The State of DCIO

What opportunities and challenges do investment management firms face this year?

Back in the early days of defined contribution (DC) plans—say, the 1990s—mutual fund companies were a logical solution to the many challenges that the new plans posed. Thanks to the mutual fund boom of the 1980s, the vehicles a decade later offered a wide variety of equity and bond investments, and, as they were accustomed to gathering contributions in small amounts from many shareholders, they provided a recordkeeping solution, as well.

But it turned out that the breadth and quality of mutual fund giants’ offerings and in-house recordkeeping were not enough. “In the late 1990s, there was a pull from plan sponsors and participants to add best-of-breed funds,” recalls Harris Nydick, managing member of CFS Investment Advisory Services, in Totowa, New Jersey. “Plan advisers wanted to add those products, too. And, from the other direction, there was a push from asset managers that wanted access to the growing DC asset pool.”

Thus the defined contribution investment-only (DCIO) business was formed and gained substantial competitive momentum over the following 20 years. The growth occurred through a three-way tug of war among asset managers, advisers and recordkeepers striving to optimize investments, while reducing the costs of asset management and related recordkeeping. Depending on the segment of the DC landscape and who is doing the counting, DCIO assets—which include any fund on a nonproprietary platform—have expanded to claim well over half the market and, in the views of advisers and asset managers, are expected only to grow.

Inside the Numbers

DCIO exists because of two competing value propositions. A recordkeeper wants to capture as much revenue as possible and, when sponsors place its proprietary funds on their plan menu, can offer concessions on recordkeeping fees. But asset managers that do not run recordkeeping platforms want shelf space in plans, too. Early on they offered labyrinthine fee arrangements to the recordkeepers and advisers, but these have largely disappeared, says Chris Brown, a principal of Sway Research, in Newton, New Hampshire. “The fund companies are still writing checks to recordkeepers to be on their platforms, but it’s not coming out of plan assets as it once was.”

Up to a point, recordkeepers would resist adding DCIO funds, but as minding participants’ interests became more carefully enforced by advisers and large plan sponsors, “recordkeepers wanted strong options to offer, and they recognized that part of their role is promoting best-in-class outside managers to their platforms,” says Lee Freitag, head of investment strategy for Retirement Solutions at Northern Trust Asset Management, in Chicago.

Sway Research has been a diligent observer of the defined contribution scene—including the DCIO market—since 2004 and, from its samples, estimates the size of the entire DCIO asset base. By Sway’s measure, between 2010 and 2020 the DCIO sector grew at an average 9.5% annually, steadily outpacing the 7.5% asset growth for the DC market as a whole. It estimates that, as of last year, DCIO’s share of total DC assets had risen to 54%—or $5.3 trillion—up from 49% in 2010. In the aggregate, that is over $3 trillion of incremental assets over 10 years. Sway predicts a 56% share by 2023.

In such a growing market, the ranks of the top asset management firms reaching into the DCIO market has been fluid. In PLANADVISER’s own annual surveys, just six managers in the top 10, as of first quarter 2013—viz., BlackRock, T. Rowe Price, State Street Global Advisors, PIMCO, Invesco and J.P. Morgan—remained so by first quarter 2020.

A Series of Small Shocks

The two seismic shifts in the DC market and in asset management overall—target-date funds (TDFs) replacing portfolios of individual funds and active management giving way to low-cost passive—were also transmitted to the DCIO sphere.

DCIO managers’ share of target-date funds has risen sharply. This growth is to be expected given that these are most plans’ default investment and gather the bulk of contributions. But the philosophies of sponsors and their advisers in selection of the funds goes well beyond cost, to include investment suitability and risk control. “Today is the first time we’re seeing people retire without defined benefit [DB] plans,” notes Barbara Delaney, principal and founder of StoneStreet/Renaissance (SS/RBA), now a member of Global Retirement Partners, in Pearl River, New York. “Many of them are in target-date funds, on which we conduct a separate study for clients every three to five years.

“The idea of recordkeepers keeping DCIO funds off their platforms has gone away,” Delaney adds. “If we find funds that fit with a client’s model, the recordkeeper pretty much has to go along with that and add those funds.”

In the 2020 edition of the DC survey from financial advisory firm Callan, 75% of plans offered DCIO target-date funds, up from 31% in 2010. “Ten years ago, if a plan was on board with a large recordkeeper, it often automatically would use the proprietary target-date funds,” says Jamie McAllister, senior vice president in Callan’s Chicago office. “But fast forward, and those target-date funds might not fit the plan’s demographics: Maybe they’re too expensive, maybe they’re passive and not active. With an increased level of fiduciary duty and responsibility, sponsors are looking more closely and offering funds more geared to their population, and that might be a nonproprietary fund.”

“Recordkeeper considerations are a big part of our target-date discussions with clients,” says Ed McIlveen, chief investment officer (CIO) at Francis Investment Counsel, in the Milwaukee suburbs. “Sponsors and advisers have to demonstrate that they’re making prudent choices in the best interests of participants, and you can’t accomplish that with inferior investment products, regardless of their impact on total cost.”

In the separate tussle between active management and passive investing, active still holds a lead in DCIO, but that is steadily slipping. Sway Research says that at the end 2019, 44% of overall DCIO assets were in passive forms, up from 38% in 2015.

Of course, not all advisers are going with that flow. “I don’t want to strive for mediocrity, and that’s what you get with passive,” says Delaney. “You should strive for an ‘A,’ not a ‘C.’

“My clients are saying that, in a post-pandemic world, maybe [having passive funds] is not so smart,” she adds, referring to early last year’s reminder that markets can go very wrong in a hurry. “You really want someone to be ‘driving the bus,’ particularly in target-date funds. How do you control for the risks when people are approaching retirement, and then how do you make those assets last a lifetime? Sponsors are recognizing that indexing everything can be dangerous.”

Critical Path

Advisers approach the economics and decisions regarding DCIO vs. proprietary funds in several ways. “Work for a new client would typically start with choosing a recordkeeper, and an analysis of the target-date funds as a second step,” says Greg Adams, consultant at Fiducient Advisors, in Windsor, Connecticut. “Based on fund flows, assets and the number of participants, the recordkeeper will tell us its fee to recordkeep the plan without any [proprietary] funds. Then it will offer a decrease in that fee if the plan uses [the recordkeeper’s] stable value account, and other reductions for using its target-date and index funds.

“Then we do a full QDIA [qualified default investment alternative] analysis showing four different DCIO target-date series, both active and passive, to see the glide paths, style composition, fees and performance, to narrow it down to a target-date series that works,” Adams says.

About half of Fiducient Advisors’ clients go with the recordkeeper’s funds, and half go out to DCIO managers. “It’s hard to make a decision on expected future performance, whereas on cost, you know a lower-cost solution is going to be lower cost in the future,” Adams says. “I don’t think I’ve ever seen a target-date series become more expensive.”

On the other hand, “We screen target-date funds before we screen recordkeepers, because we can’t let the tail wag the dog,” says Delaney. “We’ve been fiduciaries for a long time, and a target-date search is a whole different process from a recordkeeper search.”

In their efforts to reduce costs, many advisers seek out collective investment trusts (CITs), which can operate at lower fees than mutual funds, owing to different regulation protocols. Tracking share prices is more difficult for participants, but advisers see that as a minor hindrance. “Most participants want to be able to look up a mutual fund, see the ticker and NAV [net asset value]. CITs are harder to track that way,” Nydick says. “But if your active manager is charging you 40 basis points [bps] for a mutual fund, and there’s a comparable CIT at 10 basis points, you’d better have a good reason for not using it.”

“There has been so much litigation over fees in DC plans that CITs are a natural place to begin to move assets,” Freitag observes. The 2021 PLANADVISER DCIO Survey reports 20% of assets in CITs, up from 13% in 2013.

“CITs in DC plans are a trend in favor of participants across the board,” McIlveen says. In addition to potentially lower fees, the minimum investment and plan size required to participate has declined, and the universe of trusts that clone mutual funds keeps expanding, he says.

Change in Course?

Are there any forces at work that might accelerate, or reverse, the steady increase in DCIO managers’ share of plan assets? “Nothing is going to turn it around,” Delaney asserts. “Advisers and sponsors are so conscious of the risks in using proprietary funds, and know they need more evidence to validate including recordkeepers’ funds.”

Recordkeepers are unlikely to wage a new battle, McIlveen says. “Recordkeepers are fully occupied with the industry’s demands of better technology and faster capabilities, and it feels as though the proprietary investment component has been moved to the back burner.”

According to Freitag, one factor will definitely spur further DCIO growth, though its impact is unknown: the interest in environmental, social and governance (ESG) strategies. “It tends to come from younger workers, who might consider a separate ESG fund alongside their investment in a target-date fund.”

Freitag also points to the momentum gathering behind multiple employer plans, or MEPs, advanced by the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. “There’s no agreement on the pace of uptake, or who’s best qualified to manage assets or administer the plans, but it seems it’s going to happen sometime. And, down the road, that new market should benefit DCIO managers.”

DCIO might also get a boost from the “SECURE Act 2.0,” currently in the legislative works. “Hopefully it’s going to incorporate the opportunity for 403(b) plans to include CITs in their investment lineup,” Freitag says. “Not all recordkeepers are set up to offer CITs, and that, too, would likely bring a new source of assets to DCIO managers.” —John Keefe

Art by Gizem Vural