The Art and Science of DC Plan Investment Design

Since their emergence in the 1970s, defined contribution (DC) plans in the United States have evolved. One notable change has been a shift in how they develop investment lineups for participant-directed DC plans. Plan sponsors are progressing from simply using commonly held investment beliefs to creating a structure that intentionally considers the characteristics and needs of their unique group of participants.

In this article, I outline the process for creating such a structure from an asset class perspective. A key component to thoughtful DC plan investment design is crafting a diversified investment structure before selecting specific investment vehicles.

Regulatory Foundation & Guidance for Investment Menu Structure

The Employee Retirement Income Security Act of 1974 (ERISA) mandates that plan fiduciaries act prudently and diversify the plan’s investments to minimize the risk of large losses. By providing a greater degree of asset class diversification, plan sponsors can enable more opportunities for participants who self-direct their retirement account to mitigate investment risk.

For DC plans subject to ERISA, there are several prescriptive requirements, along with a principles-based standard of care (duty of loyalty and duty of care) that plan fiduciaries must follow when building a plan’s investment structure. Even for plans not subject to ERISA, many plan sponsors consider the guidelines set forth under ERISA as best practice and choose to implement them.

Generally, ERISA section 404(c) provides DC plan fiduciaries protection from the liability for participant investment choices if they offer a minimum of three diversified investment options that bear materially different risk and return characteristics, such as equity, fixed income, and cash equivalents.

In practice, it is quite rare for an investment structure to be limited to just three investment options. This is because many investment fiduciaries believe that offering a larger, diversified opportunity set is beneficial for participants. Under the Pension Protection Act of 2006, certain pre-diversified investment options, such as Target Date Funds (TDFs), are considered qualified default investment alternatives (QDIA), which provides a safe harbor to mitigate fiduciary risk.

The US Department of Labor (DOL) provides guidance for the selection of TDFs as well as periodic reviews of continued suitability. The DOL guidance is best practice and plan sponsors should leverage it when evaluating TDF usage in their plan’s investment structure. Plan sponsors should establish a structured process that first identifies a TDF philosophy and then reviews participant demographic data, including retirees, to review and ultimately select an appropriate TDF suite. The same participant data review is also useful when assessing a plan’s core investment structure.

Beyond ERISA requirements and optional safe harbor provisions, DC plans’ named investment fiduciaries and their 3(21) investment advisors and 3(38) investment managers have wide-ranging investment structure flexibility if decisions are made in the best interest of participants and beneficiaries. Such flexibility allows for an array of suitable investment options, which can be overwhelming for plan sponsors.

Crafting a Robust Investment Structure

While the variability of DC plan participant groups’ needs and characteristics precludes a set formula of a “right” or “wrong” investment lineup design process, plan sponsors should maintain a prudent and documented selection process to satisfy their fiduciary responsibilities under ERISA.

A comprehensive design process is multi-step, demands engagement by a plan sponsor’s retirement plan committee, and is best led by a qualified retirement plan advisor who is committed to facilitating committee conversations and preparing demographic and fund utilization reviews, among other duties.

A Sample Process in Seven Steps

1. Identify a purpose & objectives statement

Identify the company’s philosophy about the DC plan’s primary purpose and objectives. Sample statements and their potential impact on investment structure:

Purpose: It is important that our DC plan reflect the company’s goal to promote a culture of “retirement environment.” This would manifest as: long employee tenure, employees who commonly retire from our company, and retirees who find it attractive to retain their DC plan accounts in the employer’s plan throughout retirement.

Potential impact: The purpose statement might suggest that plan asset classes and TDFs support a retiree’s need to diversify fixed income allocations, because fixed income typically becomes a larger portion of an investor’s portfolio near throughout retirement.

Purpose: It is important that our DC plan further the company’s goal of supporting employees as they save and invest for retirement. We observe that our company has a long history of employing mostly early-career persons, and based on past experience, we expect high employee turnover that results in few, if any, retirements from the company. When retirements occur, we observe that accounts are removed from the DC plan shortly thereafter.

Potential impact: The purpose statement might merit the inclusion of multiple equity asset classes and core or core plus fixed income because, for the non-TDF investor segment, this design would provide for adequate equity diversification, while minimizing the need to allocate to separate fixed income sub-asset classes. It also might lend itself to a TDF designed for high equity allocations early in its glide path and low-to-moderate equity allocations (relative to the TDF universe average) near the target retirement age.

2. What percent of participants are enrolled in managed account services and/or self-directed brokerage accounts?

Participant enrollment in a managed account service is typically low enough that it does not influence the plan’s overall investment structure, aside from ensuring the service’s minimum required asset classes are included. But if the managed account service serves as the plan’s QDIA, and retention in the QDIA is high, identify the asset classes the managed account provider will use and not use. Perform a cost-benefit analysis of including asset classes beyond those required by the managed service provider.

3. Develop a participant group profile to understand the plan’s investors.

A DC plan’s participant group profile should be based on demographics and investor type. Since each plan’s participant group has diverse demographic characteristics, don’t rely on participant group averages for information such as age, compensation, education level, and company tenure. Analyzing averages often fails to reflect the breadth of a plan’s unique participant group, as well as any concentrated segments that represent the largest number of participants.

When developing the participant group profile, think of what best describes the largest number of participants. Plan sponsors may divide participants into the following categories:

a. Investor type

• The “do it for me” type: Participants who elect to invest in the QDIA; any fund with broad asset allocation, such as target risk or other asset allocation funds; or a managed account service.
• The “do it myself” type: Participants who elect to invest mostly in individual asset class funds or a self-directed brokerage account.

If “do it for me” is the plan’s predominant investor type, the investment structure may or may not need to contain more than the primary asset classes depending on the profile of the “do it myself” investors. For example, if the “do it myself” investors have a high level of investment proficiency or are likely to have their own personal investment advisors, the investment structure may be justifiably more comprehensive. However, depending on the characteristics and number of the “do it myself” investors, ad hoc requests from participants for specific sub-asset class options and other investment vehicles may be best addressed by offering a self-directed brokerage option.

b. Demographic profile

• Identify the number and percent of participants by age range and investor type.
• Look for any prevalent age cohorts. Understanding the concentration in each age cohort can signal consideration for special needs.

c. Investment proficiency of non-QDIA investors

• Rank the committee’s perception of participant investment proficiency as high, medium, or low. Investment proficiency can be estimated based on how well the “do it myself” group utilizes non-QDIA asset classes. For example, is there a pattern of selecting few asset classes, and does the pattern vary by age cohort?
• It is reasonable to expect early-career participants to use fewer asset classes. For this cohort, there is likely to be a focus on equities over fixed income. It is reasonable to assume the selected number of asset classes would increase for mid- and late-career cohorts because diversification and risk mitigation tend to become more valued.
• Another way to observe investment proficiency is by using a scatter plot of participant equity/fixed income allocation splits by age, compared to a sample TDF allocation. The plan’s recordkeeper should be able to provide this information. If the scatter plot shows wide dispersion from the sample TDF allocation, it is reasonable to assume investment proficiency is likely low. A low degree of investment proficiency can influence whether the investment structure designed for non-QDIA investors can be streamlined by excluding non-core asset classes, such as commodities.

d. Downside risk tolerance

Using a similar low-medium-high rating system, gauge downside risk tolerance of the largest participant segment. Downside risk tolerance is a critical factor in intentional investment structure design and QDIA selection.

To help identify participant downside risk tolerance, plan sponsors can:

• Review recordkeeping reports of transfers into and out of investment options during calendar quarters immediately following a market downturn or large loss in a specific asset class.
• If the industry does not require post-secondary education for most employees, downside risk tolerance is relatively low and most plan sponsors will eclude asset classes subject to more frequent and significant losses. Alternatively, if advanced levels of education are required, plan sponsors may want to assume a moderate to high level of downside risk tolerance.

e. Stability of workforce

If turnover and liquidations by laid-off employees are high, it is reasonable to assume that the investment structure and any TDFs offered should lean toward a low downside risk profile.

f. Presence of a defined benefit pension plan

In addition to the DC plan, does the company also sponsor a defined benefit pension plan that it intends to keep active with continued benefit accruals? Does it provide adequate, targeted replacement income to long-term employees? If yes, does the company view the DC plan as “supplemental”? In this instance, it is reasonable to assume that the investment structure of the DC plan may be limited to broad, core asset classes.

4. Review the number of asset class options.

The number of asset classes should be informed by the plan’s purpose and objectives statement and participant group profile, rather than proactively setting an arbitrary limit on the number of asset classes. The latter action could result in plan sponsors overlooking the best interests and needs of “do it myself” investors. As the most popular QDIA, TDFs allow less engaged participants, or those with lower investment proficiency, to avoid confusion or challenges in making asset allocation decisions.

The average number of investment options has declined because participants who are less comfortable making informed investment decisions now have greater access to pre-diversified options like TDFs or managed accounts. For reference, the average number of investment options (not asset classes) offered by plans is currently 21. The three highest ranges by respondents were:

1. 1 to 15 options: 21.5%,
2. 16 to 20 options: 26.2%
3. 26 or more: 25.9% 

5. Avoid complicated investment menu design.

If the participant group profile suggests a streamlined investment structure and number of investment options, keep the following points in mind.

• Multiple investment options in the same asset classes: Offer only one option per asset class unless the options consist of an active and passive implementation.
• Global equity and fixed income: If the investment structure has separate domestic and international asset classes, global asset classes may result in unintended overlap.
• Sector, regional, and country-specific asset classes, excluding real estate investment trusts (REITs): These asset classes have greater risk exposure due to their more specific or concentrated nature and other areas of the investment structure also likely have exposure to them. Be aware that this may lead to overlap and unintentional, large allocations to specific areas of the market.
• Single-commodity asset classes: If commodities are appropriate for the plan’s investment structure, the diversification effect of including a vehicle with broad-based commodity exposure may help mitigate the risk associated with exposure to a single commodity, such as gold, oil, or small groups of commodities like precious metals.
• Target risk: Target risk funds, which maintain a fixed or limited range of equity versus fixed income, are prone to unintentional misuse by participants who remain in the same fund for longer than appropriate, rather than shifting to lower-risk, lower-equity allocation versions as their time horizons decrease.
• Money market and stable value funds: Stable value funds have historically outperformed money market funds because they can invest in intermediate-term bonds and maintain principal protection through wrap insurance. Including both money market and stable value funds can complicate participant asset movement because money market funds are deemed “competing funds” to stable value. Stable value funds do not permit direct transfers to competing funds such as money market or other low-duration fixed income funds.

6.  Review historical performance prior to asset class selection.

Review historical performance for the last 10 years of all asset classes considered for lineup inclusion to identify asset classes that are too volatile or subject to large losses. This will help the committee understand their historical patterns and magnitude of gains and losses. Focus on the largest gains and largest losses for each asset class during the 10-year period. Review the standard deviation for five- and 10-year periods.

7. Update the organization’s investment policy statement to document permissible asset classes.

Check the DC plan’s Investment Policy Statement (IPS) to confirm it expressly permits the desired asset classes. Amend the IPS, if needed, before making investment structure changes to the plan menu.

Putting the Participant Group Profile into Practice

Here are two potential scenarios and the resulting sample investment structures:

Participant Group A:

• Plan purpose statement: It is important that our DC plan supports the company’s goal of creating a “retirement environment” culture that promotes long tenure of employment with frequent retirements from our company, and for retirees to find it attractive to retain their plan accounts throughout retirement.
• Plan currently offers a managed account service.
• The “do it myself” investors represent 60% of participants. The largest age cohort is ages 50-80, and participants have a high level of investment proficiency.
• Eighty percent of retirees leave their account in the plan for the long term and take systematic withdrawals following retirement.
• The “do it for me” investors represent 40% of participants. The largest age cohort is the 21-40-year range, and participants have a high level of investment proficiency.
• The workforce is stable and not subject to periodic layoffs based on economic cycles.
• The company does not provide a defined benefit pension plan in addition to the DC plan.

Suggested asset classes:

• Domestic equity
  • Large cap: growth, core, and value
• • Mid cap: growth, core, and value
• • Small cap: growth, core, and value
  • REITs
• International equity
  • Large cap: growth, core, and value
• Fixed income
  • Stable value
  • Core intermediate
  • High yield
  • Treasury inflation-protected securities
• International fixed income
  • Large cap
• Broad-based commodities
• Asset allocation (TDFs)

Participant Group B:

• Plan purpose statement: It is important that our DC plan reflects the company’s goal of creating a culture that supports employees as they save and invest for retirement. Our organization tends to employ predominantly early career people. We expect and have historically experienced high employee turnover that results in few, if any, retirements. When retirements occur, accounts are removed from the plan shortly thereafter.
• Plan does not currently offer a managed account service.
• The “do it myself” investors represent 20% of participants. The largest age cohort is 40-45 years, and participants have a moderate level of investment proficiency.
• Plan offers a self-directed brokerage option, used by approximately half of the “do it myself” investors.
• The few participants that remain in the plan past age 65 have historically rolled over their accounts to individual retirement accounts within two years post-retirement.
• The “do it for me” investors represent 80% of participants and there are no age cohorts with a materially higher concentration than others. Participants are assumed to have a low level of investment proficiency.
• The workforce is stable and not subject to periodic layoffs based on economic cycles.
• The company does not provide a defined benefit pension plan in addition to the DC plan.

Suggested asset classes:

• Domestic equity
  • Large cap: core
  • Mid-cap: core
  • Small cap: core
• International equity
  • Large cap: core
• Fixed income
  • Stable value
  • Core plus/Intermediate
• International fixed income
  • International bond
• Asset allocation (TDFs)

Empowering Plan Sponsors

Using an informed, structured investment design process will bolster DC plan sponsor confidence that investment lineup selection decisions are tailored to the needs of most plan participants. The investment menu design process should enable the plan sponsor to feel knowledgeable about how the organization arrived at its plan’s investment structure and why, as well as provide the information necessary to document a prudent decision-making process, a key tenant of fiduciary duty under ERISA.

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