The institutionalization of defined contribution (DC) plans is gaining traction and is an excellent way for retirement plan specialists to set their practices apart.
Essentially, the institutionalization of DC plans means adopting some of the investing efficiency practices more commonly associated with defined benefit (DB) plans, as well as leading-edge best practices being used by other types of large-scale asset owners, such as insurance general accounts, university endowments and charitable foundations.
“The largest DB plans are very well run by highly expert executives who employ skillful consultants, asset managers and service providers bringing all of their professional expertise into their work,” says Randal McGathey, vice president of product marketing at Milestone Group in Boston. There is no reason why that approach cannot be adopted by DC plans, even mid-sized and small DC plans, McGathey says.
Institutionalization incorporates more diversified investment products, lower-cost products and, often, customized products tailored to the demographics of the company. It also means better risk controls; adopting DC best practices for plan design such as automatic enrollment at 6% or higher and annual escalations of 1% or more; as well as financial wellness programs to educate participants about their financial lives, holistically. All of the plan elements should be working towards the bottom line of driving better returns, higher savings and, therefore, better outcomes for participants.
Institutionalizing DC plans is a great way for advisers to differentiate themselves and achieve greater scale, says Fredrik Axsatar, global head of defined contribution at State Street Global Advisors in San Francisco. The number of lower-cost institutional funds and collective investment trusts has grown in recent years, giving “more advisers access to products used by the largest plans in the world,” Axsatar says.
Customization and diversification
“When plan sponsors transform their lineup to an institutional approach, they move from mutual funds to lower-cost separate accounts and collective investment trusts,” says Winfield Evens, director of investment strategies and solutions at Aon Hewitt in Lincolnshire, Illinois. “The assets classes tend not to change; they just move to a lower-priced vehicle. Also, the plan sponsor may rationalize the lineup by eliminating funds that have the same objective. Several years ago, a plan might have three large-cap funds, for example. Today, that’s a single fund.” (See “Streamlined, Simplified.”)
David Hinderstein, president of Strategic Retirement Group in White Plains, New York, agrees that customization is a central tenet of institutionalizing DC plans: “It’s the ability to structure price, risk and investment management to the particular demographic and plan goals, rather than using an off-the shelf investment option that was not designed for a specific situation and population. This can yield a better risk-adjusted return for the participants and, therefore, yield a more dignified retirement.”
When helping its plan sponsor clients institutionalize their retirement plans, Milestone Group is “most focused on moving from off-the-shelf products like target-date funds (TDF) toward institutionalized practices, such as a custom TDF, a separately managed account, collective investment trust or institutional share classes of mutual funds,” McGathey says. “In addition, it would likely include asset class components that are not in off-the-shelf products, such as alternatives, real estate, hedge funds, commodities and high-yield funds. Institutionalized plans move toward greater diversification, and it will be tailored to the demographics of the plan.”
In addition, portfolios may be rebalanced in a more customized manner and more frequently than in a regular DC plan, he says. Institutionalized plans “may use operational techniques that are more efficient,” he says.
North Highland’s approach to institutionalization is not to just offer institutional products but to realize that “there are different investor types and styles,” says Chad Carmichael, principal consultant at the firm, based in Charlotte, North Carolina. “It is very important for plan sponsors working with their providers to create lineups that speak to three different personas: do it yourself, you do it for me, and let’s do this together.”
For the do-it-yourself type of investor, Carmichael likes to offer self-directed brokerage windows and the ability for a participant to build a portfolio from the lineup. For those who are hands-off, discretionary offerings like a risk-based asset allocation tool or a managed account make sense. For those who want a combination, a mix of the above works, he says.
“SEI defines the institutionalization of plans as a goals-based investment philosophy,” says Joel Lieb, director of advice in defined contribution at SEI in Oaks, Pennsylvania. “Plan sponsors should be asking the question, ‘What is the end goal of our plan?’ If the plan sponsor decides that the end goal is to make sure that each participant is able to retire at 65, they should focus on the best path to accomplish that by examining plan demographics, plan design and custom investments.”
In SEI’s conversations with plan sponsors, the firm has learned that the biggest obstacle to getting sponsors to adopt institutional practices is to change how they measure the success of their plan, Lieb says. “There needs to be a fundamental change in the way plan sponsors measure the success of their plan,” he says. “They are focused on actions rather than outcomes—participation rates, deferral rates and investment returns, rather than income replacement ratios.”
This is where advisers need to incorporate financial wellness programs, which can be educational for both participants and sponsors, Axsatar says. “Financial wellness tools really help participants and help advisers differentiate themselves,” he says.
Institutionalization also means adopting the best possible plan design, Axsatar says. “You need choice architecture so that it becomes more common for people to participate in plans and save at a reasonable rate through auto enrollment and auto escalation,” he says.
It isn’t good enough to just adopt auto enrollment if you are going to defer people at a 3% savings says, says Shawn Sanderson, senior investment consultant at Manning & Napier in Rochester, New York. Thankfully, he says, “a growing number of plan sponsors are looking to default participants at a 6% savings rate. You also need to ensure that you select a qualified default investment alternative (QDIA) in sync with the participants’ needs, which you can do by looking at the plan demographics and their savings rates and loan rates.”
Ultimately, all of this translates not just to better results for participants but to better fiduciary protections for the sponsor. “The overarching benefit is for participants,” says Shelby George, senior vice president of advisor services at Manning & Napier. Through institutionalization, plans “are looking to improve outcomes both in terms of participation and savings rates and, ultimately, the performance of participants’ portfolios. The more people have accumulated by retirement, the better the outcomes. The overarching mandate for fiduciaries is to act in the best interest of participants. If plan sponsors are improving the outcomes, they are well positioned as a fiduciary.”
The biggest obstacle that SEI has found is that sponsors are worried about the work “going institutional” might entail, Lieb says. They can mitigate this by hiring a 3(38) fiduciary or an outsourced chief investment officer (OCIO), he suggests. There is also a lot of data sponsors need to analyze on an ongoing basis and to benchmark against their goals, which is where firms like SEI can help.
Sponsors also need recordkeepers that can handle complex and custom investments, as well as open architecture, McGathey says. “To service custom, open-architecture TDFs, for example, requires technology that can handle the complexity—individually, for each client,” he says. “The technology needs to be flexible, reliable, operationally secure and scalable.” Milestone Group has developed a solution for this express purpose, he says.
Likewise, Aon Hewitt is also a long-time provider of an open-architecture platform, which it developed in the 1980s, when it first began offering recordkeeping, Evens says. “Over time, more DC recordkeepers have increased their flexibility,” he says. “The real driver for that in recent years has been the pressure on plan sponsors from lawsuits; plan costs and fees are top of mind. As a result, we have seen that even providers that have traditionally not offered as much flexibility are becoming more accommodating.”
As to where the institutionalization of DC plans is headed, Axsatar says that “the next step—and a key objective we are working on with our clients—is about helping participants transition from savings to distribution through income products. Right now that is going to be led by the mega market. That will help advisers in the future adopt products and practices to help participants manage their retirement.”