Simplified, Streamlined
Industry thinking about the retirement plan investment menu has seemingly converged around the “KISS” principle. KISS, of course, is short for “Keep it simple, stupid.” According to a variety of business leaders and regulatory experts, expansive and complicated defined contribution (DC) plan investment menus are falling out of favor about as fast as any other practice in the industry.
As observed by Paula Smith, New York-based senior vice president and head of defined contribution investment only (DCIO) and college savings products for Voya Investment Management, complicated menus simply do not line up with the reality of defined contribution plan usage in the U.S. The vast majority of participants do not know how to navigate an investment menu on their own, she notes, nor do they want to learn how to sift through dozens of funds on the core menu to build a portfolio. Given these factors and others, it makes little sense to keep expanding defined contribution menu choices.
“The current trend is clearly skewing toward paring down investment menus and reducing the necessary engagement from participants,” Smith says. “As a part of this, there is also a rethinking of how we label and present choices to plan participants. At a very high level, we’re seeing a move away from a lineup of dozens of funds to a menu made up of the qualified default investment alternative [QDIA], usually a target-date fund [TDF], along with a small second tier of white-labeled options and then perhaps a third tier that is an open brokerage window.”
This three-tiered approach has been adopted by a variety of providers. Richard Davies, senior managing director and global head of defined contribution at AllianceBernstein in New York City, agrees that streamlining the investment menu has already become a best practice. He adds that his firm also takes the three-tiered approach and that “most plan design consultants are selling this model today.”
As Davies explains, the first tier of the simplified menu is typically a QDIA, which is most often a target-date fund but may be a balanced fund or managed account, depending on the plan demographics. He notes that AllianceBernstein is already seeing “60%, 70% or even 80% of the new money directed into a given client’s plan being pumped into the QDIA,” highlighting the critical role the default plays in a streamlined menu.
Use of a plan’s QDIA should include smooth, automated implementation of an appropriate asset allocation, as well as automated rebalancing and, likely, auto-enrollment into the fund. Davies says these three elements taken together generally make the QDIA the best way for an “average Joe” to put his money into a retirement plan.
“Greater use of the QDIA is already the biggest trend when it comes to simplified investing in DC plans, and we expect that to continue,” Davies says. “By that token, a big part of the job of building a simplified menu will be selecting and monitoring the right QDIA.”
Different groups of participants will be better served by different QDIAs, he contends, so it is up to the adviser to help the sponsor understand what demographic considerations should drive the default selection. It is important for advisers to get good access to plan demographic data and to keep this in mind when making recommendations.
The factors that might influence the glide path include everything from average salary of the plan population to the occurrence of anticipated pension benefit income for some or all of the participants. Average retirement age is another. Will the plan population generally retire in a low tax bracket and therefore get more income replacement from Social Security? This element of lifetime income protection could mean a more aggressive glide path is appropriate within the 401(k).
More active and engaged participants will have the chance to create their own portfolio via tier two, sometimes called the core menu. Even in this part of the menu, there is a trend to pare everything down and eliminate redundancy, Smith says. This segment of the menu might have in the ballpark of 10 options, ideally covering all of the broad equity and fixed-income asset classes through multi-manager portfolios or a fund-of-funds approach. Custom and white-labeled funds could also be considered. Whatever the exact breakdown, participants must be able to create global, well-diversified portfolios through the core menu. Given all the focus on fees and litigation, it is also becoming standard to make sure there are at least a handful of basic passive options under tier two.
Davies and Smith suggest that tier two of the investment menu must be carefully constructed to make participant decisionmaking as easy as possible. For example, advisers should ensure participants are not forced to choose among multiple options for a given single-asset-class fund type. Another common hiccup to consider: Unless a custom managed account or automated rebalancing service is overlaid on tier two, participants using this segment of the menu will have to be diligent and rebalance their own portfolios as markets move up and down.
White-Labeling Opportunities
Tier two may be the most appropriate place for
white-labeling to occur, though it is also becoming common to white-label the
plan’s QDIA. This is not a concept that is precisely defined, but looking at
either the QDIA or the core menu, white-labeling basically involves working
with an investment provider or consultant to put a simplified wrapper around a
fund or fund-of-funds.
When white-labeling a single fund, a big part of the effort is making the fund name and its slot in the investment menu easier for participants to understand, Davies explains. For example, instead of listing the BlackRock U.S. Aggregate Bond Index, the fund would be presented to participants as the U.S. Bond Index Fund. This lets participants know the goals of the fund and why it is on the menu. With the fund-of-funds approach to white-labeling, the plan sponsor does essentially the same thing, taking a selection of funds/managers and presenting the aggregate as a single investment option.
Beyond benefiting participants, defined contribution investment providers report that white-labeling can make it easier for the plan sponsor to make changes to the investment menu. This is because the underlying elements of the white-labeled fund may be changed out and the participants’ dollars rerouted to a replacement without requiring the individual to choose a new option from the menu. White labeling is also a great way for plan officials to add diversifying asset classes to the menu without adding more complexity for participants—perhaps by folding alternatives into a white-labeled equity fund-of-funds. Davies says this can bring access to lower-correlation asset classes not as commonly used by retirement investors, such as real estate or private equity, without demanding additional sophistication from participants.
Tier three of a streamlined menu then generally consists of a brokerage window or perhaps a more aggressively individualized or higher-price managed account service. Different approaches are possible here, Davies and Smith feel, but the main goal is giving savvier participants a place to put their skills to work—while controlling fiduciary risks. Davies notes probably no more than 10% of plan assets should be allowed to flow into the brokerage window, given the challenges of investing successfully when flying solo.
Setting the Right QDIA
According to Susan Viston, client portfolio manager for
Voya’s multi-asset strategies and solutions team out of Middleton, New Jersey,
a good place to start the investment menu reassessment remains the DOL’s “Tips
for ERISA [Employee Retirement Income Security Act] Target-Date Fund
Fiduciaries,” released in 2013.
“One of the key aspects that publication explores is that target-date funds can be really different from one another in some important ways, which leads to a pretty wide performance and risk dispersion in different market environments. In 2008, it was really stark—managers in the same TDF category demonstrated a performance dispersion of over 20%,” she says.
Viston points to data that shows this dispersion does not just arise during rocky markets. Even during the relatively strong growth of 2014 and into early 2015, the managers of target-date funds with a 2045 vintage showed a performance dispersion of more than 9%.
“Picking the right TDF is about understanding the manager’s risk philosophy and its approach to glide path implementation,” Viston says. Even two funds with a nominally similar glide path in terms of stocks and bonds could have exposure to different sub-asset classes and use different mixes of passive and active investments, leading to significant differences in performance.
An increasingly important question in target-date fund construction mentioned specifically by the DOL is open architecture vs. closed architecture. With the former type of TDF, which remains less common than fully proprietary TDFs, the manager can look across fund providers to choose the best-of-breed managers for each individual asset class going into the fund. Proprietary funds, on the other hand, rely exclusively on in-house managers.
“Today we are still seeing many TDF providers using this proprietary-only approach and looking only within their own fund complexes,” Viston notes. “The DOL wants to know: Is this good enough, and should plan sponsors accept closed-architecture funds?”
The Importance of Continual Review
From the plan adviser’s perspective, Smith says there is a
growing capability to look specifically at investment vehicles and approaches
to investing, and to sell the process of reviewing and reporting on the
investment menu as a distinct service. “Given some recent court cases, there is
a big focus on the fact that plan fiduciaries have an ongoing duty to monitor
their investment menu and the performance and costs built into it,” she notes.
“One outcome for plan advisers is an improved environment for selling to
clients the process of reviewing and refining the investment menu.”
Whether the adviser is doing this work on a per-project basis or on retainer, Smith feels there is significant opportunity in making sure that sponsors use the lowest-cost share classes and in helping sponsors to understand how things such as revenue sharing affect net menu pricing. Advisers may have an opportunity to bring exposure to exchange-traded funds (ETFs) or collective trusts, as well.
“Streamlining of investment menus does not mean limiting exposure to the market or limiting access to investment vehicles or asset classes,” she adds. In fact, advisers who can serve the double purpose of increasing asset-class exposures and diversification on the plan menu while simultaneously making the investment menu more efficient and easier to use should meet strong success in today’s marketplace.
“Simplification of the menu means putting participants in the best position to take full advantage of the investment menu and the opportunities that abound in global markets,” Smith says.
White-labeling and multi-asset-class solutions may be a part of this, as could asking whether any critical asset classes are missing from the menu. For instance, looking at fixed income, does the plan offer access that goes beyond intermediate-term bonds and really looks for the global opportunity that exists out there?
“These are the questions advisers should be bringing to their clients,” Smith concludes.