A fresh start
Most of the time, a well-designed defined contribution retirement plan operates with a modest amount of maintenance from its plan fiduciaries. However, every once in a while, it becomes necessary to create, or re-create, a retirement plan from scratch. What might prompt this change? Maybe you work for a young and growing business that is starting a retirement plan for its employees for the very first time. Maybe your company had an existing retirement plan, but it needed extensive revision, changed recordkeepers, and needs to be rebuilt from the ground up. Maybe the overall plan design structure fundamentally changed, and the existing investment vehicles are incompatible with the new plan. Maybe there are several retirement plans getting consolidated and rebuilt as part of a company merger or acquisition. For whatever reason, creating an investment lineup for an employee sponsored retirement plan is a challenge, but far from impossible. Today, we’re going to think about what it takes to design an investment lineup from the ground up.
Start with a written IPS
The first recommendation for creating an investment lineup for your new retirement plan is to double-check your existing documentation. Your previous and revised plan documents, plan charters, bylaws, and – most importantly – your Investment Policy Statement (IPS) may have specific rules about what’s allowed and expected to be in the new investment lineup. Your investment lineup should be consistent with your documentation, so be prepared to make changes – either to the investments or the documentation – to reconcile the two.
New retirement plans may not have a lot of these supporting documents at first, and your consultant can help you generate the necessary documentation to protect you and other the plan fiduciaries. When it comes to the investment lineup, most of the critical information will be in specified in your new (or revised) IPS. While it is true that ERISA doesn’t require a retirement plan to have an IPS, ERISA does require plans to “provide a procedure for establishing and carrying out a funding policy in a method consistent with the objectives of the plan.” Realistically, there’s every reason to use an IPS and no reason not to have one. Drafting, using, and maintaining an IPS is a popular choice, reasonably straightforward, and a recommended best practice.
Again, your IPS may be very explicit about what sort of investments are allowed in the plan. It might specify the types of investment categories that are required (e.g., US core bonds) and what might be prohibited (e.g., speculative ventures or non-diversified sector funds). It might specify the types of investment vehicles allowed in the lineup. For instance, your retirement plan might consist of mutual funds, collective investment trusts, unitized company stock, or stable value programs. Your IPS might determine the due-diligence criteria for selecting and monitoring investments, which benchmarks are used to evaluate your investments, and more. While the IPS often includes elements of your retirement plan’s administration not directly applicable to the lineup – for example, the IPS might specify the roles and associated duties for the plan fiduciaries and plan vendors – it is most often the key document to refer to when generating or evaluating your investment list.
Understand and balance total plan costs
When generating a list of potential investments, it is always necessary to keep an eye on the costs. This is important both for original investment selection, but also important when it comes to monitoring if the investments are still the best choice. The past few years have seen an explosion in litigation, as complacent retirement plan fiduciaries are being challenged for maintaining expensive plans or for not monitoring plan investments to ensure the appropriate (i.e., cheapest available share-class) is being utilized. Certainly, that means keeping an eye on individual investment fund costs (e.g., a mutual fund’s expense ratio), but it means more than that. There are often costs not expressed in the expense ratio alone – like high-water mark payments buried inside prospectus details.
Beyond the investment manager costs, it is mandatory to understand how total plan costs are calculated and how the investment selections change that calculus. Recordkeepers and other service providers get paid somehow, but not every plan sponsor clearly understands how it happens and how much it costs. Does your retirement plan sponsor plan pay your recordkeeper and service vendors directly with hard-dollar fees? Alternatively, do the investments within the retirement plan generate revenue-sharing fees that can be used to offset these plan administration costs? Are excess fees generated by the plan saved in an ERISA budget account and distributed back to the plan participants, or does the recordkeeper pocket the difference? There is a multitude of potential fee and payment arrangements – charging the plan by the number participants, charging the plan by total assets, fixed fees with hard-dollar payments, sliding scales, breakpoints, additional credits for using on-platform or proprietary investments, and so on.
While the number of options can make the prospect of total plan cost evaluation daunting, you can take comfort in three basic principles. First, as a rule, keeping your combined net costs low and equitable for plan participants is usually viewed favorably, but costs are not the only consideration. Second, you determine fiduciary prudence by understanding the plan costs and comparing them to similarly run plans. Third, plan fiduciaries are not required to choose the least expensive option for their plan administration costs or investment manager fees. Rather, the goal is to determine if the costs are reasonable. Are the services or investments you’re getting worth the cost? If you know what you’re getting, how much you’re paying, and how peers compare, then you are already making great strides towards defending your decisions. Remember, there is a multitude of options that are being utilized today. Many various plan and investment fee options chosen by plan sponsors and their consultants can be defended — provided these decisions are properly vetted and documented.
Create adequate investment scope
You now have an idea of what investments are going to be in your plan and how everything is going to be paid for. The next challenge is to create the actual investment lineup. What investments are going in your plan? How many investments do we need to provide for plan participants?
In legal terms, the guidelines laid out by ERISA 404(c) safe harbor provisions are surprisingly lenient. Basically, ERISA 404(c) says plan sponsors aren’t liable for losses if they have provided participants a minimum of three diversified investment options, the ability to transfer assets between them, and appropriate disclosures. For instance, these three investment options could be as simple as a money market fund, a broad US equity fund, and an aggregate bond fund. In other words, the legal requirements for an investment lineup are pretty minimal.
Investment diversity vs. lineup simplification
Given this low bar, you might think investment plans might veer towards a small number of investments – say four or five. That has not been the case. Historically, plan sponsors and consultants have been eager to add funds to diversify the lineup. Consider, US equity is generally split into nine categories – a tic-tac-toe board of large, mid-sized, and small equities, separated across the valuation spectrum as value, core, or growth. This delineation subtly encourages plan sponsors and fiduciaries to begin creating an investment lineup with nine US equity funds, just to cover every named style box. US fixed income funds are similarly delineated into nine categories by duration (short to long) and quality (low to high). Even worse, every time a new investment categorization is created, it creates an incentive to add another fund to the list.
The practical upshot of these refinement of categorization and expansion of investment options means modern retirement plans have become, if anything, too large and complicated. That many options are likely to confuse employees rather than to empower them to make the best choices. Employees, overwhelmed by the investment selection list, may make common mistakes like splitting their investments equally between each option, picking a single (potentially inappropriate) option, or simply foregoing the retirement plan altogether.
The average 401(k) plan may offer over 20 investment choices. While there is no single “right” number for the number of investments in an ideal plan, most plans are adequately covered by plans with six to 15 investments. How might we simplify a potentially huge investment lineup to a more manageable set?
Savvy investment consultants could advise their clients to utilize a number of techniques to manage these unwieldy plans and reduce the number of investment options, thereby reducing confusion. For instance, an investor could forgo unique value and growth options (i.e., the left and right side of the tic-tac-toe style box board) and opt for central core options instead. Similarly, a consultant could forgo separate small-sized and mid-sized equity options into combined small-mid options.
Combinations of clustered investment types works outside of US equities as well. For instance, we could combine individual foreign-developed equity and foreign emerging markets into single international equity. Instead of utilizing each subcategorization of exotic bond options – high yield, international bond, core-plus bonds, and so on – the consultant could opt for a single multisector bond option, which, used in tandem with a core-bond option, should provide adequate fixed income exposure to plan participants. Other investments might be best limited or omitted. Satellite investments like commodities, real estate and other alternatives might be best limited to a single option within a plan. These techniques can be used to create an investment lineup with adequate scope to the investible universe without overwhelming plan participants.
Pay special attention to the QDIA
As we’ve seen, there may be advantages to simplifying investment decisions for your plan participants. To their credit, the framers of ERISA and the Pension Protection Act recognize this and allowed for safe-harbor protections for a retirement plan’s use of a Qualified Default Investment Alternative (QDIA). When utilized properly, plan sponsors are not responsible for the investment performance of this default investment. Simply put, the QDIA is where contributions go when the plan participant hasn’t made an explicit investment declaration.
A QDIA is utilized in a number of ways. Again, assets are mapped to these funds without plan participant direction. As a default investment, it often captures employer contributions, assets from automatic retirement plan enrollment and contributions, and other situations (incomplete enrollment forms, removal of existing investment options from a lineup). Moreover, the QDIA often attracts assets directly elected assets from participants, as it is a balanced option with automated asset allocation decisions. As such, these investments often become the largest investment element of the retirement plan. Therefore, whatever option you use as your qualified default investment alternative – a target date series, a risk balanced account, or managed account – it is assuredly due an additional measure of due diligence. Again, utilizing a properly vetted QDIA will shield plan sponsors and the co-fiduciary from liability from investment decisions. Reviewing and monitoring the safe-harbor requirements periodically should protect plan fiduciaries.
Tailor the plan to your participants
There are other investment options to be decided upon. Does the plan want to focus on actively managed investment products, low-cost passive investments, or both? Do we need to provide socially responsible investing options with ESG (environmental, social, governance) criteria applied? Do our employees expect additional layers of customization, in which case they might be best served by managed accounts, and personalized advice?
To answer these questions, it is critical to know about the company and its employees. Knowing employee demographics, their past investment behavior, and how well the investment lineup fits with these inclinations are key. Using a fiduciary advisor to get unbiased advice when designing and tailoring the investment plan to your plan participants can be invaluable to the success and utilization of the plan going forward.
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