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Form and Function: Optimizing Participant-Directed Menus

Mar 8, 2017

The objective of a participant-directed menu is to achieve the best possible investment outcomes for plan participants, given their time horizons and risk tolerance. As a consultant to both qualified and non-qualified defined contribution plans, Newport Group’s fiduciary consulting team has developed what we consider a “best-in-class” menu design framework that can serve as a starting point for plan sponsors. This can then be overlaid with philosophies from client investment committees and limitations associated with their respective recordkeeping platforms. This structure seeks to improve participant outcomes by encouraging increased plan participation while allowing for the construction of broadly diversified portfolios.

Menu Design Objectives
We identified several core objectives for what we consider the ideal defined contribution menu. First, a best-practice menu should allow for high risk-adjusted returns across the risk spectrum. Broad access to capital markets is desirable in our view because diversification can be expected to improve the overall portfolio’s return per unit of risk. Second, research1 has shown that 401(k) plan participation rates decline as the number of menu options increases, so fewer options should be offered where possible. Third, the menu should be developed from a strategic perspective in order to encourage long-term planning and discourage often-detrimental attempts at market timing. Last, costs have a significant cumulative impact on participant outcomes and should be limited to the extent possible.

Addressing each of these objectives requires balance. For example, greater diversification argues for more menu options, which is in conflict with the goal of increasing participation by reducing choices. More choices also place responsibility for ever-more-specific decisions on the participant, and we believe that most participants will benefit from delegating decisions within markets (e.g. mortgage-backed securities versus corporate bonds) rather than making those decisions themselves, due to the experience and focused attention of well-vetted professional investors.

Qualified Plans: Overall Structure
Participants in self-directed retirement plans vary in investment knowledge, experience and risk tolerance. We believe that the plan’s options should be designed with this variability in mind and advocate three tiers of increasing customization for ERISA-qualified plans:
  • Target-Date Funds
  • Core Menu of best-in-class funds following both active and passive mandates
  • Self-Directed Brokerage Accounts

Tier 1: Target-Date Funds
We think that most participants are accidental investors, meaning that they would like to save for retirement but do not have an interest in fine-tuning their allocations among asset classes or investment managers. Our experience suggests that many participants will remain in the qualified default investment alternative (QDIA) option within the plan for a meaningful period of time. This observation is confirmed by Vanguard’s “How America Saves 2016” report, which noted that, within the 98% of plans the firm recordkept in 2015 that offered target-date funds, 62% of participants were 100% invested in one target-date fund. We believe that this inertia should be harnessed by using target-date funds as the QDIA in participant-directed plans that are subject to ERISA, which will address the needs of participants who would like asset allocation and manager selection to be done for them.

Qualified retirement plans have the advantage of a readily estimable investment horizon, since plan withdrawal restrictions and tax policy discourage early withdrawal of assets. Accordingly, we believe that most participants’ investment horizons can be estimated by their current ages and a target assumption of retirement at a certain later age. This allows the participant to be effectively mapped into a certain target-date fund within a series.

Tier 2: Core Menu
While a significant portion of participants will prefer the all-in-one approach of Tier 1, a participant’s investments outside of the plan, as well as the level of total savings relative to his or her individual needs and risk tolerance, suggest that additional customization is warranted in many situations.

Balancing the objective of brand diversification and encouraging participation, we believe that asset categories should be consolidated when practical. We also believe that only one option should be offered per asset class (e.g. active large) because we think that the circumstances under which a participant should use one of the managers over another within a category would be unclear. We also recommend that index funds be offered in each of the major liquid asset classes (U.S. large cap equities, U.S. small/mid cap equities, non-U.S. equities and U.S. fixed income) in order to allow participants to minimize expenses. U.S. equity index funds that include both mid- and small-cap stocks are often unavailable in share classes that offset other plan expenses, so we often recommend that clients seeking revenue share offer separate U.S. mid- and small-cap equity index funds.

The combination of our objectives and these beliefs, as well as a review of the vehicles available, leads us to recommend a best-practices core menu of 11 options, with each option representing a distinct combination of the addressed market and management approach (active or indexed). The menu is summarized below.

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Note that this menu is shown in the context of a new and unconstrained plan, which is not the case for most plan sponsors. There are many situations where the specific options shown in this idealized menu will not be the most prudent. For example, if the options within a category are of poor quality or overpriced due to platform constraints, it would be prudent to consider the omission or replacement of that category. Such a substitution is more likely to occur within constrained platforms or when the plan’s structure causes its options to be limited. Provided that the fund fits within the broader context of the overall plan, we also would not necessarily recommend removing a strong manager that addresses a market segment not delineated above.

U.S. Equity: Passive Large Cap and Small/Mid Cap
Within equities, we recommend including large and small/mid-cap index strategies. The passive U.S. equity options offer cost efficiency and do not require participants to take active management risk. In choosing a pair of large- and small/mid-cap index funds, we recommend that plan sponsors take the index providers and their construction methodologies into account in order to limit the potential for overlap or gaps between the two indexes. For example, the S&P 500 Index’s membership is actively determined by a committee, so we would recommend that a large-cap equity option that tracks that index be paired with an option tracking the small/mid-cap S&P Completion Index, which explicitly excludes the members of the S&P 500 Index, where otherwise appropriate.

U.S. Equity: Active Strategies (Active Large Cap and Active Small/Mid Cap)
To complement the passive U.S. equity strategies, we recommend that a standard menu also include two strategies where the manager has the flexibility to make active selection decisions. These portfolios will have higher concentrations than a passive strategy, with the objective of outperforming their respective benchmarks. Two sub-classes have been chosen to segment the U.S. equity market: large cap and small/mid cap. This delineation allows for selection from the multitude of managers that have demonstrated particular skill levels in these particular size segments of the market.

This is a departure from the menu construction philosophy that dominated the industry in the 1990s and 2000s. Rather than “covering all the style boxes” this new approach focuses on minimizing the number of active managers that is necessary to provide true diversification to participants.

Non-U.S. Equity: Passive International
A passive strategy should also be included within the non-U.S. equity segment of the standard menu. When available, we recommend a strategy that includes developed and emerging markets, such as the MSCI All Country World ex-U.S. Index. A passive ex-U.S. component also allows for a long-term, strategic allocation to all regions of the world.

Non-U.S. Equity: Active International
Symmetric to the U.S. equity exposure, an active strategy should be available in the core menu to complement the broadly diversified passive strategy. The objective of this option is to provide the potential for outperformance of the benchmark by constructing a more selective portfolio from the overall non-U.S. market. We concluded that two non-U.S. strategies, as compared to four in the U.S., are sufficient to provide broadly diversified exposure to non-U.S. markets in recognition of the lower allocations granted to non-U.S. equities in the overall asset allocation framework.

Fixed Income: Passive U.S. Aggregate Bond
We recommend that fixed-income strategies be included in the core menu for diversification, protection during down equity markets and incremental return. We recommend that the passive option within this major asset class track the Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Aggregate), which we consider broadly representative of the domestic investment-grade fixed-income market. We expect the high-quality domestic portion of the market to provide more reliable protection against slowing economic conditions than a more global strategy or one including low-quality debt. Funds tracking this index are also broadly available.

Fixed Income: Active Core Plus
We also recommend an active, primarily domestic “core plus” fixed-income fund. This option is meant to benefit from skilled active management both within the sectors represented in the U.S. Aggregate (this is called the “core”) and through opportunistic, limited allocations to sectors not included in it, such as high-yield bonds and debt without a fixed interest rate (the sectors outside the index are the “plus” in this option’s title). The high- yield allocation is included within this active option in order to incorporate the $1.3 trillion2 market into the plan while reducing the likelihood of tactical participant behavior that can sometimes be driven by the recent results of high-yield bonds.

Many investors also refer to the “core plus” mandate as an “intermediate-term bond” allocation. While the terms are often used interchangeably, we use the “core plus” label in this paper for precision, in order to differentiate it from the definition of the word “intermediate” as used in the names of Bloomberg Barclays indexes. The index provider uses the word to mean that securities with more than 10 years to maturity are excluded from a given index. Due to our diversification objective, our best-practice approach does not omit longer maturity securities.

Fixed Income: Active Global Bond
The U.S. Aggregate is a broadly accepted domestic fixed-income index, but it is not comprehensive in addressing the global fixed-income opportunity set. As mentioned above, high-yield bonds and floating-rate debt are excluded, and so is most foreign debt. The Bloomberg Barclays Global Aggregate Bond Index ex-USD had a market capitalization of $24.4 trillion as of December 31, 2016, which was greater than the $19.1 trillion market capitalization of the Bloomberg Barclays U.S. Aggregate Bond Index3. We believe that home country bias is reasonable for U.S. fixed-income investors since most participants’ retirement needs will be U.S. dollar-denominated, currency volatility is high, and the dollar tends to strengthen in risk-off environments. Thus, we prefer to allow an active manager to reduce risk by increasing the allocation to the U.S., particularly when the incremental return available from foreign markets is low, and recommend global (including the U.S. in the opportunity set) rather than international fixed- income strategies.

Inflation Protection: Active Inflation-Linked Bonds
Fixed-income investments are particularly sensitive to sudden increases in inflation because lenders normally require compensation for expected future inflation as part of a bond’s yield. Accordingly, nominal (before the removal of the inflation effect) interest rates tend to rise, and bond prices decline, when inflation expectations rise. At the same time, equity investments can lag an increase in inflation as the discount rate applied to future cash flows that is embedded in stock prices rises. Accordingly, we believe that some source of inflation protection should be available in the plan. U.S. Treasury Inflation Protected Securities (TIPS) were first issued by the U.S. Treasury in 1997 and have since grown to an asset class with a market capitalization of $1.1 trillion4. Their principal values are adjusted for changes in the Consumer Price Index such that their interest payments also rise and fall with inflation. As obligations of the U.S. Treasury, TIPS yields are usually lower than debt that is considered to have more default risk, and their real (after inflation) interest rates can sometimes be negative. Accordingly, while TIPS may underperform inflation at times, we expect them to provide protection against inflation surprises that we would expect to negatively impact other bonds.

Capital Preservation: Stable Value
When a suitable option is available, we recommend that participant-directed plans offer a stable value fund. Stable value funds are intended to serve a capital preservation role in the plan while earning a return in excess of those available from money market funds in most market environments. This is due to their investment in longer maturity fixed-income securities than are included in money market funds, while a stable net asset value is expected to be provided from insurance company and bank wrap provider guarantees.

We believe that the role of stable value funds is primarily capital preservation and secondarily the achievement of modest yield. We recommend that plan sponsors focus on funds with conservative approaches both in their underlying fixed-income holdings and in the structure of their wrap relationships, where we prefer security-backed contracts and broad diversification among high-quality wrap providers.

Tier 3: Self-Directed Brokerage Accounts
The first two tiers offer sufficient choice for most participants to create well-diversified portfolios with risk and return expectations appropriate for their situations, without requiring overly granular decision-making. We also recognize that some participants will want access to specific strategies not included in the first two tiers, due to their confidence in a particular asset management firm, a specific market view or better fit with holdings outside the plan. We recommend that our clients’ ERISA-qualified plans offer self-directed brokerage accounts for those participants. We prefer that such accounts only allow participants to invest in pooled funds while disallowing the selection of individual stocks in order to discourage frequent trading and encourage diversification.

Considerations for Non-ERISA-Qualified Deferred Compensation Plans
Deferred compensation plans represent a mutual agreement between an employer and an employee that a portion of the employee’s compensation will be paid on a delayed basis. This profile is different from ERISA-qualified plans, where the assets are owned by the participant and the retirement investment horizon is reasonable to assume, as it is strongly encouraged by tax penalties on early distributions. Since we cannot assume that participants defer their pay into non-qualified plans to save for retirement, the investment horizon is less uniform, and we therefore recommend that participant-directed, non-qualified deferred compensation (NQDC) plans offer risk-based model portfolios rather than target-date funds as their Tier 1 investment options.

Corporate ownership of a non-qualified plan’s assets also influences the categories that we recommend for the core menu. We recommend that NQDC plans only offer participants options that may be directly hedged, meaning that the plan sponsor should be able to reduce its balance-sheet risk by purchasing an asset that will perform similarly to the return offered the participant. Since stable value funds are not available for investment by corporate assets, we recommend that participants be offered an option with as similar a risk and return profile as is available to the plan sponsor. In order to reduce the mismatch between the time that taxes on earnings are paid and the time that benefit payments are made, assets to meet NQDC liabilities are most often invested in corporate-owned life insurance (COLI) policies when the employer’s earnings are subject to taxation. For such plans, we recommend that clients offer a fixedrate account, such as an investment in the general account of the carrier that issued the COLI policy, provided that the insurance carrier is of high credit quality. U.S. equity index funds that include both mid- and small cap stocks are generally unavailable in COLI policies, so we recommend that non-qualified plans offer separate U.S. mid- and small-cap equity index funds. Last, we do not recommend that deferred compensation plans offer self-directed brokerage accounts due to concerns about participant direction of corporate assets and the costs involved with hedging participant activity within the account. Our best-practice menu for non-ERISA-qualified plans is below.

Conclusion
We are often asked by prospects and clients what our “ideal” menu structure looks like. By surveying academic papers, industry studies and our own research, we have refined our answer to that question. We also recognize that one size does not fit all. We welcome the opportunity to collaborate with plan sponsors about the ideal menus for their specific plans.

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Authors:
Ben Baldridge, CFA, CAIA, Director of Manager Research
Julie Leinenbach, FSA, CFA, Director of Asset Allocation
Newport Group
February 2017

References
1 Sethi-Iyengar, Sheena, Gur Huberman, and Wei Jiang. “How Much Choice is Too Much? Contributions to 401(k) Retirement Plans.” Pension Design and Structure: New Lessons from Behavioral Finance. Ed. Olivia Mitchell and Stephen Utkus. Oxford: Oxford University Press, 2004. 83-95. Print.
2 Capitalization of the Bloomberg Barclays U.S. Corporate
High Yield Index as of December 31, 2016, as reported by Barclays Live.
3Barclays Live.
4 Capitalization of the Bloomberg Barclays U.S. TIPS Index as of December 31, 2016, as reported by Barclays Live.

FOR INFORMATIONAL PURPOSES ONLY.
Securities and investment advisory services offered through Newport Group Securities, Inc. (“NGS”) Member, FINRA (finra.org). NGS is located at 300 Primera Boulevard, Suite 200 Lake Mary, Florida 32746. Phone: 407–333–2905. NGS and Newport Group, Inc. are affiliated entities. Any information presented in connection with this communication is general in nature and is not intended to provide personal investment advice. Before investing, please talk with your investment consultant and obtain a fund prospectus. The prospectus contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

This information does not take into account the specific investment objectives, financial situation, and particular needs of any investor. Investors should understand that statements regarding future prospects may not be realized. Past performance does not indicate future results. All investments are subject to risks, which may result
in the loss of principal.

This information is provided solely for educational purposes only and is based on information available at the time of publication. It does not consider subsequent developments that have taken place after publication. Any discussions concerning investments should not be considered a solicitation or recommendation by NGS. Any information presented about tax considerations affecting your financial transactions or arrangements is not intended as tax advice and cannot be relied upon for the purpose of avoiding any tax penalties. NGS, Newport Group, its affiliates, its registered representatives, and investment advisory representatives do not provide tax, accounting or legal advice.

An investment in a stable value fund is neither insured nor guaranteed by the U.S. government. There is no assurance that the fund will be able to maintain a stable net asset value and it is possible to lose money by investing in the fund. Stable Value Funds are not made directly available to the general public. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund. Investments in bond funds are subject to interest rate, credit, and inflation risk.

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Newport Group, Inc. and its affiliates provide recordkeeping, plan administration, trust and custody, consulting, fiduciary consulting, insurance and brokerage services. Fiduciary consulting services are provided through Newport Group Securities, Inc., an SEC-registered investment adviser and FINRA-registered broker-dealer, and InterServ, LLC, an SEC-registered investment adviser. Newport Group Securities, Inc. and InterServ, LLC are affiliates of Newport Group, Inc. All securities transactions are provided through Newport Group Securities, Inc., in its role as broker-dealer. All fiduciary consulting services are provided through the registered investment adviser. when offering variable insurance products, Newport Group Securities, Inc. acts solely in its capacity as a broker-dealer.
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