Randal McGathey, Multi-Asset Product – North America, Milestone Group
Once little more than a conceptual goal, ‘institutionalization’ is now rapidly becoming the central guiding principle of product development in defined contribution (DC) investment. Institutionalization means ensuring that the standards of DC investment options are raised to be in line with the best practices of institutional investors. Among other things, this includes advanced portfolio design and implementation, as well as rigorous ongoing evaluation and control.
These advanced practices were (and still are) developed by and for sophisticated institutional investors, including some of the largest and most innovative pension plans and endowments in the world. While such approaches have become routine for these investment professionals, they are beyond the reach of most others, including DC plan participants who do not have the expertise to navigate their complexity, nor the scale to justify their cost.
Historically, DC plans have typically been judged on how many investment options they offer to participants. However, many participants lack the knowledge of how to construct a portfolio that balances risk and return, in which case a longer list of investment options only serves to increase the potential for a suboptimal return outcome.
Huge efforts have been made to educate participants in this regard, and the situation has improved significantly as a result. But education only tackles one side of the equation – the investor. Even greater improvements can be achieved by rethinking how the investment products themselves are designed and run.
This switch in focus lies at the heart of institutionalization – instead of focusing squarely on giving individual participants control, the focus is instead on outcomes. Outcome-based solutions are designed and run according to the aforementioned institutional best practices, in order to optimize risk, return and cost. But this is all easier said than done: complexity remains the main barrier to widespread adoption of these practices.
The disparity between institutional and DC investors has already been bridged to some extent by the proliferation of Target Date Funds and other similar ‘off the shelf’ multi-asset managed allocation products. These employ basic portfolio diversification and asset allocation principles, and adjust over time for the investor’s expected capacity for risk. They have improved matters significantly, but many of them are not truly institutional. Advanced portfolio administration practices and value adding asset classes (such as alternatives) are often omitted from many of these products because of their complexity and cost.
This gap – between off-the-shelf products and what could be achieved for retirement investors – will only broaden as research improves our understanding of those investors’ behavior and requirements. More and more solutions will be fine-tuned to increasingly specific cohorts of investors, a development foreshadowed by Custom Target Date Funds.
Also fundamental to the principal of institutionalization is rigorous management of cost and performance. Investment management expenses can be driven down for DC investments through use of institutional investment products such as separately managed accounts, collective trusts and/or institutional share classes of mutual funds. Costs can be further controlled through competitive bidding, and then performance monitored and managed by rigorous and disciplined ongoing review.
These two abilities – to include any investment product type and select any combination of providers – are referred to as ‘open architecture’. These provide value, but, once again, for the trade-off of increased complexity. Custom Open Architecture Target Date Funds are the current state-of-the-art in the context of the institutionalization of DC investments.
It is clear that as the institutionalization of DC investment options continues, they will become increasingly complex, requiring technology platforms that are more flexible and scalable. However, this poses something of a dilemma. Typically, as process flexibility increases, process reliability diminishes, and as process reliability increases, process flexibility is constrained; an increase in either limits scalability and an increase in both can bring innovation to a dead stop.
Nevertheless, this opportunity demands a response. Plan sponsors, asset managers, consultants and service providers will discover more effective ways to implement and operate these high-value investment options. Their search will lead them away from legacy technologies and operating models, toward specialist providers that offer advanced platforms that are purpose-built for the task of managing complex investment structures.
Randal McGathey is Milestone Group’s multi-asset product leader for North America.