After growing in popularity for more than 30 years, the defined contribution plan has become the dominant force in employee retirement benefits. As the prevalence of these plans has grown, so too have the choices available for investment options. The result: The selection process for a plan sponsor has become more complicated, yet the importance of making well-informed fiduciary decisions is more critical than ever.
Regardless of the complexity of your retirement plan, it makes sense to periodically revisit the step-by-step approach for reviewing plan design and selecting investment options. Before you get started on the process, it’s important to have a clear understanding of the needs of your participant base as well as your plan’s goals and objectives.
Know your participant base
In today’s defined contribution environment, your participants may be as varied as the number of funds you have to choose from. From a range of education levels to different primary languages spoken, your workforce is diversified. You will want to make sure that your fund lineup matches the needs of your employees. For example, if a portion of your participants are
relatively uninvolved when it comes to investments, you may want to include asset allocation options in your fund array. Investment vehicles, such as target date funds and managed account
programs, are designed for participants who want a specialist to help manage their investments. Other types of participants may benefit from more sophisticated choices. Either way,
Institutional Retirement and Trust
Selecting a fund array
for your retirement plan
Developing an Investment Policy Statement
Every plan should have an investment policy statement to guide the investment decision-making process for the plan. In addition to making the fund selection process easier with a set of guidelines to follow, your investment policy statement can also help you manage your fiduciary liability and simplify your plan audit process.
According to the Profit Sharing Council of America (PSCA), implementing an investment policy statement can:
• Help clarify the plan’s investment-related goals and objectives. • Provide a framework for evaluating investment performance.
• Aid in clear communication of the plan’s investment policy to participants. • Ensure continuity in decision-making as plan fiduciaries change.
• Protect the plan sponsor from inadvertently making capricious or arbitrary decisions.
• Help the plan sponsor manage pressure for change generated by participants, vendors, or the media.
The key goal for your investment policy statement is to create an easy-to-use road map for selecting and monitoring your investment options. It does not need to pinpoint specific details since to do so would create a very narrow band to operate within. Instead, your statement should provide general guidelines to remove the risk of individual preferences taking over, rash or short-sighted reactions, or random decision-making.
an investment policy statement should provide guidance for creating a fund array that’s best suited to meeting your participants’ needs.
Meeting your plan’s objectives
Your company’s objectives for your plan and how these objectives support your organization’s culture also play a big role in fund array design. Is your company focused on increasing participation rates? Or is helping your participants achieve “retirement readiness” a key driver behind your fund array design? Is the use of automatic enrollment an attractive feature in your plan design? Does your company have a philosophy on an appropriate default fund? You’ll need the answers to these types of questions before you can design a fund array to meet your company’s overall goals and objectives.
We have outlined a step-by-step approach to reviewing plan design and selecting and monitoring your investment options. This can serve as a guide to help you stay on course in an industry that is constantly changing.
Step one: Designing your
fund array framework
Whether you decide on a comprehensive mix of different investment styles, a series of asset allocation funds, or a combination of both, you’ll want to have a clear idea of what is available before picking the fund array structure and specific funds for your plan. Here are some guidelines to help you create your framework.
Asset allocation
While variations on these funds have been around since the 1980s, pre-mixed asset allocation funds have become increasingly more sophisticated and popular in recent years. Part of the reason could be due to the market downturn during the last decade that exposed some of the fundamental flaws of participant-directed investing. Many participants were overexposed to very aggressive single-style funds — simply because these were the funds that delivered double-digit returns in earlier years.
On the flip side, many participants may be invested in funds that are too conservative for them, thus increasing the risk that the growth of their retirement plan will not meet their savings goals. This is especially true for younger participants who remain invested in stable value or money market default funds on a long-term basis. Asset allocation funds provide a more diversified solution with higher growth potential than a stable value or money market fund offers.
Pre-mixed asset allocation funds appeal to a wide range of participants. They’re easy to understand because they offer a diversified portfolio within just one fund choice. Depending on the needs of your participant base, you may want to consider a series of asset allocation funds as a complete fund array for your plan. By keeping your fund array limited to one series of
asset allocation funds, you simplify the decision-making for your employees. Participants can then focus more of their attention on increasing their contribution levels, which many suggest is the real key to long-term retirement savings success.
There are two common types of pre-mixed funds:
• Target date: These funds are
designed to allocate the underlying assets according to the date in which the investor is expected to begin drawing upon those assets (i.e., his or her targeted date of retirement). The participant needs only to select the fund that is closest to his or her expected retirement date. The asset allocation mix of the fund will slowly become more conservative as the target year approaches. In addition, the fund will be rebalanced periodically to its specified target asset allocation mix. Target date funds are offered as a series of funds, and come in five- or ten-year increments. • Risk-based: The funds in a
risk-based series are usually labeled from conservative to aggressive. The funds are rebalanced periodically to their base mix, but the asset allocation does not change over time as the participant nears his or her retirement date. At times, managers may adjust the allocation of risk-based funds, based on prevailing market conditions. You can expect these types of fund series to include three to five funds.
Managed account programs
Some providers offer personalized asset allocation programs. These programs typically request participants to provide additional information on their personal financial situation, such as additional retirement assets and spousal retirement assets. Based on the information provided, a personalized investment strategy is created for the participant.
Questions to answer before designing a fund array • Is your company focused on increasing participation rates? • Is helping your participants achieve “retirement readiness” a key driver behind your fund array design?
• Is the use of automatic enrollment an attractive feature in your plan design?
• Does your company have a philosophy on an appropriate default fund?
Single-style funds
While some participants may benefit from a limited fund selection menu and one-stop shopping, many plan sponsors prefer to include an array of single-style funds for those participants who prefer to select individual funds on their own. Again, this may be in addition to a series of asset allocation funds, or can compose your entire fund array. If your participant base will benefit from an array of single-style funds, consider including at least one option from each of these categories:
• Principal protection: Most plans offer
a stable value or money market fund as the most conservative option in the plan.
• Fixed income: An intermediate-term
bond fund is a good choice if you plan to offer just one bond fund. If you are considering a broader bond selection, you may want to add sector or strategy-specific bond alternatives, such as high-yield, government, inflation-protected and/or global/ international bonds. However, these types of specialty funds should be reserved for those plans with a more sophisticated participant base, and should be accompanied by investor education.
• Balanced funds: These actively
managed funds aim to deliver both long-term growth and consistent income. Balanced funds typically include a combination of stocks, bonds and money market instruments. • Large cap core equity: Typical choices
in this category would be a broad-based fund that passively mimics the broad equities market (e.g., S&P 500 Index) and/or an actively managed large cap equity strategy.
• Large cap growth/value equity:
Offering both a value and a growth option within the large cap category protects against times when one or the other investment style is out of
favor. When presented with both options, participants should invest in both styles, but more sophisticated investors can temporarily tilt their asset allocation strategy toward the area they believe will provide the greatest opportunity.
• Mid Cap: A value and growth style
can also be considered in this category. However, for those plan sponsors wanting to limit the sheer number of fund offerings to avoid the “overload factor,” a single mid cap core fund may suffice.
• Small Cap: Value and growth styles
are often the most prevalent choices. However, a single core-oriented strategy can also be considered here. • International: A fund focusing on
non-U.S. stocks can provide diversification when U.S. markets are down, or simply provide additional investment opportunities in companies domiciled outside of the U.S.
Company Stock
For years, the accumulation of company stock has provided a nice retirement nest egg for many retirees and has been a great way for companies to concentrate their stock in “friendly” hands and build loyalty among its workforce. However, in recent years, the risk to employees from investing large portions of their retirement account in company stock has been well documented. If you offer a company stock option in your retirement plan, be sure to consider all of the ramifications. The Pension Protection Act regulations provide important guidelines. In addition, you’ll want to educate your employees about the risks of investing in
individual securities and the need for diversification.
Consider going beyond the basics
For most plans, an asset allocation series complemented by a single-style lineup from the previously The expanding importance of the default option
With the Department of Labor (DOL ) regulations regarding Qualified Default Investment Alternatives (QDIA), and the increasing addition of automatic features to retirement plans, the default fund has grown in importance and should be given serious consideration by plan sponsors.
As a product of the Pension Protection Act of 2006 (PPA), the QDIA regulations create a safe harbor that relieve a plan’s fiduciaries of liability for investment performance when participants are defaulted into a qualified investment. The final rules from the DOL identify three long-term categories of investments that are considered QDIAs:
• Age-based investment products (such as target date funds) • Group-based investments (such as a balanced fund)
• Age-based investment services (such as professionally managed accounts) Automatic enrollment and quick enrollment options mean that more employees may be participating, but may not be actively managing their account. As participation grows and regulations tighten, plan sponsors should look at their current plan design and choose an appropriate default fund that follows the plan objective and meets the needs of their participants, but also evaluate the benefits of the fiduciary protection offered by the PPA.
described list meets the needs of most participants. However, some plans may consider other options as well, often as the result of employee or executive requests. The challenge for today’s plan sponsor is striking the right balance for their plan and avoiding the temptation to cater to everyone’s demands at the expense of the majority of the participants. Furthermore, many alternative options come with their own set of investment risks, which need to be clearly outlined and communicated to participants. If you choose to add one or more of these options, be sure your investment policy statement defines an overall guideline to employee requests and justification for adding funds or plan features considered outside of the norm.
Sector funds
A sector fund invests in a particular industry or sector of the economy. Examples include a technology, energy, or real estate fund. Sector funds provide little diversification within the fund itself, but can provide additional asset
allocation opportunities for participants. Sector funds can be attractive
alternatives to some participants, especially more sophisticated investors who follow the market closely. However, before investing in sector funds, participants need to understand the funds and the risk of their more focused investment approach.
Mutual fund windows and brokerage options
At one point, brokerage options in retirement plans were being considered by many plan sponsors. A brokerage option offers virtually unlimited access to mutual funds and individual securities. Mutual fund windows are another option that can expand the investment options available, but are limited to an available set of mutual funds designated by the provider of the service. Despite the flexibility of these options, the reality is that few participants venture into these options, largely due to the complexity and potential for additional fees.
Socially responsible funds
Your company may have an
environmental or socially responsible mission. Or you may have employees who advocate for socially responsible investing. If your investment policy statement accommodates adding socially responsible funds to your plan, you’ll need to consider whether adding just one fund will meet that need. Adding an entire array of socially responsible funds may make your overall lineup too complex. Like all decisions related to the options outside of your core array, you need to balance the potential benefit of adding funds against the goal of keeping your options as streamlined and straightforward as possible.
Step two: Fund selection
Once you have a solid framework built, you can begin to make your actual fund selections. This can be overwhelming, given the sheer number of funds in the marketplace. However, with the help of
Example fund array
The above fund array design is for illustration purposes only and is not intended to depict actual risk and return characteristics of different asset class categories or specific funds.
The information contained herein and any information provided by employees and representatives of Wells Fargo are for educational purposes only and do not constitute investment, financial, tax, or legal advice.
PRINCIPAL
PROTECTION INCOMEFIXED BALANCED LARGE CAP EQUITY CAP EQUITYMID/SMALL INTL EQUITY
Managed Account Program
Potenti al Return Potential Risk Stable Value Bond Balanced Fund Large Cap Value Large Cap Blend Large Cap Growth Small Cap Mid Cap Non-U.S. Global
your investment policy statement, other resources (such as your plan service provider or an independent investment consultant), and the following guidance, you can more easily narrow your choices and make your final determinations.
Taking the holistic approach
Neighbors talk about and compare 401(k) plans. Relatives provide hot stock tips. Nearly everyone has something invested in the stock market and their long-term financial security now depends on the decisions they make. While that doesn’t make everyone a sophisticated investor, it has brought a new awareness of the importance of making smart investing decisions. Of course, the ultimate objective is to construct a fund array composed of investment options that will perform well during all market cycles. However, this goal has proven to be largely unattainable. The best a plan sponsor can do is to take a holistic approach to analyzing investment options and create a fund array that meets the majority of their participants’ needs. When creating a fund array, plan sponsors should use a prudent set of criteria to select funds and then closely monitor their array for appropriateness going forward.
As for researching and analyzing the funds available in the marketplace today, it’s unrealistic for most plan sponsors to do this on their own. Few plan sponsors have the time, resources, or expertise. To meet this need, plan service providers and/or consultants generally have a team in place to systematically do this type of research on a regular basis. With their larger scale and extensive resources, they have access to the type of information and research that would be very difficult for plan sponsors to compile on their own. It’s smart to use these resources, but remember that the final fund choices and the fiduciary responsibility remain with you, the plan sponsor.
With this in mind, the following are both qualitative and quantitative
factors to consider when selecting investments for your fund array. • Past performance: Today, it is
mandatory to dig deeper than a single time period for performance comparison. Consider and compare performance for one-, three- and five-year increments (even longer if available). Shorter performance time frames, such as one year, can help identify early trends. A longer time frame (five years and more) may include an entire financial cycle to show how the fund performed in multiple types of markets. Another variation on the traditional “point in time” analysis is to evaluate three- and/or five-year annualized returns on a rolling monthly or quarterly basis. This approach significantly increases the number of observation points evaluated and eliminates the endpoint bias that can come into play with the more traditional approach.
• Comparison to peer group: Any
analysis of a fund must include a comparison with funds in its peer group (funds with a similar investment objective). By itself, a fund may appear to be performing well. However, it is important to obtain a “relative” measurement of this performance. Avoid the temptation to focus solely on those funds at the top of their respective categories. Numerous studies show that funds placing at the top of their category based on recent performance have a high tendency of underperforming in subsequent periods as they revert to the mean.
• Comparison to market index: In
addition to comparison to a peer group, you should compare funds to a market index (e.g., S&P 500 Index or Barclays Capital Aggregate Bond Index). This type of comparison can help you determine whether the funds you are evaluating have performed in line with the index you are using as a performance benchmark. It will also help you determine if an actively managed fund has consistently outperformed (either in absolute terms or on a risk-adjusted basis) a passively managed alternative.
For some categories, such as a large cap core fund, many fund managers find that it’s hard to consistently beat the index. In this case, you might choose an index fund as your option, such as an S&P 500 Index Fund. An index fund provides an easy-to-understand alternative for the less sophisticated investor, typically with a lower expense ratio than actively managed funds. • Risk-adjusted returns: Another
way to look at funds is to compare how much an investment returned in relation to the amount of risk or volatility it experienced, called the risk-adjusted return. While there are many different types of investment risk, the most common risk factor referred to when analyzing returns is volatility What is the role of fees?
There’s always been an ongoing debate about the point at which you consider fees and expenses when comparing funds. Keep in mind that performance should be considered net of fees. For example, it is commonly accepted that an index fund has lower fees than an actively managed fund. Don’t overact to a higher expense ratio if the resulting performance is superior. Sometimes, you get what you pay for (higher expenses may mean better research or other qualitative factors). However, if two funds are equal on all counts, but one has lower expenses, a reasonable tie-breaker would be to go with the fund with lower expenses. All else being equal, this could provide an advantage over time or in different market conditions.
(range of returns, typically measured by standard deviation). Most plan sponsors should look for funds that deliver competitive performance with a relatively low amount of volatility. Statistical measurements for comparing risk-adjusted returns include alpha, information ratios and Sharpe ratio. You should compare these measurements not only across the funds being analyzed, but also against the market index and peer group as well. • Style adherence: To make fair
comparisons and to provide a well-rounded fund array, you’ll need to understand how closely a manager follows the given style. If there has been variation, what is the reason? If the manager’s approach is not focused, it could cause this fund to overlap with another, causing confusion and unintended style bets among participants. However, if the style variation falls within the investment philosophy, there may be an advantage to including one or more of these “non-style specific” funds in your array, as long as their strategies are clearly communicated.
One way to measure style adherence is to use a returns-based methodology to evaluate whether a fund has performed in line with its stated style. While this methodology is a useful and relatively simple way of evaluating style adherence, this approach has its shortcomings. A returns-based style measurement is really just evaluating whether a fund’s patterns of returns have behaved more or less similarly to a set of market indexes. Holdings-based analysis (evaluating a fund’s historical security holdings) is another way to measure style adherence. This type of analysis can be more comprehensive, but can be very
point-in-time specific and requires a significant amount of data-gathering to evaluate whether a fund has invested in line with its stated philosophy. • Qualitative information: Analyzing
investment options goes beyond plotting dots on paper and filling boxes on the style grid. Often referred to as the “Three P’s” of investment fund analysis — Performance, People, and Process — the latter two emphasize the importance of gathering qualitative
information on a fund’s investment team and how the fund operates. A large part of obtaining qualitative information involves building relationships with fund managers and other representatives at the fund companies. It’s hard to make judgments based on just a single interaction. Multiple meetings over time make it easier to see differences and potential warning signs. Research teams seek out consistency in the investment teams and consistency in the story they tell.
In addition, building relationships with managers allows better access when things aren’t going well. Fund managers will call their key analysts and clients to let them know about major changes as soon as they happen. With this information in hand, a decision can be made whether to monitor a fund or eliminate it from your array.
If you are not getting this type of information from your provider or consultant, find out why. If they do not conduct this type of research, it may be time to search for another partner. • Offering funds from more than
one company: A decade ago, many
providers only allowed proprietary funds in their lineups or limited their non-proprietary choices to a handful of fund companies. Today, most major providers offer much more flexibility
as it has become clear that one fund company couldn’t offer competitive funds in every category, and that it wasn’t necessarily prudent for plan sponsors to limit the choices available. There is risk in choosing funds from only one company. This issue reached a peak in the first part of the decade when some fund companies fell under investigation for inappropriate trading practices.
Today, most plan service providers offer an array of proprietary and non-proprietary funds from multiple fund families. As a plan sponsor, you should compare funds on a stand-alone basis. If all things are equal, there might be cost advantages in using a proprietary fund. However, you should make that choice only after you have analyzed each fund on its own investment merits. The “Three P’s” of investment fund analysis
Performance, People, and Process
While everyone understands the importance of analyzing fund performance, the qualitative information on a fund’s investment team and investment process should not be overlooked.
Step three: Monitoring your
fund array
Once you have your fund lineup in place, the work continues. Your investment policy statement should spell out the process for monitoring your funds, watching for issues, and making a change if necessary. There’s no doubt that you will pick at least one fund that underperforms some of its peers, or its index, at some point in time. Monitoring requires guidelines for review and patience to endure market shifts over the short term.
If a fund is underperforming, ask: What is causing the underperformance? Is it the fault of the fund management team? Is something fundamentally wrong? Is it a logical result of the state of the markets? Is it the style? It is important to compare the fund to its peer group. Significantly underperforming funds can sometimes signal a serious problem. Other times it may indicate that many of the fund’s peers are employing an investment approach that may be somewhat counter to the investment philosophy for this fund, or have migrated in the face of certain market conditions.
In addition to monitoring the funds in your lineup, it is important to monitor what is happening in the industry. For example, five years ago there were limited target date fund series available. Today, there are numerous target date fund series available, and you can choose a series that matches the goals of your plan and needs of your employees. The retirement plan industry is constantly evolving. The funds you chose a few years ago may no longer be the best the industry has to offer. Your plan service provider or consultant should help you stay on top of trends as they relate to your plan and allow you to decide if a change is required.
A continual challenge
Designing, selecting, and monitoring your fund array is not a one-time process. Based on the history of defined contribution plans and the expanding emphasis on an employee’s responsibility for his or her financial future, the importance of offering appropriate fund choices will only continue to grow. As a plan sponsor, you can rely on resources such as your investment committee, your investment policy statement, your plan service provider, and possibly a third-party investment consultant. You should use these resources as your guides to help you stay on course as employee needs, industry regulations, and investment vehicles continue to change.
For more information, please contact Wells Fargo at 1-800-690-9721.
Recordkeeping, trustee and/or custody services are provided by Wells Fargo Institutional Retirement and Trust, a business unit of Wells Fargo Bank, N.A. This information is for educational purposes only and does not constitute investment, financial, tax or legal advice. This information is general in nature and is not intended to be reflective of any specific plan. Neither Wells Fargo, nor any of its representatives, may give legal or tax advice. Please contact your investment, financial, tax or legal advisor regarding your specific needs and situation.
Ongoing monitoring
Once you have your fund lineup in place, the work continues. Your investment policy statement should spell out the process for monitoring your funds, watching for issues, and making a change if necessary.
