With so many defined contribution participants using target funds, which has become the most popular default option, and a vast majority of contributions going into that strategy and so much talk about managed accounts, it might be easy to neglect designing the “ideal investment menu.” But aside from offering professionally managed options, plan sponsors and their advisors need to offer a diversified menu with the right mix for the plan and participants, which is reviewed by investment consultant Conrad Siegel in a recent article.
The best place to start are the goals of the plan, which may differ by employer but generally the “90-10-90” rule coined by UCLA Professor Shlomo Benartzi is worth considering:
- 90% participation
- 10% deferral rate
- 90% of participants in professionally managed investment
Next step is to review the demographics of the plan, which could include:
- Age of workers
- Salaries
- Education
- Tenure
- Type of organization (like not-for-profit, retail or professional services)
- Marital status
- First generation workers
- Access to a defined benefit plan
- Location
The last criteria will determine the cost of living, affinity to ESG funds and life span affected by the quality of healthcare.
Most important is the default options as more and more plans are using auto enrollment, which is why 87% of participants use them compared to 23% investing in large cap index funds, the next highest usage, according to Vanguard. There is a debate raging about whether managed accounts are better options than TDFs but until costs come down and more data is available on the record keeping systems, there is little argument to deploy them as the default, especially for younger workers. The middle path could be personalized TDFs currently offered by PIMCO and American Funds, which use a few data points and costs are comparable to simpler TDFs.
Other considerations include:
- Index vs. Active Funds – The average active fund does not beat their index so the argument is why pay the higher price with fees the one controllable factor. But averages lie and the results vary by asset class as well as fund complex with many larger ones faring better and charging less. Litigation has driven more plans to seek the perceived safety of low cost index funds but a spat of cases filed against BlackRock argued that their returns have lagged active funds though none of these cases have been successful so far.
- Retirement Income – There are a lot of reasons to offer retirement income options, especially if the employee population is older but there are a lot of reasons why most plans do not offer it with minimal usage by participants. Many TDF managers and managed accounts providers are starting to incorporate this option.
- Menu Size – The average plan uses 18 funds with TDFs as one option yet the average participants use 2.4 investments, down from 3.1 a decade ago. Siegel recommends 12 investments. Large menus like those used by higher education plans invite litigation as plans are not able to optimize share classes with little value in offering so many options
- ESG and Alternatives – Though the DOL prevailed in their lawsuit brought by 26 states against their ESG rule, most plan sponsors are still gun shy. Charitable organizations and those in areas like Northern California are more likely to offer ESG investments. Alternatives, especially private equity, are hotly discussed not as a standalone option but as a sleeve in a professionally managed investment.
- Capital Preservation – Beyond money market, many plans want to offer fixed income or stable value funds.
Cryptocurrency and esoteric funds are not discussed intentionally because few participants are interested while those who are can get access through brokerage windows rather than cluttering up the menu.
Some plans are private labelling options naming them by their goal like growth, inflation protection and capital preservation, which might include multiple managers rather than the industry nomenclature, which is mostly meaningless to the average investor. Switching out a fund becomes easier.
Finally, the plan must decide which wrapper to use, including mutual funds and collective investment trusts for mid-size and smaller plans and separately managed accounts for institutional plans. CITs are gaining traction because of lower costs and flexibility.
Fred Barstein is founder and CEO of TRAU, TPSU and 401kTV.