Improving Participant Outcomes Through Investment Menu Design

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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.

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Improving Participant Outcomes Through Investment Menu Design

  1. 1. Improving Participant Outcomes Through Investment Menu Design ©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
  2. 2. Scott Cameron, CFAScott is the Chief Investment Officer for the Multnomah Group and a FoundingPrincipal of the firm. In that role, Scott leads Multnomah Group’s InvestmentCommittee, is responsible for the development of the firm’s investmentresearch methodology, and conducts investment manager due diligence. Scottalso consults with plan sponsors on investment menu design, investmentmanager selection, fiduciary governance, and vendor fees/services.Scott is a member of the CFA Institute, the CFA Society of Portland, theInvestment Management Consultants Association, and the Portland Chapter ofthe Western Pension Benefit Conference.2 Improving Participant Outcomes Through Investment Menu Design
  3. 3. Agenda• Evolution of Defined Contribution Plans• Plan Sponsor Best Practices• Target Maturity Investment Products• Options for Low Risk Investors3 Improving Participant Outcomes Through Investment Menu Design
  4. 4. DC Investment Lineups: Old Paradigm• All participants are active investors• More choices lead to better portfolios• Fiduciary focus on 404(c) protection• Focus on investment products/manager analysis High Risk• Vendors compared on features Specialty Intl Equity Funds (i.e. U.S. REITs) Equity Core Bond Money Market / Stable Value Low Risk4 Improving Participant Outcomes Through Investment Menu Design
  5. 5. 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 Services5 Improving Participant Outcomes Through Investment Menu Design
  6. 6. Is the Old Paradigm Effective: the Evidence Impact of Choice on P a r t i c ip a t i on Rates Source: Iyengar, Sheena S.; Jiang, Wei; Huberman, Gur “How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans”6 Improving Participant Outcomes Through Investment Menu Design
  7. 7. Investors Fail to Track the MarketAnnualized Returns for the 20 Years Ended 12/31/201010.00% 9.14% 9.00% 8.00% 6.89% 7.00% 6.00% 5.00% 3.83% 4.00% 3.00% 2.57% 2.00% 1.01% 1.00% 0.00% Avg. Equity Investor S&P 500 Index Avg. Fixed Income Investor Barclays Agg Bond Index Inflation Source: Dalbar, Inc. 2011 Quantitative Analysis of Investor Behavior7 Improving Participant Outcomes Through Investment Menu Design
  8. 8. DC Investment Lineups: New Paradigm• Not all participants are the same• Incorporate behavioral finance knowledge into retirement programs• Fiduciary focus on participant outcomes Tier One• Focus on menu construction• Vendors compared on solutions Tier Two Tier Three8 Improving Participant Outcomes Through Investment Menu Design
  9. 9. The Paradigm is Shifting• 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”9 Improving Participant Outcomes Through Investment Menu Design
  10. 10. Plan Sponsor Best Practices Develop Fiduciary Governance Program Communicate to Analyze Employee Employees Demographics Determine Select Investment Objectives for the Managers/Products Plan(s) Select Asset Decide Investment Classes Menu Structure10 Improving Participant Outcomes Through Investment Menu Design
  11. 11. Analyze Employee Demographics• Relevant Information • Methods • Age • Anecdotal/Experience • Income • Vendor Demographic Reports • Tenure • Payroll Data • Financial Literacy • Participant Surveys • Participant Opinions • Focus Groups11 Improving Participant Outcomes Through Investment Menu Design
  12. 12. Determine Plan Objectives• 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 important12 Improving Participant Outcomes Through Investment Menu Design
  13. 13. Decide Investment Menu Structure• 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 options13 Improving Participant Outcomes Through Investment Menu Design
  14. 14. Index Tier Option• Ability to Build Globally Diversified Index Portfolio• Low Cost• Broad Diversification Asset Allocation Funds (i.e. Target Maturity, Target Risk, etc.)• Style Specific Actively Managed Funds for Active Participants• Optional Self-Directed Brokerage Core Index Funds Account for Most Active Participants Active Style Funds (Optional) Self-Directed Brokerage Account / Mutual Fund Window14 Improving Participant Outcomes Through Investment Menu Design
  15. 15. Sample Index Tier Tier 1: QDIA Tier 2: Core Index ArrayStable Principal Fixed Income U.S. Equity International Equity Intermediate Money Market U.S. Stock International Stock Bond Tier 3: Core Active ArrayStable Principal Fixed Income U.S. Equity International Equity Specialty Funds Active Intermediate Bond Large Cap Value Large Cap Growth Large Cap Value Large Cap Growth Fixed Annuity Inflation REIT Protected Bond Global Bond Small Cap Value Small Cap Growth International Small Cap Tier 4: Self-Directed Brokerage Account 15 Improving Participant Outcomes Through Investment Menu Design
  16. 16. Multi-Manager Core Tier Option• Core Array Consisting of Multi- Manager Portfolios • Money Market/Stable Value • Equity Asset Allocation Funds (i.e. Target • Fixed Income Maturity, Target Risk, etc.) • (Optional) Other Categories• Core Strategies Incorporate Multiple Sub-Asset Classes • Small Cap Core Multi-Manager Strategies • REITs • Emerging Markets • High Yield • Global Bond• Core Strategies Incorporate Open (Optional) Self-Directed Brokerage Account / Mutual Fund Window Architecture Managers16 Improving Participant Outcomes Through Investment Menu Design
  17. 17. Tier 1 – Asset Allocation Strategies • Tier 1 is Typically the QDIA or QDIA-Type Option • Target maturity or target risk Growth of Target Maturity Products $400,000,000,000 • Fund or model portfolio • Target Maturity Funds are Most $350,000,000,000 Common $300,000,000,000 • Simplicity in design $250,000,000,0005 Year Annualized Returns (Period Ending 12/31/2010) $200,000,000,000 Percentile Single Target- Managed All Other Date Fund Account Participants $150,000,000,000 Mean 3.93% 3.65% 3.76% 5th 3.62% 2.20% -0.02% $100,000,000,000 25th 3.62% 3.08% 2.66% 50th 3.90% 3.66% 3.80% $50,000,000,000 75th 3.90% 4.22% 4.64% $0 95th 4.65% 5.06% 8.09%Source: Vanguard 2011 “Participants During the Financial Crisis: Total Returns 2005-2010” Source: Morningstar Direct 17 Improving Participant Outcomes Through Investment Menu Design
  18. 18. Target Maturity Selection Criteria Investment Management Firm Capabilities Equity Glide Path Costs Asset Class Selection Portfolio Management18 Improving Participant Outcomes Through Investment Menu Design
  19. 19. Select Core Asset Classes• Objectives • Provide participants with the ability to create a diversified portfolio tailored to their specific risk tolerance and time horizon • 16 Allow participants to diversify their holdings among a number of 14 different asset classes with 12 different risk and return profiles • Utilize low correlated asset classes 10 to minimize the amount of risk at Return, % 8 any given return profile• Constraints 6 • 4 Minimize opportunity for participants to select undiversified 2 portfolios with unrealistic return 0 and risk expectations 0 2 4 6 8 10 12 Ris k (StDev Rtn), % 14 16 18 20 22 • Avoid narrowly defined “asset Frontier Cas h S&P 500 Index Small Cap Stoc ks Mid Cap Stoc ks REITs Intl Stoc ks Corporate Bonds classes” with risks that are difficult to identify19 Improving Participant Outcomes Through Investment Menu Design
  20. 20. Global Market Capitalization $31.7 Trillion as of December 31, 2011Source: 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 equal100% due to rounding. For educational purposes; should not be used as investment advice. 1. An example large cap stock provided for comparison. 20 Improving Participant Outcomes Through Investment Menu Design
  21. 21. Style Boxes ≠ Asset Classes Calendar Year Returns (2008) Large 0.00% -5.00% -10.00% -15.00% -20.00% -25.00% Mid -30.00% -35.00% -40.00% -45.00% -50.00% Small Large Value Large Blend Large Growth Mid Cap Value Mid Cap Blend Mid Cap Growth Small Value Small Blend Value Blend Growth Small Growth21 Improving Participant Outcomes Through Investment Menu Design
  22. 22. Diversification is Tricky Correlation to the S&P 500 Index (Rolling 60 Month) 1.0 Correlation 0.0 -1.0 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 Stoc ks Mid Cap Stoc ks REITs Intl Stoc ks Corporate BondsSmall 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 22 Improving Participant Outcomes Through Investment Menu Design
  23. 23. Select Investment Managers/Products• 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 Philosophy23 Improving Participant Outcomes Through Investment Menu Design
  24. 24. Manager Performance Does Not Repeat100% 90% 25% 25% 80% 35% 70% 25% 23% 60% 23% 50% 40% 23% 25% 13% 30% 20% 25% 29% 29% 10% 0% 1996-2000 2001-2005 2006-2010 Source: Morningstar; 190 funds with 15 year track records24 Improving Participant Outcomes Through Investment Menu Design
  25. 25. Communicate to Employees• Benefits • Challenges • Demonstrates meaningful choices • Standard vendor communications to participants don’t always support tiered • Minimizes “choice overload” investment menus • Simplifies participant decision- • Vendor websites are not structured making to support tiered investment menus • Tiered menu communications are usually tailored for proprietary investment products25 Improving Participant Outcomes Through Investment Menu Design
  26. 26. Low Risk Investment Options Option 1 Option 2 Option 3 Option 4 Money Money Money Stable Value Market Market Market Fund Short Term Ultra Short Short Term Government Term Bond Bond Bond Intermediate Bond Intermediate Intermediate Intermediate Bond Bond Bond26 Improving Participant Outcomes Through Investment Menu Design
  27. 27. Stable Value Funds Face Market Pressure• Consolidation of stable value • Back to the future providers • Use of more traditional • Higher costs/lower capacity will GICs/separate account GICs with continue to squeeze providers synthetic GICs portfolios• More expensive wrap insurance will bring new entrants into the market • Bundling of wrap insurance with investment management• Low interest rate environment • Increased usage of traditional GICs • Improved MV/BV ratios and separate account GICs by plan • Stable value funds have only existed sponsors 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)27 Improving Participant Outcomes Through Investment Menu Design
  28. 28. Questions?Scott.Cameron@MultnomahGroup.com(888) 559-015928 Improving Participant Outcomes Through Investment Menu Design
  29. 29. DisclosuresMultnomah Group, Inc. is an Oregon corporation and SEC registered investmentadviser.Investment performance and returns are based on historical information and are nota guarantee of future performance. Investing contains risk. Some asset classesinvolve significantly higher risk because of the nature of the investments and thelow liquidity/high volatility of the securities.Any information and materials contained herein or on our website are provided forgeneral informational purposes only and are not intended to be comprehensive forany particular subject. Multnomah Group utilizes information from third partysources believed to be reliable but not guaranteed, and as a result, information isprovided to you "as is." We do not represent, guarantee, or provide any warranties(either express or implied) regarding the completeness, accuracy, or currency ofinformation or its suitability for any particular purpose. Multnomah Group shall notbe liable to you or any third party resulting from any use or misuse of informationprovided.Receipt of information or materials provided herein or on our website does notcreate an adviser-client relationship between Multnomah Group and you.Multnomah Group does not provide tax or legal advice or opinions. You shouldconsult with your own tax or legal adviser for advice about your specific situation.29 Improving Participant Outcomes Through Investment Menu Design

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