A report, “Defined Contribution Investments on Trial,” from the Institutional Relationship Group at PGIM, the asset management arm of Prudential Financial, notes that recent lawsuits have challenged the investment menu selection approach of many defined contribution (DC) retirement plans.
Some plans use what PGIM calls the Retail Approach with a primary focus on appealing to what is believed to be what participants want, using a wide array of choice and an emphasis on name recognition. Others use what PGIM calls the Simple Approach, focusing on minimizing fees and maximizing simplicity, using heavy or exclusive use of passively managed funds and basic asset classes.
Josh Cohen, PGIM’s head of Institutional Defined Contribution, based in Chicago, tells PLANSPONSOR that maximizing simplicity and cheapness can benefit plan sponsors, calling into question whether fiduciaries are acting in the best interest of participants, unless these plan sponsors truly believe active management doesn’t work. However, he notes institutional peers haven’t come to that conclusion.
PGIM advocates for what it calls the Institutional Approach to DC plan investments, and suggests DC plan sponsors look to the approach of defined benefit (DB) plans, endowments, sovereign wealth funds, insurance company general accounts, sophisticated wealth management platforms and family offices. These institutional investors focus on solutions that are believed to offer a higher probability of meeting a desired outcome.
An Institutional Investment Approach uses outcome-oriented investments, broad asset class diversification, best-of-breed investment management, a thoughtful mix of active and passive strategies and are vehicle agnostic, meaning they consider institutional mutual funds, collective investment trusts (CITs) and separate accounts. According to Cohen, this mindset can be used in the DC plan framework as well.
According to Cohen, institutional investors look at what investments will provide better outcomes. “For example, a DB plan may use liability-driven investing, or LDI. A similar option in DC plans is TDFs, or target-date funds,” he says. Cohen adds that institutional investors have seen advantages from using a broad asset class. There has been a move from just stocks and bonds to credit, private equity and private real estate. He says the types of asset classes may differ based on the institution’s asset size or liquidity needs. He also suggests DC plan sponsors look at emerging markets, emerging market debt and illiquid asset classes, such as real estate.
“Another thing I like is [institutional] investors are thinking about active versus passive. They are all using a combination of active and passive investment, although there may be differences in how they allocate them. But, very few are all in one or the other,” Cohen says. “For example, we asked DB plan chief investment officers how many used passive bonds, and no hands were raised. But many DC plans only focus on simplicity and fees, and their TDFs will have half or more of assets in fixed income funds.”
Cohen says that having an institutional mindset for TDFs means they will have a mix of active and passive underlying investments and diverse asset classes. “There are some off-the-shelf TDFs that fit that bill, but larger plans and a few down market can create customized TDFs taking into account demographic differences of participants,” he says.
According to Cohen, 26% of DC plan sponsors say active funds would be harder to monitor, but he points out that just because plan sponsors go passive, it does not reduce monitoring responsibilities. Plan sponsors must think about to what indexes they will benchmark and the lowest possible share class. He adds that there is no such thing as a passive TDF—underlying investments need to be monitored. “There are plenty of OCIOs and other experts that will share investment monitoring responsibilities with plan sponsors,” Cohen says.
DC plan sponsors should also follow institutional investors’ approach to using multi-manager funds (white-labeled investments can fit this bill), institutional mutual funds, CITs and separate accounts, he adds, pointing out that experts want to work with plan sponsors to determine the best investment vehicles for their plans.
“It’s all about the best interest of participants. To protect plan liabilities and reduce risk, diversifying asset classes really makes a lot of sense,” Cohen says.He concludes: “The average investor couldn’t get access to these asset classes on their own, and even if they could, they would be paying much higher than institutional prices, so why are we denying individual workers these asset classes?”