In real world terms, what is the difference between a developed market and an emerging market? There are plenty of quantitative measures, such as per capita income, standards of living, and human capital development. In real-world terms, the difference is consistency. A developed market has already demonstrated useful patterns. A developed market is not insulated from competitors, so businesses must compete on price or services to maintain customers. A developed market has matured to the point where expectations are high and you, as a consumer, are rightfully surprised when things go wrong. For the most part, bad ideas have already been tested and dismissed.
These are broad generalizations, so let’s consider a truly real world example. Go buy a hamburger from a McDonald’s anywhere in the US. The system that brings the Big Mac to you has been honed through decades of iterative refinement and it works with miraculous efficiencies in consistency, cost, and logistics. You pay your money and you’re going to get a reasonable hamburger. For any consumer good with reasonable volume, the failure rates are tremendously good. Even if you buy a store-brand television, the quality may not equal the consumer electronic giants, but you can be pretty sure it isn’t defective. Just for argument’s sake, let’s say that consumer goods have a 99% success rate. 99% of the time, if you order a Big Mac, you’ll get a hamburger with the quality you expect. If you buy a TV from a store, 99% of the time, your TV will turn on when you get it home.
Consumer and industrial goods are the product of a mature, integrated global marketplace, but the services which make the bulk of our economy are also becoming more dependable. Third party independent reviews from diverse sources, such as Angie’s List or the Better Business Bureau, can promote a consistent and mature approach from service providers with a broad audience. However, the picture isn’t so rosy for specialized services for small audiences. There are fewer quality controls and standards that have been applied, and performance can vary widely between competing firms. Specialized service industries operate more like an emerging market, with poor transparency, consistency, and competitiveness. There is progress being made. For instance, in the financial services industry, the Center for Fiduciary Excellence (CEFEX) has tried to fulfill a role as an independent review, but there is still significant room for improvement within the financial services industry.
Let me share an example of inconsistency in the financial services industry:
Many of our clients are defined contribution plans, like 401(k)s, which use Qualified Default Investment Alternatives (QDIAs) within their investment lineup. QDIAs are investments which grant specifically provided legal protections for the employer, so long as they satisfy certain criteria. Most QDIAs are target-date funds (e.g. the ABC 2045 Target Date Retirement Fund) or target risk funds (e.g. the XYZ Moderately-Aggressive Balanced Fund). However, some insurance companies have been creating model portfolios from existing investments within the 401(k) lineup to act as a QDIA.
To ascertain that these model portfolios still satisfied the requirements for a QDIA, we began asking some questions. We started with a QDIA checklist from a legal firm, Drinker Biddle & Reath LLP, and started asking the insurance companies questions about their QDIA model portfolios. It turns out most insurers don’t get asked a lot of questions and their ideas are not the subject of frequent scrutiny. Many insurers had difficulty answering the questions. Worse, we realized the model portfolios are being presented to employees as educational guides and the implementation of these models is really up to the plan sponsor / employer. This raises a few questions. For starters, does this mean that plan sponsors have unknowingly adopted a role as a co-fiduciary on the QDIA? Second, can these model portfolios function as QDIAs at all?
In the final analysis, we estimated that only one out of every six insurers was setting up their QDIA model portfolio correctly.
One out of six. That is a terrible proposition. Imagine if you went to McDonalds and there was only a 1 in 6 chance of getting a what you ordered. Imagine if you bought a TV and there was a 5 in 6 chance it wouldn’t turn on. The financial services industry clearly has a lot of room to mature. Find someone who can ask the right questions.