DC Investments | Published in March 2017

State of the Art

The next evolution of investment lineups

By John Keefe | March 2017
Art by Gizem Vural

German architect Ludwig Mies van der Rohe, who emphasized open space defined by steel and glass in his 20th century minimalist designs. A like mindset leads plan sponsors and their consultants to improve participants’ investment outcomes through simplified architecture. In achieving “less,” wide-ranging lineups of specialized funds are being streamlined to a few or just one choice per asset class. The goal of “more” is fulfilled with funds being diversified across asset classes and professionally managed—to keep participants from chasing short-term markets and to offer a greater chance for solid risk-adjusted returns.
The state of the art in defined contribution (DC) menus has been a structure of three tiers, which correspond to participants’ degree of engagement in their retirement investing. The first tier is an asset allocation fund such as a target-date series. Tier two holds the core menu, where investors are free to choose their own asset allocation; choices may include actively managed portfolios, passive strategies or both. Tier three is more free-ranging, possibly including funds in more narrow markets or sectors, as well as company stock and/or a brokerage window.
Current thinking goes beyond structure. “Tier structures have been around for a while and have migrated from large plans to the midsized and smaller markets,” notes Lorie Latham, senior defined contribution strategist at T. Rowe Price Group, Baltimore. “But,” she adds, “today there is an overlay, which raises the state of the art, ensuring that the participant is engaged and understands the tiers.”
Is there an ideal number for investment choices in a DC plan? “We don’t think there is one structure that is right for every sponsor,” observes Liana Magner, U.S. head of DC investment consulting in the Boston office of Mercer Investments. “In advising sponsors on how to streamline a plan, we look at how participants are using existing options. In industries with more sophisticated participants, where allocations are in line with the market, there isn’t a strong case for further streamlining.
“But if participants are not making good decisions on their own, there’s often a need for fewer choices, where the sponsor broadens the mandate of each one to increase diversification,” Magner explains. Typically, clients offer choices in capital preservation and diversified fixed income and, in the equity realm, consolidate value and growth style options into core funds for large-, mid- and small-cap U.S. equities, along with one non-U.S. equity fund. Some will offer passive and active versions of each equity option as well.
But, depending on the participant base, that can still be too many choices. Sponsors emphasizing active management have consolidated further, Magner notes. Thus, there might be one all-cap fund encompassing the entire U.S. equity market, or just one equity fund that embraces non-U.S. markets as well. “The more a sponsor provides choices of professionally managed diversified portfolios, the greater are participants’ chances to outperform the broad market,” she observes.
An investment lineup that limits choices can have a visible impact on savers’ returns. In an April 2016 research paper, “Constructing a Defined Contribution Investment Lineup: Four best practices,” Vanguard Group sampled portfolio results of 2,000 participants on its defined contribution recordkeeping platform from 2010 through 2015; half had invested in target-date funds (TDFs), while the other half had “done it themselves” via conventional menus. While it is no surprise that the two groups realized different results, the variation is striking.
Results for investors in TDFs were tightly clustered along a line demonstrating rising return and risk according to retirement dates, as would be expected. But for the 1,000 self-directed investors, “The dots are all over the map, showing little logical relationship between the portfolios and the risk and return they received,” says Matthew Brancato, head of Vanguard defined contribution advisory services, in Valley Forge, Pennsylvania.
The comparison is not simple, as Vanguard lacked information on what levels of risk the self-directed investors intended to take. A fraction of investors did beat TDFs and realized greater return while incurring similar or less risk. However, many also fell short on return, even while taking far more risk than investors in TDFs. Brancato extends the same potential to multi-manager funds, because these also narrow the range of outcomes through professional asset allocation and security selection.
Notwithstanding sponsors’ efforts to streamline, by some measures, available fund options continue to grow: Consultant Callan Associates noted in its June 2016 “DC Observer” report that, within a sample of over 90 large and very large DC plans, the average count between 2006 and 2015 rose from about 11 to about 15.
“That’s an interesting phenomenon,” notes Lori Lucas, Callan’s DC practice leader, in San Francisco. “Sponsors embrace the need to make navigation simpler and are reducing multiple funds in the same asset class. At the same time, though, there’s a force I call ‘fund creep’ that introduces additional choices.” She points to participant demand for funds in current fashion, such as social responsibility portfolios. Simplification can also be thwarted by a favored incumbent option that may not fit, such as a traditional balanced fund people like, and sponsors are loath to get rid of, she says.