Tangled

Even in the early days of defined contribution (DC) plans, it was clear that the economic opportunities they provided were enormous, and the structure of mutual funds made them a go-to investment vehicle. Large mutual-fund managers adapted their shareholder accounting systems for DC recordkeeping, to offer sponsors a turnkey investment-and-administration package. In the years since, DC plans have evolved to become a complex and competitive ecosystem, holding about $8 trillion in total assets at year-end 2018, according to the Investment Company Institute (ICI).

But sponsors realized that investing through captive recordkeeping outlets had its drawbacks. “Defined contribution investments used to be all proprietary funds, bundled with recordkeeping services from the asset manager,” says Stephen Dopp, national director of defined contribution at investment manager Lord, Abbett & Co. in Jersey City, New Jersey. That made for a good start, but then sponsors wanted a greater choice of funds.

“No single manager has the best products in every asset class, and you can’t satisfy your fiduciary requirements with a single fund family,” Dopp says. Thus, an open architecture investment structure developed among DC plans, like the one that had arisen in the private wealth market, and asset managers welcomed the opportunity to sell into the enormous DC retirement space without having to be affiliated with a recordkeeping business—a structure known as DC investment only, or DCIO.

“Why tether yourself to just a proprietary offering?” says James Martielli, head of defined contribution advisory services at The Vanguard Group in Malvern, Pennsylvania. “DCIO provides a wider choice, allows a more appropriate menu and puts things in competition. There’s more transparency and a greater focus on costs—those are all healthy trends.”

For sponsors and advisers, implementing a new DCIO investment choice to a plan lineup is straightforward. “In the large-plan market, it’s pretty easy,” says David O’Meara, senior investment consultant at Willis Towers Watson in New York City. “If a plan has $50 million it wants to put into a fund, its consultant or adviser will just go to the recordkeeper and tell it to add the fund. Most of the time there’s no cost to the client.”

For smaller plans, it may take some time and money, O’Meara says. “Sometimes the recordkeeper will just say, no. Other times there will be some cost involved, and maybe the fund family will pay some of that to get on the platform. Other managers might be able to say, ‘I represent all of these strategies, and all of your clients will benefit if you put them on your platform.’ For recordkeepers that are not asset managers, they might like that, as they have more to offer all of their clients.”

DCIO investments have been around long enough that few in the business today remember exactly when they got started, although many observers place this around 20 years ago. But, clearly, sponsors endorse the idea, as open architecture and DCIO have gained plenty of momentum: Researchers at Cerulli Associates sized the DCIO market at $4.6 trillion at the end of 2017—more than half the DC plan  industry’s assets.

Recently, some recordkeeping firms have begun taking advantage of their consolidated scale by chipping away at the unaffiliated fund manager DCIO market. Some advisers and fund managers believe these new programs lack transparency and introduce conflicts of interest that DCIO was intended to prevent, while others see the move as, instead, a middle ground compromise that could lead to lower costs and benefit DC plan participants.

Benefits to Advisers

Besides offering participants a broader investment choice and sponsors a means to better fulfill their fiduciary responsibility, DCIO structures provide benefits to the advisers who rely on them. One is in-depth analysis of fund results.

“The best DCIO teams go beyond simple performance numbers and explain fund returns in the context of the level of portfolio risk,” says David Griffin, director of institutional retirement plans at the eponymous Atlanta Retirement Partners. “And, with so much data coming out weekly, monthly and quarterly, things can change very quickly; the good DCIO managers expedite that flow of information.”

Greg Porteous, head of defined contribution intermediary strategy at State Street Global Advisors (SSgA) in Boston, notes, “We’ve found that, while advisers have their own processes in place to evaluate active managers, they may not have a structured method for index managers. We also ask advisers to define the objective of the fund. If it’s to provide diversification, then we help with defining the right index.

“Fees are a big consideration for index funds,” Porteous continues, “but also important are how closely a fund tracks a benchmark and operating considerations such as whether the manager crosses trades in-house, and how he handles the risks in securities lending—all points that may not be apparent from a fund fact-sheet.”

Asset managers additionally provide advisers with qualitative information on funds—for instance, on their efforts at social responsibility. “Many Millennial participants are interested in investment choices that have been carefully screened for companies’ ESG [environmental, social and governance] performance,” Griffin says. “A fund company might have options that score high on social responsibility that we’re not aware of, and DCIO teams reach out to us on that.”

DCIO asset managers also support advisers on the business side by giving insights on customers they might be prospecting, as well as regulatory updates and practice consulting. Sometimes, they facilitate events for clients. “I think advisers look to managers’ DCIO teams as thought leaders and true partners, not just a checkbook,” Porteous says.

In a 2018 survey that confirms this, researchers at Cerulli Associates found that specialist DC advisers put the greatest value on DCIO firms’ participant engagement tools, target-date fund (TDF) evaluation, in-depth product information, regulatory guidance, and plan fee benchmarking.

However, some advisers believe such assistance has its limits. “DCIO salespeople give us their attention, and we welcome hearing about new products, but we take it upon ourselves to do the impartial analysis,” says Dominic DiPietro, president of independent adviser firm Newport Capital Group in Red Bank, New Jersey. “Some advisers lean on the fund companies for marketing help with events, but I see that as a conflict. We’re careful about even going out for lunch.”

Beyond Mutual Funds

Like most developments in the retirement business, DCIO structures started with the largest plans and spread to smaller plans due to competition and improvements in technology. Low-cost collective investment trusts (CITs) were once available only to large plans, Griffin says. “It used to be that plans needed assets of $100 million to access collective trusts, but that has decreased to below $25 million,” he says. “If a collective trust is the right investment and will save our client money, we’ll consider it.”

Porteous reports that his firm has devised DCIO collective trusts with zero minimums. “We look at the recordkeeper as an omnibus relationship, giving us one buy and one sell transaction, and the recordkeeper disseminates the details to the underlying plans,” he says. “That allows for no minimum, from the plan perspective.”

Integrated Architecture

As with other aspects of the DC business, because of widening costs, narrowing revenues and investment complexity, open architecture DCIO structures may have started transforming—not regressing entirely to in-house proprietary funds but retreating to a limited fund menu. “For a long time, there was a trend away from bundled funds and recordkeeping toward open architecture, but lately that has reversed somewhat to a semi-closed architecture,” Dopp says. Other observers named the phenomenon “integrated architecture” or “managed architecture.”

A rationalization on the investment side is logical. Jeffrey Ptak, head of global manager research at fund researcher Morningstar in Chicago, points out that last year, of the nearly 8,000 mutual funds in the U.S. market, the largest 900 accounted for 80% of assets. The many at the small end levy high fees, too, which does not play well in a climate where many investment decisions emphasize cost. As Ptak wrote in the Winter 2019 issue of Morningstar’s magazine for advisers: “[T]hese undersized, pricey funds are increasingly finding themselves on the outside looking in.”

Several recordkeepers have initiated platforms that restrict the number of fund managers. One is Empower Select, offered by recordkeeping giant Empower Retirement. PLANADVISER contacted Empower several times for comment on the structure and economics of the program, but our emails went unanswered.

The Empower Retirement website lists 22 asset managers, including marquee names such as Pimco, Invesco, BlackRock and Fidelity, as well as Empower affiliate Great-West Financial, and notes that additional funds are available. Even though Empower declined to talk, industry sources were well aware of this program and eager to share their views, although for the record only selectively.

Observers report that fund managers pay Empower Select an annual fee for including their funds, ranging from $250,000 to $1 million depending on the number listed. The fees help defray the cost of recordkeeping charged to DC plans. The target market for Empower Select is said to be plans with assets of $50 million and below—especially those with less than $10 million. The field sales force is said to be fairly large, at 60 or 70. In general, the industry considers it a serious competitive threat.

Reaction to the concept within the industry has been mixed. “I won’t speak to any one program,” says Martielli of Vanguard, “but we’ve had a longstanding philosophy and practice of not paying recordkeepers for distribution of our funds. And it’s not just about cost—it’s about transparency, as well. The end participant doesn’t know what sort of payment is going to that platform provider and the potential incentives to skew sales.”

“Empower is huge, and it knows where the puck is going in this business,” says the head of DC at one of the manager firms participating in Empower Select. “It’s created a product that is cheaper than everyone else’s, but it’s not transparent to the consumer, and that’s not a good thing. But we’re in it because we have to be.”

Mike Miller, head of retirement distribution for U.S. funds at J.P. Morgan Asset Management in New York City, notes, “One objection I have seen to Empower Select is that it replaces the judgment of the adviser or firm home office for manager selection and due diligence.” His firm, too, participates in Empower Select. “A lot of that is already worked. But there is still an opportunity for advisers to put their views on the investment lineup at the asset-class level.”

Griffin views Empower Select as one more opportunity to propose to clients. “Empower Select has been a controversial product, but from [the provider’s] perspective, it’s been smart,” Griffin says. “Plans don’t need 10,000 mutual funds to choose from, and certainly an adviser can select a portfolio from 25 managers and 1,000 funds. We walk clients through the pros and cons and tell them they can have the whole world and it will cost a little more, or a smaller universe that will cost a bit less.” Griffin adds that, while his firm has proposed the idea a few times, so far, no clients have signed on.

Others see Empower Select as an inevitable concession to the pressures of an industry where many sales decisions are motivated by fees. “Over time, advisers have demanded open architecture, but the vast majority of funds were never used,” says Dick Darian, an investment industry veteran and currently head of Wise Rhino Group, a merger and acquisition advisory firm, in Mount Pleasant, South Carolina, that focuses on the retirement industry. “There’s a need to improve the industry’s economics and for advisers to pick fewer investment management partners, which is happening anyway.”

He adds: “Empower has invested in its technology and service model and calls it ‘the supermarket.’ It is enabling fund companies to put their cans of soup on the shelf. It’s smart to limit the number of partners and help them deliver, and there is a price point for that.” He points out, however, “The jury is still out on whether that money is worth the investment.”

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Art by Valeria Petrone