improving participant outcomes through investment menu design
DESCRIPTION
The structure of retirement plan investment menus continues to evolve, from "more choice is better" to "less is more". Many fiduciaries initially sought protection under ERISA §404(c) by offering a wide array of investment choices to their participants, but participants found themselves overwhelmed by the task of evaluating and selecting from amongst so many managers. Plan sponsors soon realized that less could be more, and built menus that offered a few fixed income options and a diverse set of a dozen or more stock funds, but in the bear market of 2008, many of those plans saw similar declines across their investment menu. With an increasing number of plans utilizing automatic enrollment and QDIA, just providing adequate choice is no longer enough. Fiduciaries are again asking, what does an effective investment menu look like? In this presentation, we cover: Incorporating the science of behavioral finance into your investment menu design; Selecting appropriate asset classes; Whether a tiered structure could be right for your plan; Passive versus active investment options; Options for low risk investments; and When to use target date funds.TRANSCRIPT
©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
Improving Participant Outcomes Through Investment Menu Design
Scott Cameron, CFA
Improving Participant Outcomes Through Investment Menu Design2
Scott is the Chief Investment Officer for the Multnomah Group and a Founding Principal of the firm. In that role, Scott leads Multnomah Group’s Investment Committee, is responsible for the development of the firm’s investment research methodology, and conducts investment manager due diligence. Scott also consults with plan sponsors on investment menu design, investment manager selection, fiduciary governance, and vendor fees/services.
Scott is a member of the CFA Institute, the CFA Society of Portland, the Investment Management Consultants Association, and the Portland Chapter of the Western Pension Benefit Conference.
Agenda
Improving Participant Outcomes Through Investment Menu Design3
• Evolution of Defined Contribution Plans
• Plan Sponsor Best Practices
• Target Maturity Investment Products
• Options for Low Risk Investors
Improving Participant Outcomes Through Investment Menu Design4
• All participants are active investors
• More choices lead to better portfolios
• Fiduciary focus on 404(c) protection
• Focus on investment products/manager analysis
• Vendors compared on features
DC Investment Lineups: Old Paradigm
Money Market / Stable Value
Core Bond
U.S. Equity
Intl EquitySpecialty Funds (i.e. REITs)
High Risk
Low Risk
Improving Participant Outcomes Through Investment Menu Design5
Is the Old Paradigm Effective: the Evidence
Participant Type How Participants Self-Identify
Delegators 69%
Do-It-Yourselfers 30%
Self-Directed Sophisticates 1%
Source: J.P. Morgan Retirement Plan Services
Improving Participant Outcomes Through Investment Menu Design6
Is the Old Paradigm Effective: the Evidence
Impact of Choice on Part icipat ion Rates
Source: Iyengar, Sheena S.; Jiang, Wei; Huberman, Gur “How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans”
Improving Participant Outcomes Through Investment Menu Design7
Investors Fail to Track the Market
Series10.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
3.83%
9.14%
1.01%
6.89%
2.57%
Avg. Equity Investor S&P 500 Index Avg. Fixed Income Investor Barclays Agg Bond Index Inflation
Source: Dalbar, Inc. 2011 Quantitative Analysis of Investor Behavior
Annualized Returns for the 20 Years Ended 12/31/2010
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• Not all participants are the same
• Incorporate behavioral finance knowledge into retirement programs
• Fiduciary focus on participant outcomes
• Focus on menu construction
• Vendors compared on solutions
DC Investment Lineups: New Paradigm
Tier One
Tier Two
Tier Three
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• Pension Protection Act of 2006
• Automatic enrollment
• Qualified Default Investment Alternatives (QDIA)
• J.P. Morgan – “Focus your AIM: Innovating the Defined Contribution Core Menu to Help Increase the Odds of Participant Success”
• Manning & Napier – Two-Tier Menu Design
• Schwab Retirement Plan Services Inc. - Launches Schwab Index Advantage
• Vanguard – “Converging Trends Drive Sponsors to Change Plan Lineups”
The Paradigm is Shifting
Improving Participant Outcomes Through Investment Menu Design10
Plan Sponsor Best Practices
Develop Fiduciary Governance
Program Analyze Employee
Demographics
Determine Objectives for
the Plan(s)
Decide Investment
Menu Structure
Select Asset Classes
Select Investment Managers/Product
s
Communicate to Employees
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• Relevant Information• Age
• Income
• Tenure
• Financial Literacy
• Participant Opinions
Analyze Employee Demographics• Methods
• Anecdotal/Experience
• Vendor Demographic Reports
• Payroll Data
• Participant Surveys
• Focus Groups
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• Retirement Readiness
• Income Replacement is Best Measure• General rule of thumb is 70%-80% of final year’s salary
• Can vary based on lifestyle, income, etc.
• Be Careful of Measurement Issues• No one is “average”
• Shortfall risk is important
Determine Plan Objectives
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• Tiered Methodologies are Preferable
• Simplifies Decision-Making• Employee communication is clearer
• Decision-making is easier
• Offers Meaningful Choices to Participants• Acknowledges participants are different
• No one-size-fits-all choice is available
• Participants want different options
Decide Investment Menu Structure
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• Ability to Build Globally Diversified Index Portfolio
• Low Cost
• Broad Diversification
• Style Specific Actively Managed Funds for Active Participants
• Optional Self-Directed Brokerage Account for Most Active Participants
Index Tier Option
Asset Allocation Funds (i.e. Target Maturity, Target Risk, etc.)
Core Index Funds
Active Style Funds(Optional) Self-Directed Brokerage
Account / Mutual Fund Window
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Sample Index Tier
Tier 1: QDIA
Tier 2: Core Index ArrayStable
PrincipalFixed
Income U.S. Equity International Equity
Money Market Intermediate Bond
U.S. Stock International Stock
Tier 3: Core Active ArrayStable
PrincipalFixed
Income U.S. Equity International EquitySpecialty
Funds
Fixed Annuity
Active Intermediate
BondLarge Cap Value Large Cap Growth Large Cap Value Large Cap
Growth
REITInflation Protected
Bond
Global Bond Small Cap Value Small Cap Growth International Small Cap
Tier 4: Self-Directed Brokerage Account
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• Core Array Consisting of Multi-Manager Portfolios
• Money Market/Stable Value
• Equity
• Fixed Income
• (Optional) Other Categories
• Core Strategies Incorporate Multiple Sub-Asset Classes
• Small Cap
• REITs
• Emerging Markets
• High Yield
• Global Bond
• Core Strategies Incorporate Open Architecture Managers
Multi-Manager Core Tier Option
Asset Allocation Funds (i.e. Target Maturity, Target Risk, etc.)
Core Multi-Manager Strategies
(Optional) Self-Directed Brokerage Account / Mutual Fund Window
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• Tier 1 is Typically the QDIA or QDIA-Type Option
• Target maturity or target risk
• Fund or model portfolio
• Target Maturity Funds are Most Common
• Simplicity in design
Tier 1 – Asset Allocation Strategies
Percentile Single Target-Date Fund
Managed Account
All Other Participants
Mean 3.93% 3.65% 3.76%
5th 3.62% 2.20% -0.02%
25th 3.62% 3.08% 2.66%
50th 3.90% 3.66% 3.80%
75th 3.90% 4.22% 4.64%
95th 4.65% 5.06% 8.09%
1994
1996
1998
2000
2002
2004
2006
2008
2010
$0
$50,000,000,000
$100,000,000,000
$150,000,000,000
$200,000,000,000
$250,000,000,000
$300,000,000,000
$350,000,000,000
$400,000,000,000
Growth of Target Maturity Products
Source: Morningstar Direct
Source: Vanguard 2011 “Participants During the Financial Crisis: Total Returns 2005-2010”
5 Year Annualized Returns (Period Ending 12/31/2010)
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Target Maturity Selection Criteria
Investment Management Firm Capabilities
Equity Glide Path
Asset Class Selection
Portfolio Management
Costs
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• Objectives• Provide participants with the ability
to create a diversified portfolio tailored to their specific risk tolerance and time horizon
• Allow participants to diversify their holdings among a number of different asset classes with different risk and return profiles
• Utilize low correlated asset classes to minimize the amount of risk at any given return profile
• Constraints• Minimize opportunity for
participants to select undiversified portfolios with unrealistic return and risk expectations
• Avoid narrowly defined “asset classes” with risks that are difficult to identify
Select Core Asset Classes
0
2
4
6
8
10
12
14
16
Ret
urn,
%
0 2 4 6 8 10 12 14 16 18 20 22
Risk (StDev Rtn), %
Frontier Cash S&P 500 Index Small Cap Stocks Mid Cap Stocks REITs Intl Stocks Corporate Bonds
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Global Market Capitalization$31.7 Trillion as of December 31, 2011
Source: Dimensional Fund Advisors; In US dollars. Market cap data is free-float adjusted from Bloomberg securities data. Many small nations not displayed. Totals may not equal 100% due to rounding. For educational purposes; should not be used as investment advice. 1. An example large cap stock provided for comparison.
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Style Boxes ≠ Asset Classes
Value Blend Growth
Large
Mid
Sm
all-50.00%
-45.00%
-40.00%
-35.00%
-30.00%
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
Calendar Year Returns (2008)
Large Value Large BlendLarge Growth Mid Cap ValueMid Cap Blend Mid Cap GrowthSmall Value Small BlendSmall Growth
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Diversification is Tricky
-1.0
0.0
1.0
Co
rre
lati
on
Dec-82 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Mar-12
Small Cap Stocks Mid Cap Stocks REITs Intl Stocks Corporate Bonds
Correlation to the S&P 500 Index (Rolling 60 Month)
Small Cap Stocks = Russell 2000 Index; Mid Cap Stocks = Russell MidCap Index; REITs = Dow Jones US Select REIT Index; Intl Stocks = MSCI EAFE; Corporate Bonds = BC Corporate Idx
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• Pre-Determine Investment Manager’s Role in the Menu
• Understand the Investment Manager’s Investment Philosophy• Source of Value-Added
• Types of Market Environments That Create Headwinds/Tailwinds
• Evaluate Historical Performance in the Context of Investment Philosophy
Select Investment Managers/Products
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Manager Performance Does Not Repeat
1996-2000 2001-2005 2006-20100%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
25% 29% 29%
25% 13%23%
25%
23%
23%
25%35%
25%
Source: Morningstar; 190 funds with 15 year track records
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• Benefits• Demonstrates meaningful choices
to participants
• Minimizes “choice overload”
• Simplifies participant decision-making
Communicate to Employees• Challenges
• Standard vendor communications don’t always support tiered investment menus
• Vendor websites are not structured to support tiered investment menus
• Tiered menu communications are usually tailored for proprietary investment products
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Low Risk Investment Options
Option 1
Stable Value Fund
Intermediate Bond
Option 2
Money Market
Ultra Short Term Bond
Intermediate Bond
Option 3
Money Market
Short Term Government
Bond
Intermediate Bond
Option 4
Money Market
Short Term Bond
Intermediate Bond
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• Consolidation of stable value providers• Higher costs/lower capacity will
continue to squeeze providers
• More expensive wrap insurance will bring new entrants into the market
• Low interest rate environment• Improved MV/BV ratios
• Stable value funds have only existed during a period of steady, declining interest rates
• Increasing rate environment will put pressure on MV/BV ratios
• May also cause higher levels of participant transactions as participants try to arbitrage return differentials
• Money market funds react more quickly to yield changes (may outperform stable value for a period of time)
Stable Value Funds Face Market Pressure• Back to the future
• Use of more traditional GICs/separate account GICs with synthetic GICs portfolios
• Bundling of wrap insurance with investment management
• Increased usage of traditional GICs and separate account GICs by plan sponsors
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[email protected](888) 559-0159
Questions?
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Multnomah Group, Inc. is an Oregon corporation and SEC registered investment adviser.
Investment performance and returns are based on historical information and are not a guarantee of future performance. Investing contains risk. Some asset classes involve significantly higher risk because of the nature of the investments and the low liquidity/high volatility of the securities.
Any information and materials contained herein or on our website are provided for general informational purposes only and are not intended to be comprehensive for any particular subject. Multnomah Group utilizes information from third party sources believed to be reliable but not guaranteed, and as a result, information is provided to you "as is." We do not represent, guarantee, or provide any warranties (either express or implied) regarding the completeness, accuracy, or currency of information or its suitability for any particular purpose. Multnomah Group shall not be liable to you or any third party resulting from any use or misuse of information provided.
Receipt of information or materials provided herein or on our website does not create an adviser-client relationship between Multnomah Group and you. Multnomah Group does not provide tax or legal advice or opinions. You should consult with your own tax or legal adviser for advice about your specific situation.
Disclosures