Retirement Plans In The Private Sector
The financial industry never stops innovating. Individual investors can easily turn on the television to see what new investment products are being offered to the public. It is equally important to recognize ongoing changes to the less visible, but equally important, structure of institutional investments.
Let us consider recent changes to the corporate retirement plan structure and the resulting investment lineups. For the past few decades, investment consultants have been inured into thinking about investments along the Morningstar style box schema. The traditional Morningstar style box approach is to break U.S. investments into a 3x3 tic-tac-toe grid, splitting investments along two axes – value, blend, and growth stocks vs. small, mid, and large stocks. For many retirement plans, the traditional method to fill the lineup with investments for each one of the boxes, along with an international and a bond fund.
The 2008 financial crisis accelerated change away from this traditional approach. During times of financial stress, the correlations between supposedly diverse asset classes within the 3x3 grid got very high, suggesting a lack of true diversification. Thus, retirement plans began to truncate their plans and select investments that granted broad exposure to multiple style boxes. Other plans followed the direction of the Pension Protection Act of 2006 and simplified their investment lineup even further, directing participants into all-in-one investments like target-date funds or target-risk funds.
Other innovations include the proliferation of the open architecture model, wherein retirement plans could select investment managers not affiliated with the plan’s recordkeeper platform. Also, the expansion of cost and service disclosures opened the door for aggressive cost cutting measures by recordkeepers and other service vendors. Finally, in Westminster Consulting’s November and December 2017 articles, we discussed advantageous changes to the revenue sharing agreements common in defined contribution plans.
Higher Education Plans Are Farther Behind The Curve
For engaged retirement plan committees willing to conduct price-checks, it is a buyer’s market. Startups and new companies starting fresh should be able to get great deals, in the context of history, with a little bit of comparison shopping and modest benchmarking efforts. The competitive nature of the marketplace has pushed many cost and service benefits widely across the 401(k) universe.
However, in our work as a fiduciary consultant, we have noted a number of retirement plans that have been harmed by adherence to a legacy of uncompetitive service agreements and old-fashioned thinking. Specifically, we’ve noted a particular slowness in higher education plans, along with other nonprofits, i.e., the 403(b) and 457 universes. We expect the free market and its corresponding retirement system, the 401(k), to move more quickly than nonprofit plans, but the difference between the levels of services provided and fees charged between comparable plans is surprising.
Some of this deficiency is due to inaction at the plan sponsor level, and some is due to a lack of pressure upon service providers. Why might higher education, government, and nonprofit plans be slow to take advantage of modern retirement plan benefits?
Group Level Contracts vs. Individual Contracts
Some retirement plan sponsors in higher education had, prudently, begun a relationship with a retirement plan vendor but had implemented their contracts on an individual, plan-participant level. For example, John Doe is a professor working at Monroe University. Monroe University’s retirement plan is being provided by First-Bank Custodial and Asset Management. Monroe University wants to replace First-Bank and transfer retirement plan management duties to a less expensive competitor, New-Place Asset Management. However, First-Bank points out its contracts are between First-Bank and individual participants, like John Doe, not the university. New hires and future employees at Monroe University may start a new retirement plan administered with New-Place management, and that plan itself may be portable to future competitors if necessary. However, John Doe and other employees will have to opt out of their relationship personally with First-Bank to make the transition to New-Place. This is a step not everyone is willing to take. It is notoriously difficult to convince plan participants to opt into change, no matter how objectively attractive the long-term benefits are. As a result, Monroe University will end up overseeing multiple plans concurrently: new employees with New-Place and a legacy of older employees with First-Bank. The plan committee and investment consultants will have to manage multiple vendors concurrently.
The Long Unwind
Contractual obligations that attach substandard service levels to participants are bad enough. Worse, depending on the vintage of the plan, there may be inherent lock-up periods even if you can separate plan participants en masse to a more competitive service provider. So, for example, Monroe University is now allowed to move all of its participants from First-Bank’s system to New-Place Asset Management, but it may not happen in a timely way. First, there are some investments, like stable value products, that have lock-up periods where the plan must allow 12 to 24 months to fully redeem the book value of the original investment. So, any Monroe University employees with assets in the First-Bank stable value program may have to wait a few years to move all their money to the new plan. Similarly, there are lock-up provisions that have extended this principal to create five-to-10 year lock-ups from changing service providers. So, employees know that their money will eventually change hands, but it may take years to happen. It is inevitable that a plan sponsor will have to monitor multiple plans during this transition lock-up period; that understandably discourages sponsors and their planning committees from making the move.
There is a greater cultural tendency in the nonprofit world to act and to portray one’s actions as being separate from self-interest. It isn’t just business; it’s personal. Our actions aren’t driven by profit, but by commitment to a shared mission. It isn’t just dollars-and-cents; it’s emotional. The relationships are more insular; service providers move beyond trusted professional partnerships into friendships, even if they are one-sided. This type of business arrangement can end up being lucrative for service providers who do not have to react quickly to industry best practices or competitive-pricing pressure. To promote change, investment consultants must translate how the ultimate goals of the nonprofit are being undermined by using the existing noncompetitive service agreements.
Making The Change
Given these discouraging elements, retirement plan sponsors and their committees may be lulled into inertia and hopelessness. If the process is going to take years, why not simply defer the decision to future committee members? There is a proverb, “The best time to plant is a tree is 20 years ago; the second best time is now.” The fiduciary duty to act in participants’ best interest should bolster the case for action, even if the benefits are deferred. Therefore, we advocate forward-looking action from today’s committee members to ensure a better future for tomorrow’s employees and plan fiduciaries.
(A version of this article originally appeared on Westminster Consulting’s website in June 2016, as “Sorting Out Legacy Retirement Plans”)