Evolving the Investment Lineup Process

Since their emergence in the 1970s, defined contribution (DC) plans in the United States have matured significantly. One notable change has been a shift in how plan sponsors develop investment lineups for participant-directed DC plans. Plan sponsors are evolving from simply using commonly held investment beliefs to create the investment structure of their DC plan, towards using a thoughtful process to create a structure that intentionally considers the characteristics and needs of the plan’s unique group of participants.

Here, we outline how plan sponsors may consider such a process, and we focus specifically on a plan’s investment structure from an asset class perspective, such as large-cap growth equity or high yield fixed income, rather than the selection of individual investment funds.

Regulatory Foundation & Guidance for Investment Menu Structure

In our view, a key component to thoughtful DC plan investment design is crafting a diversified investment structure, before the selection of specific investment vehicles. The Employee Retirement Income Security Act of 1974, as amended (“ERISA”) mandates that plan fiduciaries act prudently and diversify the plan’s investments to minimize the risk of large losses. In fact, asset class diversification has a significant impact on the variability of a portfolio’s investment performance. By providing a greater degree of asset class diversification, plan sponsors can enable more opportunities for participants who self-direct their retirement account to mitigate investment risk.

For DC plans subject to ERISA, there are several prescriptive requirements, along with a principles-based standard of care (duty of loyalty and duty of care) that plan fiduciaries must follow when building a plan’s investment structure. Even for plans not subject to ERISA, many plan sponsors consider the guidelines set forth under ERISA as best practice and choose to implement them.

Generally, ERISA section 404(c) provides DC plan fiduciaries protection from the liability for participant investment choices if they offer a minimum of three diversified investment options with materially different risk and return characteristics, such as equity, fixed income and cash equivalents. In practice, it is quite rare for an investment structure to be limited to just three investment options because many investment fiduciaries believe offering a larger, diversified opportunity set is beneficial for participants. Additionally, since the Pension Protection Act of 2006, certain pre-diversified investment options, such as Target Date Funds (TDFs), are considered qualified default investment alternatives (QDIA), which provides a safe harbor to mitigate fiduciary risk.

The U.S. Department of Labor (DOL) provides guidance for the selection of TDFs[1] as well as periodic reviews of continued suitability. We view the DOL guidance as best practice and encourage plan sponsors to leverage it when evaluating TDF usage in their plan's investment structure. We encourage plan sponsors to work with a knowledgeable retirement plan advisor to establish a structured process that first identifies a TDF philosophy and then reviews participant demographic data, including retirees, to review and ultimately select an appropriate TDF suite. More broadly, the same participant data review is also useful when assessing a plan’s core investment structure.

Beyond ERISA requirements and optional safe harbor provisions, DC plans’ named investment fiduciaries and their 3(21) investment advisors and 3(38) investment managers have wide-ranging investment structure flexibility as long as decisions are made in the best interest of participants and beneficiaries. Such flexibility allows for an array of suitable investment options, which can be overwhelming for plan sponsors. A skilled retirement plan advisor can also lead in crafting a review process for the plan’s current investment structure, specifically one that is supported by the characteristics and needs of the plan’s unique group of participants. 

Crafting a Robust Investment Structure

While the variability of DC plan participant groups’ needs and characteristics precludes a set formula of a “right” or “wrong” investment lineup design process, plan sponsors should maintain a prudent and documented selection process to satisfy their fiduciary responsibilities under ERISA.

In our view, a comprehensive design process is multi-step, demands engagement by a plan sponsor’s retirement plan committee, and is best led by a qualified retirement plan advisor who is committed to facilitating committee conversations and preparing demographic and fund utilization review, among other duties.

Steps 1-7 outline a sample process.

1. Identify a purpose & objectives statement

In order to guide investment design decisions, begin by identifying the company’s philosophy about the primary purpose and objectives behind the creation of the DC plan. The organization’s retirement plan committee and/or human resources executives likely have a purpose and set of objectives for the plan, even if not previously expressed in a formal manner.

Below are sample statements and their potential impact on investment structure:

  • Purpose: It is important that our DC plan reflect the company’s goal to promote a culture of “retirement environment.” This would manifest as: long employee tenure, employees who commonly retire from our company, and retirees who find it attractive to retain their DC plan accounts in the employer’s plan throughout retirement.
  • Potential impact: The purpose statement might suggest that plan asset classes and TDFs support a retiree’s need to diversify fixed income allocations, as fixed income typically becomes a larger portion of an investor’s portfolio near and throughout retirement.
  • Purpose: It is important that our DC plan further the company’s goal of supporting employees as they save and invest for retirement. We observe that our company has a long history of employing mostly early-career persons and based on past experience, we expect high employee turnover that results in few, if any, retirements from the company. When retirements occur, we observe that accounts are removed from the DC plan shortly thereafter.
  • Potential impact: The purpose statement might merit the inclusion of multiple equity asset classes and core or core plus fixed income because, for the non-TDF investor segment of the participant group, this design would provide for adequate equity diversification while minimizing the need to allocate to separate fixed income sub-asset classes. It also might lend itself to a TDF designed for high equity allocations early in its glide path and low-to-moderate equity allocations (relative to the TDF universe average) near the target retirement age.

2. If your plan offers a managed account service and/or self-directed brokerage account, review the percent of participants currently enrolled in these options and consider their impact on the overall investment lineup structure.

Participant enrollment in a managed account service is typically low enough that it does not influence the plan’s overall investment structure, aside from ensuring the service’s minimum required asset classes are included. However, if the managed account service serves as the plan’s QDIA, and retention in the QDIA is high, identify the asset classes the managed account provider will use and not use. Perform a cost-benefit analysis of including asset classes beyond those required by the managed service provider to understand the value to all plan participants.

3. Develop a participant group profile to understand the plan’s investors

We believe a DC plan’s participant group profile should be based on demographics and investor type. Since each plan’s participant group has diverse demographic characteristics, we caution against relying on participant group averages for information such as age, compensation, education level and company tenure. We find that analyzing averages often fails to reflect the breadth of a plan’s unique participant group, as well as any concentrated segments that represent the largest number of participants, leading to subpar analysis and outcomes.

When developing the participant group profile, think of what best describes the largest number of participants. Plan sponsors may divide participants into the following categories:

a. Investor type

  • The “do it for me” type: Participants who elect to invest in the QDIA; any fund with broad asset allocation, such as target risk or other asset allocation funds; or a managed account service, if offered.
  • The “do it myself” type: Participants who elect to invest mostly in individual asset class funds or a self-directed brokerage account, if offered. 

If “do it for me” is the plan’s predominant investor type, the investment structure may or may not need to contain more than the primary asset classes depending on the profile of the “do it myself” investors in the plan. For example, if the “do it myself” investors have a high level of investment proficiency or are likely to have their own personal investment advisors (e.g., highly-compensated employee types such as physicians or attorneys), the investment structure may be justifiably more comprehensive. However, depending on the characteristics and number of the “do it myself” investors, ad hoc requests from participants for specific sub-asset class options and other investment vehicles may be best addressed by offering a self-directed brokerage option.

b. Demographic profile

  • Identify the number and percent of participants by age range and investor type.
  • Look for any prevalent age cohorts. Understanding the concentration in each age cohort can signal consideration for special needs. 

c. Investment proficiency of non-QDIA investors

  • Rank the committee’s perception of participant investment proficiency as high, medium or low.  Investment proficiency can be estimated based on how well the “do it myself” group utilizes non-QDIA asset classes. For example, is there a pattern of selecting few asset classes, and does the pattern vary by age cohort?
  • It would be reasonable to expect early career stage cohorts to use fewer asset classes. For this cohort, there is likely to be a focus on equities over fixed income. It would be reasonable to assume the selected number of asset classes would increase for mid- and late-career cohorts because diversification and risk mitigation tend to become more valued.
  • Another way to observe investment proficiency is by using a scatter plot of participant equity/fixed income allocation splits by age, compared to a sample TDF allocation. The plan’s recordkeeper should be able to provide this information. If the scatter plot shows wide dispersion from the sample TDF allocation, it is reasonable to assume investment proficiency is likely low. A low degree of investment proficiency can influence whether the investment structure designed for non-QDIA investors can be streamlined by excluding non-core asset classes, such as commodities.

d. Downside risk tolerance

Using a similar low-medium-high rating system, gauge downside risk tolerance of the largest participant segment. Downside risk tolerance is a critical factor in intentional investment structure design and QDIA selection. Optimal retirement outcomes tend to result from participants who stay invested rather than moving into cash or making material asset allocation adjustments, based on unfavorable short-term market volatility or losses in a particular asset class.

To help identify participant downside risk tolerance, plan sponsors can: 

  • Review recordkeeping reports of transfers into and out of investment options during calendar quarters immediately following a market downturn or large loss in a specific asset class.
  • Conservatively estimate that if their industry does not require post-secondary education for most employees, such as certain areas of hospitality and manufacturing, downside risk tolerance is relatively low. Alternatively, if advanced levels of education are required, plan sponsors may want to assume a moderate-to-high level of downside risk tolerance. 

If the participant group profile is believed to have low downside risk tolerance, most plan sponsors will design investment structures that exclude asset classes subject to more frequent and significant losses.

e. Stability of workforce

Does the company have high turnover in the largest cohort of the participant group profile? Is the industry seasonal or subject to large-scale layoffs in certain phases of the business or economic cycle, which could result in laid-off plan participants liquidating their accounts? If stability is low and liquidations by laid-off employees are high, it is reasonable to assume that the investment structure and any TDFs offered, should lead toward a low downside risk profile due to the likelihood that many participants have shorter-than-average investment time horizons in the plan.

f. Presence of a defined benefit pension plan

In addition to the DC plan, does the company also sponsor a defined benefit pension plan that it intends to keep active with continued benefit accruals? Does it provide adequate, targeted replacement income to long-term employees? If yes, does the company view the DC plan as “supplemental”? In this instance, it is reasonable to assume that the investment structure of the DC plan may be limited to broad, core asset classes. Our rationale is that the defined benefit plan provides a base level of guaranteed retirement income, so there may be less need for the highest risk/return-seeking asset classes in the DC plan.

4. Review the number of asset class options

In our view, the number of asset classes should be informed by the plan’s purpose and objectives statement and participant group profile, rather than proactively setting an arbitrary limit on the number of asset classes. The latter action could result in plan sponsors overlooking the best interests and needs of “do it myself” investors. Most academic studies on the impact of the number of investment choices were performed prior to the creation of TDFs and their approval as QDIAs in 2006. As the most popular QDIA, TDFs allow less engaged participants, or those with lower investment proficiency, to avoid confusion or challenges in making asset allocation decisions.

As participants who are less comfortable making informed investment decisions now have greater access to pre-diversified options like TDFs or managed accounts, the average number of investment options has declined. For reference, the average number of investment options (not asset classes) offered by plans is currently 21.[2] The three highest ranges by respondents were: 

  • 1-15 options: 21.5%,
  • 16-20 options: 26.2%
  • 26 or more 25.9% 

5. Avoid complicated investment menu design

If the participant group profile suggests a streamlined investment structure (and number of investment options), we would suggest plan sponsors avoid including: 

  • Multiple investment options in the same asset classes — Unless the options consist of an active and passive implementation, we recommend offering only one option per asset class.
  • Global equity and fixed income — If the investment structure has separate domestic and international asset classes, global asset classes create the opportunity for overlap should participants allocate to both domestic and global allocations. We note that some international-only fixed income funds fall under the Morningstar category of “global bond.” Selecting an international-only vehicle from the global bond universe would prevent overlap with the U.S. fixed income asset class.
  • Sector and regional/country-specific asset classes, excluding real estate investment trusts (REITs) — Not only do these asset classes have greater risk exposure due to their more specific or concentrated nature, but other areas of the investment structure also likely have exposure to them. This may lead to overlap and unintentional, large allocations to specific areas of the market.
  • Single-commodity asset classes — Should commodities be appropriate for the plan’s investment structure, the diversification effect of including a vehicle with broad-based commodity exposure may help mitigate the risk associated with exposure to a single commodity, such as gold, oil or small groups of commodities such as precious metals.
  • Target risk — The target risk asset class consists of multiple funds, each of which maintains a fixed or limited range of equity versus fixed income. We find target risk funds are prone to unintentional misuse by participants who remain in the same fund for longer than appropriate, rather than shifting to lower risk/lower equity allocation versions as their time horizons decrease.
  • Including both money market and stable value funds — Stable value funds have historically outperformed money market funds due to stable funds’ ability to invest in intermediate-term bonds, while maintaining principal protection through wrap insurance. Including both money market and stable value funds can complicate participant asset movement because money market funds are deemed “competing funds” to stable value. Stable value funds do not permit direct transfers to competing funds such as money market or other low duration fixed income funds. Rather, they require a transfer, first to an equity fund where monies must be held for at least 90 days, before they may be invested in a competing fund.

6. Review historical performance prior to asset class selection

While certainly not an indicator of future performance, review historical performance for the last 10 years of all asset classes considered for lineup inclusion. This will help the committee understand their historical patterns and magnitude of gains and losses. Focus on the largest gains and largest losses for each asset class during the 10-year period. Review the standard deviation for five- and 10-year periods. This review will help identify any asset classes that are too volatile or historically subject to large losses when considering the plan’s participant group profile. 

7. Update the organization’s investment policy statement to document permissible asset classes

Check the DC plan’s Investment Policy Statement (IPS) to confirm it expressly permits the asset classes desired. Amend the IPS, if needed, before making investment structure changes to the plan menu.

Putting the Participant Group Profile into Practice

For illustrative purposes we outline two scenarios and the resulting sample investment structures:

Scenario A: 

  • Plan purpose statement: It is important that our DC plan supports the company’s goal of creating a “retirement environment” culture that promotes long tenure of employment with frequent retirements from our company, and for retirees to find it attractive to retain their plan accounts throughout retirement.
  • Plan currently offers a managed account service.
  • The “do it myself” investors represent 60% of participants. The largest age cohort is ages 50-80, and participants have a high level of investment proficiency.
  • Eighty percent of retirees leave their account in the plan for the long term and take systematic withdrawals following retirement.
  • The “do it for me” investors represent 40% of participants. The largest age cohort is the 21-40-year range, and participants have a high level of investment proficiency.
  • The workforce is stable and not subject to periodic layoffs based on economic cycles.
  • The company does not provide a defined benefit pension plan in addition to the DC plan.

Suggested asset classes:

  • Domestic equity
    • Large cap: growth, core & value
    • Mid-cap: growth, core & value
    • Small cap: growth, core & value
    • REITs
  • International equity
    • Large cap: growth, core & value
  • Fixed income
    • Stable value
    • Core intermediate
    • High yield
    • Treasury inflation-protected securities
  • International fixed income
    • Foreign bond (hedged)
  • Broad-based commodities
  • Asset allocation (TDFs)

Scenario B:

  • Plan purpose statement: It is important that our DC plan reflect the company’s goal of creating a culture that supports employees as they save and invest for retirement. Our organization tends to employ predominantly early career persons. We expect and have historically experienced high employee turnover that results in few, if any, retirements. When retirements occur, accounts are removed from the plan shortly thereafter.
  • Plan does not currently offer a managed account service.
  • The “do it myself” investors represent 20% of participants. The largest age cohort is 40-45 years, and participants have a moderate level of investment proficiency. 
  • Plan offers a self-directed brokerage option, used by approximately half of the "do it myself" investors.
  • The few participants that remain in the plan past age 65 have historically rolled over their accounts to individual retirement accounts within two years post-retirement. 
  • The "do it for me" investors represent 80% of participants and there are no age cohorts with a materially higher concentration than others. Participants are assumed to have a low level of investment proficiency.
  • The workforce is stable and not subject to periodic layoffs based on economic cycles.
  • The company does not provide a defined pension plan in addition to the DC plan.

Suggested asset classes:

  • Domestic equity
    • Large cap: core
    • Mid-cap: core
    • Small cap: core
  • International equity
    • Large cap: core
  • Fixed income
    • Stable value
    • Core plus/Intermediate
  • International fixed income
    • International bond
  • Asset allocation (TDFs)

Empowering Plan Sponsors

While investment structure is a core consideration for DC plan sponsors, plan sponsors can also educate and encourage their participants to help build a financially dignified retirement. Behaviors critical to achieving such a goal include when participants:

  1. create a habit of saving and investing early in their working lives;
  2. avoid taking time off from saving and investing;
  3. avoid or seek to minimize unnecessary loans and withdrawals from the DC plan; and
  4. understand and implement the estimated savings rate required to build a “nest egg” large enough to last their retirement time horizon, based on income needs.

Using an informed, structured investment design process will bolster DC plan sponsor confidence that investment lineup selection decisions are tailored to the needs of most plan participants. With the leadership of a qualified retirement plan advisor, the exercise need not prove difficult nor time consuming. The investment menu design process should enable the plan sponsor to feel knowledgeable about how the organization arrived at its plan’s investment structure and why, as well as provide the information necessary to document a prudent decision-making process, a key tenant of fiduciary duty under ERISA.