With defined contribution plans taking the place of defined benefit pension plans as the primary retirement vehicle for most employees over the past decade, employers are being called upon to make better investment lineup decisions.
“We have evolved over the last couple of decades,” says Matthew Brancato, head of DC advisory services at Vanguard. Instead of DC plans acting as supplemental retirement vehicles, with not much thought put into the investment lineup, they are now expected to grow assets enough to get participants through retirement. That means a change of how investment lineups are constructed.
Vanguard came up with four best practices plan sponsors should consider when constructing a DC plan investment lineup: identifying plan objectives, focusing on the fundamentals of investing, creating a tiered lineup that reflects plan objectives and ensuring active, ongoing oversight.
“It is important from a plan sponsor perspective to realize how much power they have and how important framing is in the context of putting together a plan,” Brancato says.
He recommends building a lineup in a tiered structure, paring down the number of investment options and presenting the all-in-one solutions first, like target-date funds. Those are the first investment options plan participants see and are a good place to start, especially for plan sponsors and plan participants who have always let their own inertia dictate how they invest in their 401(k) plans.
It’s also important that plan sponsors gauge interest in different types of investment options before constructing a plan. Most investors just want to set it and forget it. Those are more likely to want a pre-packaged investment lineup, like a target-date fund or other qualified default investment alternative. Others may be more savvy and want opportunities to invest in more risky options and have more flexibility to manage their own accounts.
TDFs have become the most predominant tier 1 investment option, Brancato says. Investors designate them 94% of the time.
“They are a great option because they do move the allocations over time. They are a great starting point for investors,” he says.
“Inertia is something that plagues all human beings, including plan sponsors."
When considering an investment lineup, plan sponsors need to consider asset allocation, diversification and cost. Include funds that are a good mix of stocks and bonds. These will be included in the tier 1 and tier 2 investment options. Tier 3 options are more narrowly focused supplemental investments that are still appropriate and fit into the broader objectives of the plan.
“If your objective as a plan sponsor is to minimize the probability of people making construction portfolio errors, then offer fewer and narrowly focused funds, fewer tier 3 options. If they are a professional service firm and their plan participants do like choice and want options, having a broader tier 3 lineup makes sense,” he says.
Having a tiered investment lineup, along with plan design options like automatic enrollment and automatic escalation, can get plan participants to a better starting point in their retirement savings journey, Brancato says.
“Inertia is something that plagues all human beings, including plan sponsors. Only about half of plan sponsors incorporate tiering into their lineup. We have a lot of room to go improving that dimension,” he says. “The number of options in a plan has flat-lined the last five years or so. We see about 18 funds on average in a plan; that’s flat to where it was in 2010.”
He adds that on average, only three of those 18 funds are ever used and that statistic has remained flat over the last five years as well.
“I hope we start to move the dial here,” he says, pointing out that too often financial professionals in the DC space get so wrapped up in the intellectual conversations around what interest rates are going to do and whether they should put more into bond portfolios that they “lose sight of the fundamentals. These are basic things that are much more powerful than trying to structure the right duration in a bond portfolio.”
"When considering an investment lineup, plan sponsors need to consider asset allocation, diversification and cost."
No matter what the final investment lineup looks like, plan sponsors need to make sure they circle back and evaluate how the lineup is working out. Is the investment lineup still in line with the plan sponsor’s goals for the plan? If the qualified default investment alternative is working out well, plan sponsors should consider re-enrolling employees who have never participated in their company-sponsored retirement plan.
Because employee demographics evolve over time, make changes periodically based on the current state of the stock market and the makeup of employees at the organization, he says.
