The Art and Science of DC Plan Investment Design

Since their emergence within the Nineteen Seventies, outlined contribution (DC) plans in the US have advanced. One notable change has been a shift in how they develop funding lineups for participant-directed DC plans. Plan sponsors are progressing from merely utilizing generally held funding beliefs to making a construction that deliberately considers the traits and desires of their distinctive group of contributors.

On this article, I define the method for creating such a construction from an asset class perspective. A key part to considerate DC plan funding design is crafting a diversified funding construction earlier than choosing particular funding autos.

Regulatory Basis & Steering for Funding Menu Construction

The Employee Retirement Income Security Act of 1974 (ERISA) mandates that plan fiduciaries act prudently and diversify the plan’s investments to attenuate the danger of huge losses. By offering a larger diploma of asset class diversification, plan sponsors can allow extra alternatives for contributors who self-direct their retirement account to mitigate funding danger.

For DC plans topic to ERISA, there are a number of prescriptive necessities, together with a principles-based customary of care (responsibility of loyalty and responsibility of care) that plan fiduciaries should comply with when constructing a plan’s funding construction. Even for plans not topic to ERISA, many plan sponsors contemplate the rules set forth below ERISA as greatest follow and select to implement them.

Typically, ERISA part 404(c) gives DC plan fiduciaries safety from the legal responsibility for participant funding decisions if they provide a minimal of three diversified funding choices that bear materially totally different danger and return traits, reminiscent of fairness, fastened earnings, and money equivalents.

In follow, it’s fairly uncommon for an funding construction to be restricted to simply three funding choices. It’s because many funding fiduciaries imagine that providing a bigger, diversified alternative set is useful for contributors. Beneath the Pension Safety Act of 2006, sure pre-diversified funding choices, reminiscent of Goal Date Funds (TDFs), are thought of certified default funding options (QDIA), which gives a secure harbor to mitigate fiduciary danger.

The US Division of Labor (DOL) gives steering for the choice of TDFs in addition to periodic opinions of continued suitability. The DOL steering is greatest follow and plan sponsors ought to leverage it when evaluating TDF utilization of their plan’s funding construction. Plan sponsors ought to set up a structured course of that first identifies a TDF philosophy after which opinions participant demographic knowledge, together with retirees, to overview and finally choose an acceptable TDF suite. The identical participant knowledge overview can be helpful when assessing a plan’s core funding construction.

Past ERISA necessities and elective secure harbor provisions, DC plans’ named funding fiduciaries and their 3(21) funding advisors and three(38) funding managers have wide-ranging funding construction flexibility if choices are made in the perfect curiosity of contributors and beneficiaries. Such flexibility permits for an array of appropriate funding choices, which will be overwhelming for plan sponsors.

Crafting a Strong Funding Construction

Whereas the variability of DC plan participant teams’ wants and traits precludes a set system of a “proper” or “incorrect” funding lineup design course of, plan sponsors ought to keep a prudent and documented choice course of to fulfill their fiduciary obligations below ERISA.

A complete design course of is multi-step, calls for engagement by a plan sponsor’s retirement plan committee, and is greatest led by a professional retirement plan advisor who’s dedicated to facilitating committee conversations and making ready demographic and fund utilization opinions, amongst different duties.

A Pattern Course of in Seven Steps

1. Establish a objective & aims assertion

Establish the corporate’s philosophy concerning the DC plan’s major objective and aims. Pattern statements and their potential impression on funding construction:

Function: It can be crucial that our DC plan replicate the corporate’s purpose to advertise a tradition of “retirement surroundings.” This could manifest as: lengthy worker tenure, workers who generally retire from our firm, and retirees who discover it engaging to retain their DC plan accounts within the employer’s plan all through retirement.

Potential impression: The aim assertion would possibly recommend that plan asset courses and TDFs help a retiree’s have to diversify fastened earnings allocations, as a result of fastened earnings usually turns into a bigger portion of an investor’s portfolio close to all through retirement.

Function: It can be crucial that our DC plan additional the corporate’s purpose of supporting workers as they save and make investments for retirement. We observe that our firm has an extended historical past of using principally early-career individuals, and based mostly on previous expertise, we anticipate excessive worker turnover that leads to few, if any, retirements from the corporate. When retirements happen, we observe that accounts are faraway from the DC plan shortly thereafter.

Potential impression: The aim assertion would possibly benefit the inclusion of a number of fairness asset courses and core or core plus fastened earnings as a result of, for the non-TDF investor phase, this design would supply for enough fairness diversification, whereas minimizing the necessity to allocate to separate fastened earnings sub-asset courses. It additionally would possibly lend itself to a TDF designed for prime fairness allocations early in its glide path and low-to-moderate fairness allocations (relative to the TDF universe common) close to the goal retirement age.

2. What p.c of contributors are enrolled in managed account providers and/or self-directed brokerage accounts?

Participant enrollment in a managed account service is usually low sufficient that it doesn’t affect the plan’s general funding construction, apart from making certain the service’s minimal required asset courses are included. But when the managed account service serves because the plan’s QDIA, and retention within the QDIA is excessive, establish the asset courses the managed account supplier will use and never use. Carry out a cost-benefit evaluation of together with asset courses past these required by the managed service supplier.

3. Develop a participant group profile to grasp the plan’s buyers.

A DC plan’s participant group profile must be based mostly on demographics and investor sort. Since every plan’s participant group has various demographic traits, don’t depend on participant group averages for info reminiscent of age, compensation, schooling stage, and firm tenure. Analyzing averages usually fails to replicate the breadth of a plan’s distinctive participant group, in addition to any concentrated segments that symbolize the biggest variety of contributors.

When growing the participant group profile, consider what greatest describes the largest variety of contributors. Plan sponsors might divide contributors into the next classes:

a. Investor sort

• The “do it for me” sort: Individuals who elect to spend money on the QDIA; any fund with broad asset allocation, reminiscent of goal danger or different asset allocation funds; or a managed account service.
• The “do it myself” sort: Individuals who elect to speculate principally in particular person asset class funds or a self-directed brokerage account.

If “do it for me” is the plan’s predominant investor sort, the funding construction might or might not have to include greater than the first asset courses relying on the profile of the “do it myself” buyers. For instance, if the “do it myself” buyers have a excessive stage of funding proficiency or are prone to have their very own private funding advisors, the funding construction could also be justifiably extra complete. Nevertheless, relying on the traits and variety of the “do it myself” buyers, advert hoc requests from contributors for particular sub-asset class choices and different funding autos could also be greatest addressed by providing a self-directed brokerage possibility.

b. Demographic profile

• Establish the quantity and p.c of contributors by age vary and investor sort.
• Search for any prevalent age cohorts. Understanding the focus in every age cohort can sign consideration for particular wants.

c. Funding proficiency of non-QDIA buyers

• Rank the committee’s notion of participant funding proficiency as excessive, medium, or low. Funding proficiency will be estimated based mostly on how effectively the “do it myself” group makes use of non-QDIA asset courses. For instance, is there a sample of choosing few asset courses, and does the sample range by age cohort?
• It’s cheap to anticipate early-career contributors to make use of fewer asset courses. For this cohort, there may be prone to be a give attention to equities over fastened earnings. It’s cheap to imagine the chosen variety of asset courses would improve for mid- and late-career cohorts as a result of diversification and danger mitigation are likely to change into extra valued.
• One other method to observe funding proficiency is by utilizing a scatter plot of participant fairness/fastened earnings allocation splits by age, in comparison with a pattern TDF allocation. The plan’s recordkeeper ought to have the ability to present this info. If the scatter plot reveals extensive dispersion from the pattern TDF allocation, it’s cheap to imagine funding proficiency is probably going low. A low diploma of funding proficiency can affect whether or not the funding construction designed for non-QDIA buyers will be streamlined by excluding non-core asset courses, reminiscent of commodities.

d. Draw back danger tolerance

Utilizing an analogous low-medium-high ranking system, gauge draw back danger tolerance of the biggest participant phase. Draw back danger tolerance is a crucial consider intentional funding construction design and QDIA choice.

To assist establish participant draw back danger tolerance, plan sponsors can:

• Assessment recordkeeping studies of transfers into and out of funding choices throughout calendar quarters instantly following a market downturn or massive loss in a selected asset class.
• If the trade doesn’t require post-secondary schooling for many workers, draw back danger tolerance is comparatively low and most plan sponsors will eclude asset courses topic to extra frequent and vital losses. Alternatively, if superior ranges of schooling are required, plan sponsors might wish to assume a average to excessive stage of draw back danger tolerance.

e. Stability of workforce

If turnover and liquidations by laid-off workers are excessive, it’s cheap to imagine that the funding construction and any TDFs supplied ought to lean towards a low draw back danger profile.

f. Presence of an outlined profit pension plan

Along with the DC plan, does the corporate additionally sponsor an outlined profit pension plan that it intends to maintain lively with continued profit accruals? Does it present enough, focused alternative earnings to long-term workers? If sure, does the corporate view the DC plan as “supplemental”? On this occasion, it’s cheap to imagine that the funding construction of the DC plan could also be restricted to broad, core asset courses.

4. Assessment the variety of asset class choices.

The variety of asset courses must be knowledgeable by the plan’s objective and aims assertion and participant group profile, quite than proactively setting an arbitrary restrict on the variety of asset courses. The latter motion might lead to plan sponsors overlooking the perfect pursuits and desires of “do it myself” buyers. As the preferred QDIA, TDFs enable much less engaged contributors, or these with decrease funding proficiency, to keep away from confusion or challenges in making asset allocation choices.

The common variety of funding choices has declined as a result of contributors who’re much less comfy making knowledgeable funding choices now have larger entry to pre-diversified choices like TDFs or managed accounts. For reference, the common variety of funding choices (not asset courses) supplied by plans is presently 21. The three highest ranges by respondents had been:

1. 1 to fifteen choices: 21.5%,
2. 16 to twenty choices: 26.2%
3. 26 or extra: 25.9% 

5. Keep away from sophisticated funding menu design.

If the participant group profile suggests a streamlined funding construction and variety of funding choices, preserve the next factors in thoughts.

• A number of funding choices in the identical asset courses: Provide just one possibility per asset class until the choices encompass an lively and passive implementation.
• World fairness and glued earnings: If the funding construction has separate home and worldwide asset courses, international asset courses might lead to unintended overlap.
• Sector, regional, and country-specific asset courses, excluding actual property funding trusts (REITs): These asset courses have larger danger publicity attributable to their extra particular or concentrated nature and different areas of the funding construction additionally probably have publicity to them. Remember that this may occasionally result in overlap and unintentional, massive allocations to particular areas of the market.
• Single-commodity asset courses: If commodities are acceptable for the plan’s funding construction, the diversification impact of together with a automobile with broad-based commodity publicity might assist mitigate the danger related to publicity to a single commodity, reminiscent of gold, oil, or small teams of commodities like treasured metals.
• Goal danger: Goal danger funds, which keep a hard and fast or restricted vary of fairness versus fastened earnings, are vulnerable to unintentional misuse by contributors who stay in the identical fund for longer than acceptable, quite than shifting to lower-risk, lower-equity allocation variations as their time horizons lower.
• Cash market and steady worth funds: Secure worth funds have traditionally outperformed cash market funds as a result of they will spend money on intermediate-term bonds and keep principal safety by means of wrap insurance coverage. Together with each cash market and steady worth funds can complicate participant asset motion as a result of cash market funds are deemed “competing funds” to steady worth. Secure worth funds don’t allow direct transfers to competing funds reminiscent of cash market or different low-duration fastened earnings funds.

6.  Assessment historic efficiency previous to asset class choice.

Assessment historic efficiency for the final 10 years of all asset courses thought of for lineup inclusion to establish asset courses which are too unstable or topic to massive losses. This may assist the committee perceive their historic patterns and magnitude of beneficial properties and losses. Deal with the biggest beneficial properties and largest losses for every asset class through the 10-year interval. Assessment the usual deviation for five- and 10-year durations.

7. Replace the group’s funding coverage assertion to doc permissible asset courses.

Test the DC plan’s Funding Coverage Assertion (IPS) to substantiate it expressly permits the specified asset courses. Amend the IPS, if wanted, earlier than making funding construction modifications to the plan menu.

Placing the Participant Group Profile into Apply

Listed below are two potential situations and the ensuing pattern funding buildings:

Participant Group A:

• Plan objective assertion: It can be crucial that our DC plan helps the corporate’s purpose of making a “retirement surroundings” tradition that promotes lengthy tenure of employment with frequent retirements from our firm, and for retirees to seek out it engaging to retain their plan accounts all through retirement.
• Plan presently presents a managed account service.
• The “do it myself” buyers symbolize 60% of contributors. The most important age cohort is ages 50-80, and contributors have a excessive stage of funding proficiency.
• Eighty p.c of retirees depart their account within the plan for the long run and take systematic withdrawals following retirement.
• The “do it for me” buyers symbolize 40% of contributors. The most important age cohort is the 21-40-year vary, and contributors have a excessive stage of funding proficiency.
• The workforce is steady and never topic to periodic layoffs based mostly on financial cycles.
• The corporate doesn’t present an outlined profit pension plan along with the DC plan.

Prompt asset courses:

• Home fairness
  • Giant cap: progress, core, and worth
• • Mid cap: progress, core, and worth
• • Small cap: progress, core, and worth
• Worldwide fairness
  • Giant cap: progress, core, and worth
• Fastened earnings
  • Treasury inflation-protected securities
• Worldwide fastened earnings
• Broad-based commodities
• Asset allocation (TDFs)

Participant Group B:

• Plan objective assertion: It can be crucial that our DC plan displays the corporate’s purpose of making a tradition that helps workers as they save and make investments for retirement. Our group tends to make use of predominantly early profession folks. We anticipate and have traditionally skilled excessive worker turnover that leads to few, if any, retirements. When retirements happen, accounts are faraway from the plan shortly thereafter.
• Plan doesn’t presently provide a managed account service.
• The “do it myself” buyers symbolize 20% of contributors. The most important age cohort is 40-45 years, and contributors have a average stage of funding proficiency.
• Plan presents a self-directed brokerage possibility, utilized by roughly half of the “do it myself” buyers.
• The few contributors that stay within the plan previous age 65 have traditionally rolled over their accounts to particular person retirement accounts inside two years post-retirement.
• The “do it for me” buyers symbolize 80% of contributors and there are not any age cohorts with a materially greater focus than others. Individuals are assumed to have a low stage of funding proficiency.
• The workforce is steady and never topic to periodic layoffs based mostly on financial cycles.
• The corporate doesn’t present an outlined profit pension plan along with the DC plan.

Prompt asset courses:

• Home fairness
• Worldwide fairness
• Fastened earnings
• Worldwide fastened earnings
• Asset allocation (TDFs)

Empowering Plan Sponsors

Utilizing an knowledgeable, structured funding design course of will bolster DC plan sponsor confidence that funding lineup choice choices are tailor-made to the wants of most plan contributors. The funding menu design course of ought to allow the plan sponsor to really feel educated about how the group arrived at its plan’s funding construction and why, in addition to present the knowledge essential to doc a prudent decision-making course of, a key tenant of fiduciary responsibility below ERISA.

Should you appreciated this submit, don’t overlook to subscribe to Enterprising Investor and the CFA Institute Research and Policy Center.

All posts are the opinion of the creator(s). As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the creator’s employer.

The fabric offered herein is of a basic nature and doesn’t represent the availability by PNC of funding, authorized, tax, or accounting recommendation to any individual, or a advice to purchase or promote any safety or undertake any funding technique. The data contained herein was obtained from sources deemed dependable. Such info isn’t assured as to its accuracy, timeliness, or completeness by PNC. The data contained and the opinions expressed herein are topic to vary with out discover.

PNC might present hyperlinks to different websites. Content material on such websites is supplied solely for the person’s comfort. PNC makes no guarantee of any type relating to that content material and linking to such content material doesn’t represent or point out sponsorship, endorsement or affiliation in any method.

The PNC Monetary Providers Group, Inc. (“PNC”) makes use of the advertising title PNC Institutional Asset Administration® for the varied discretionary and non-discretionary institutional funding, trustee, custody, consulting, and associated providers supplied by PNC Financial institution, Nationwide Affiliation (“PNC Financial institution”), which is a Member FDIC, and funding administration actions performed by PNC Capital Advisors, LLC, a wholly-owned subsidiary of PNC Financial institution. PNC doesn’t present authorized, tax, or accounting recommendation until, with respect to tax recommendation, PNC Financial institution has entered right into a written tax providers settlement. PNC Financial institution isn’t registered as a municipal advisor below the Dodd-Frank Wall Avenue Reform and Shopper Safety Act.

“PNC Institutional Asset Administration” is a registered mark of The PNC Monetary Providers Group, Inc.

Investments: Not FDIC Insured. No Financial institution Assure. Might Lose Worth.

©2024 The PNC Monetary Providers Group, Inc. All rights reserved.

Investments: Not FDIC Insured. No Financial institution Assure. Might Lose Worth.

©2024 The PNC Monetary Providers Group, Inc. All rights reserved.

Picture credit score: ©Getty Photographs / Rudenkoi

Skilled Studying for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report skilled studying (PL) credit earned, together with content material on Enterprising Investor. Members can report credit simply utilizing their online PL tracker.