explains this mindset as a broadening of possibilities—diversifying asset classes and management of each, mixing active and passive investments, and unbundling services—to provide the greatest protection and opportunity for capital to grow.
“[DB plans] will use certain asset classes that typically you don’t find in a DC plan, such as high yields, for example,” she says. Other possibilities include real estate, real estate investment trusts (REITs) and commodities. Some investments, such as certain structures of collective investment trusts (CITs), will be available to small and midsize plans and charge lower fees than mutual funds, says the DCIIA.
In addition, DC plans typically offer a single-manager approach for each asset class, Verdeyen says, calling that inadequate diversification for an outcome-based approach.
She and her colleague Josh Cohen, managing director, head of institutional defined contribution at Russell, explain, “The DC systems grew up out of the retail investment management market [in the late 1990s], where providers that were providing recordkeeping services were also providing the investments [—their own mutual funds—] and these were also providers that focused more on a retail audience.”NEXT: The multi-manager approach for DC plans.
This approach has led—at least indirectly—to one of the biggest issues facing the industry today—excessive fees. The migration of DC plans to all-passive funds has been one result. “It would be very rare to see a DB plan or charitable trust use 100% passive management,” Verdeyen points out, calling that “a phenomenon singular to defined contribution plans.” DB plans “are going to use a thought-out mix of active and passive for different asset classes and maybe even combine them in the same asset class.”
For DC plans, taking that course employs white-label rather than brand-name funds and, often, multi-management. DB plans commonly use both best practices to increase returns, at the same time comfortably offsetting fees. “It’s a very reasonable amount of added value over the 30-, 40-year career they’re going to have, theoretically,” Verdeyen says. “That can really make a big impact on retirement readiness.”
A multi-manager approach uses different managers—which the investment committee may hand-pick—to cover different sectors and different exposures. “For example,” Verdeyen says, “instead of having one manager represent the small-cap equity space, you can combine two or three—maybe someone who has more of the growth tilt in his investment process, maybe one who focuses more on the micro-cap sector. Maybe you have one who focuses on a quantitative process as opposed to a fundamental.
“Theoretically, by combining those different managers you should not only get a more diversified portfolio but also one that will have a smoother return stream, because different managers with different styles and processes are going to outperform and underperform in different environments,” she says.
However, simplification is also involved, she adds. “You want to be sure the plan is designed in a way that’s simple to use and supports the accumulation levels that are needed. But just because the investment menu is simple, that doesn’t mean the investments themselves need to be simple.”NEXT: Making it simple.
Michael Swann, director of DC strategy for SEI Investments Co., too, advises simplifying the investment menu—especially important when participants make their own investment choices, he says. “The old consultant-driven approach would be to fill in the nine … style boxes: large-cap value, large-cap blend, large-cap growth, mid-cap value, … [etc.]. Then you have nine equity funds; they’d monitor them, then if performance drops off, they’d replace them—that’s the whole idea.”
Where the problem arises, he says, is when participants misread the performance results. “They’d say, ‘Look, the small-cap growth funds return 15% and the small-cap value only returns 3%—I’ll put my money in small-cap growth.’ What they don’t understand is these things are cyclical, and the performance of the small-cap value manager may actually be good relative to its benchmark.
“With a broader approach and a simplified menu, you might have only two options that are active in U.S. equity—a large cap and maybe a small cap. If you have these two options and they contain both growth and value managers, there’s a lot less temptation to chase performance when you’re only making a strategic decision between two different market caps,” he says.
Fiduciaries wishing to institutionalize their plan—particularly to make changes left unaddressed by the PPA or other legislation—should first seek help from a professional such as a retirement plan adviser, writes the DCIIA in “Institutionalizing DC Plans: A Starting Point for Addressing Fiduciary Issues.” The adviser can help them evaluate which strategies and types of investments best suit their plan and participants, then aid them in updating their plan governance documents and relevant participant communications, such as the summary plan description (SPD). They should consistently monitor their progress and document each step.
Investment plan committees that prefer passing on most of these responsibilities have the option to hire a 3(38) fiduciary investment manager. Some of these managers, such as SEI, offer their own multi-manager mutual funds, which operate like a multi-manager fund , except with an investment manager serving as 3(38) fiduciary, overseeing sub-managers. Interest in this service has been growing, Swann says. This “is partially due to increased litigation in the space—e.g., stock drop cases and fees, such as Tibble v. Edison,” he says.NEXT: Making efficient changes to investments.
The plan receives several benefits from this approach, says Swann. With management handled elsewhere, the committee is free to focus on strategy not merely tactics—in keeping with the plan-focus mindset. “You’ve got someone who’s engaged and watching these managers every day rather than every quarter and who’s going to make decisions on all their clients’ behalf.”
Any changes in managers takes place within the vehicle, he says. Compare that with changing a single-manager fund, he says, which requires 30- to 90-day advance notice to participants and a black-out period, where the investments leave the market while the transfer is made.
“[Informing participants of such a change] raises questions: ‘Why are they taking this fund out? What was wrong with it? Should I be taking my money out now?’ But if you use more efficient vehicles such as a white-label fund or multi-manager mutual fund, you can avoid some of those challenges,” he says. “That’s a much more efficient way of managing the money, from an administrative standpoint.”
For companies that offer both types of plans, the pension could reveal a double standard—possibly with legal consequences. Cohen, in an April newsletter, cites plan committee members who say “sponsors shouldn’t be spending participant money on active management—yet the same sponsors prefer to rely on active management for a meaningful part of their defined benefit plan assets, to enhance returns and keep long-term costs down. Are DC plan participants being short-changed by excessive use of passive management, even where good active opportunities exist?”
Further, considering recent court decisions, could those sponsors be judged as neglecting their fiduciary duty by failing to provide participants the same savings and enhancements?