The defined contribution (DC) industry has made enormous strides over the last decade in its quest to improve a system that’s become the predominant source of retirement income for many working Americans.
Part of this evolution has led to a closer examination of plan design, ensuring that DC plan investment menus are constructed in a way that is best aligned with participants’ behaviors, and their ultimate objectives: achieving retirement security. This also led to the notion that many participants would be better served through comprehensive investment solutions that delegate critical investment decisions to investment professionals.
For this above group, target date funds have been the primary vehicle of choice. Yet, a meaningful percentage of DC participants still want to maintain some control over their asset allocation decisions. Further, the majority of DC assets remain in the portion of the DC plan that necessitates participant engagement—the core menu. Subsequently, the core menu plays a vital role in DC plans. Today, it’s critical that DC plan fiduciaries design core menus that reduce confusion and overlap, encourage participant engagement, and contain investment options designed to meet the objective of achieving retirement security.
Up to this point, discussion and action around improving the core menu has been focused on helping participants to make better, more informed decisions. Reducing the number of options offered, ensuring that core menu options are organized in a clear manner with available options being distinct from one another, and debranding these to shift participants’ focus towards their respective objectives, have all been positive enhancements intended to increase participant engagement and improve the decision making process.
One critical topic that has not received enough attention has been how to construct portfolios once the general core menu framework has been established. For plans that have decided to implement a custom, white labeled approach, creating a “best-in-class” structure of investment managers in relatively narrow asset classes has been a commonly adopted solution. An example of this framework would be building a core menu organized by sub-asset classes. For illustrative purposes, assume that the plan included the following options in the core menu: Money Market, Core Bond, TIPs, U.S. Large Cap Equities, U.S. Mid Cap Equities, U.S. Small Cap Equities, International Developed Equities, Emerging Market Equities, and Diversified Inflation Hedge. Once those portfolios have been established, plan fiduciaries then have the responsibility to choose and monitor the investment manager(s) that would comprise each of these portfolios. With a “best-in-class” approach, typically two or three managers would be selected to fill out each portfolio. While seemingly appealing, this could result in potentially unintended consequences, such as the risk of over diversification, if certain factors are not taken into consideration.
A recent, simple analysis illustrates this very effectively. A fiduciary may prudently use the metric “active share” during the selection process, seeking managers with higher active share in an effort to avoid those that may be considered “closet indexers.” However, when multiple high active share managers are placed together to create a single portfolio, the resulting portfolio has a much lower active share than intended.
An alternative approach to portfolio construction begins with the core menu framework itself. Further reducing the core menu options and categorizing them into very broad asset classes accomplishes two goals. First, the menu can be simplified into terms most individuals can understand. In this scenario, a core menu could include the following investment options: Capital Preservation, U.S. Bonds, U.S. Stocks, International Stocks, and perhaps an “Alternatives” portfolio. Second, by simplifying the menu, fiduciaries can introduce broader mandates within each portfolio, designed to align more closely with the unique goals of retirement investors. These types of mandates are deemed “objectives-based”mandates.
Objectives-based mandates, also commonly known as outcome-oriented mandates, arrive in numerous forms. Simply, as market environments change, objectives-based managers use active risk management to adjust the portfolio in accordance with investors’ objectives or with outcomes desired. For the average DC plan participant, avoiding sustained losses is a critical objective. Many participants tend to exacerbate market volatility by either changing asset allocation (moving from stocks to cash at the bottom of a market cycle), or engaging in poor savings behavior (decreased savings rates, increased loan and hardship activity).
One of the differences between objectives-based managers and traditional benchmarkcentric approaches is the ability for the former to position portfolios in a way that benchmarkcentric approaches may be constrained from. A real world example is today’s fixed income environment. Many DC investors use bond funds for two primary goals: pursuit of safety and income. Yet, the composition and current yield provided by the U.S. bond market have made the prospect of achieving those goals in the future challenging.
Benchmarkcentric managers are often compelled by investment guidelines to maintain sector and duration positioning in line with their stated benchmark. In the current environment, this effectively means managers may be inadvertently forced to take on greater interest rate risk than may be appropriate through increased Treasury exposure. Conversely, managers who are free from such constraints can weigh the risk/return trade-off of having duration in line with the benchmark, and more freely pursue opportunities that potentially better meet the stated objectives of DC participants. For DC plans to help improve participants’ retirement outcomes, streamlined, whitelabeled core menus, if implemented effectively, can be an important opportunity. Introducing objectives-based mandates serves to further align participant retirement objectives with the portfolios being offered. This ensures that the portfolios are focusing on active risk management as a necessary component to meeting those objectives in the face of changing capital market environments. Too often in the past the industry has experienced the devastating impact of big draw down events, coupled with suboptimal participant behavior, impacting participant outcomes. Incorporating investment mandates into DC plans that seek to minimize those events is an important alternative to traditional approaches.
Active share can range from 0% to 100%. A high active share indicates that a portfolio’s investments significantly differ from the benchmark, while the investments of a portfolio with a low active share largely mirror the benchmark. Active Share was developed by professors at the Yale School of Management and is presented in a study originally published in 2006; most recently updated in 2013. The Yale study classifies active managers to have an active share of 60% or higher. Manning & Napier defines Truly Active Managers as managers that have an active share of approximately 88% or above.