Evolving Practices in Investment Lineup Construction

Linda Sandersen, investment consultant and partner at Bellwether Consulting, says plan sponsors fall anywhere on the continuum between “Should we protect participants from bad outcomes and ensure they have assets for retirement?” and “Should we give participants investment choice, let them make their own decisions, and let them live with the outcomes of what they choose?”

Sandersen told attendees of the 2014 Plan Sponsor Council of America (PSCA) annual conference that what drives plan sponsors’ decisions about what to include in their defined contribution (DC) plan investment lineups includes factors such as how savvy participants are as investors, corporate culture, participant demographics, individual investment or plan committee member bias, regulations and fiduciary responsibility, product development, and new trends and innovations. “There is no one right answer; investment lineup is something that is specific to the plan sponsor and its circumstances,” she said.

There are long-term patterns and there are more recent trends in investment lineup construction. Providing a diversified investment lineup is a fundamental fiduciary responsibility. Sandersen noted that back in the 1980s, many DC plans offered just three funds: an equity fund, a balanced fund, and a stable value or guaranteed investment contract. Then plan sponsors moved to the other end of the spectrum of diversification, sometimes offering so many options that participants suffered from choice overload.

Now the broad trend for diversification is target-date funds (TDFs). “TDFs are a good first step, but there are challenges,” Sandersen said. “Remember, TDFs were designed to help asset managers bring back funds to proprietary products during the open architecture environment, but a bundled product may not be best.” The second wave of the TDF trend is going on currently; plan sponsors are considering custom TDFs. “This is driven by the desire to have more control over the composition of underlying assets,” she contended. According to Sandersen, now there is a surge of plan sponsors using asset-allocation models.

Nancy Blair, director of human resources (HR) at Mohawk Fine Papers, said her firm uses an asset-allocation model. Participants can indicate not only their desired target date, but whether they want high risk, moderate risk or low risk. Their retirement plan assets are allocated among the funds in the plan according to their profile.

Sandersen noted that, through education, Mohawk participants have learned how to use the asset-allocation model.  For example, if a 2030 high-risk fund is not risky enough for them, they can use the 2035 moderate or high-risk fund. Likewise, if a 2030 low-risk fund is not conservative enough, they can move to a 2025 low-risk fund.

The asset allocation model is easier to monitor, added Blair. “It’s just one lineup of funds, instead of a lineup of funds and a target-date suite.”

Another long-term trend in investment lineup construction is index fund expansion. “It’s a way to give participants access to the investable market at lower cost,” Sandersen said. She noted that an interesting wave of the trend her firm is seeing is that once plan sponsors have a broader array of index funds in the plan, it frees them up to make new decisions about active funds in the plan. “Some are choosing more risky funds because they have safety net of index funds, saying ‘Let’s offer something completely different.’”

Collapsing the style box is a long-term trend that can give participants more “meaningful” choice. Some plans may offer a number of U.S. equity options, one non-U.S. equity option and one fixed-income fund option. “What does that tell participants about how to allocate their assets?” Sandersen queried. Or, a plan sponsor may offer a U.S. equity growth fund and a U.S. equity value fund, but participants do not understand growth versus value. Collapsing the style box means a plan sponsor may choose just one small- and mid-cap equity fund and feel that is all participants need to capture the U.S. equity market.

A more recent trend of shifting away from U.S.-centric funds acknowledges the expansion of the investable market. According to Sandersen, the biggest benefit of this trend is the focus on choosing the best investments, regardless of geography. “The best investments are not always domiciled in the U.S.,” she said. “Thinking globally is the best way to think about investment lineup, we think.”

Matthew Perna, a research analyst at Bellwether Consulting, noted another more recent trend is to use more non-traditional, or alternative, assets. He explained that when they say “alternative assets,” it means anything besides stocks and bonds. The thought among plan sponsors adopting this trend is to get a lower correlation to traditional stock and bond funds. “For example, real assets have high inflation sensitivity and are not going to behave like stocks; unconstrained bonds have more wiggle room for interest-rate sensitivity—they can have zero or negative duration. Plan sponsors are also looking at debt instruments and high-yield bonds,” he said. He added that plan sponsors should consider how this fits for participants; the education about how it fits into their investment strategy may be too much of a hurdle to overcome, depending on demographics.

Perna also noted that, at this point, many alternative strategies do not have the scale of traditional stock funds, so they have higher fees. Plan sponsors should ask whether they can justify the additional expenses. It is also harder to do due diligence and peer group benchmarking.

An emerging trend Bellwether is seeing is alternatives to TDFs. More and more managers are changing strategies; new strategies are being introduced that have a more unconstrained glide path. Providers are saying they can do it for participants, and can make use of their knowledge of the market. However, Perna warned that Bellwether recommended these investment options would be more of a complement to a traditional TDF at this point. “If you have more savvy investors that care about the limitations of TDFs—for example, someone in a 2050 fund that is more conservative—they could use a TDF alternative.”

Sandersen said plan sponsors work so hard choosing the proper investment lineup, but their reasons are often lost in communications with participants. “We believe very strongly that the underlying theses used to develop the investment lineup are what should be communicated to participants,” she told attendees. “This helps participants use the lineup in the best way for them.” 

Blair added that plan sponsors should continue to monitor their fund lineups. Mohawk added a socially responsible investment (SRI) to its fund lineup based on the values of the company and employees, but after some time, it was only used by two people, so they dropped it.

About communications, she noted that changing Mohawk’s fund lineup brought some attention to the plan from some employees that were not participating.