Constructing More Effective Defined Contribution Investment Lineups

This paper discusses seven key best practice considerations:

1. Offer asset allocation products such as target date options as the default option.
2. Offer either a stable value or a money market investment option.
3. Consider expanding the fixed income offerings beyond U.S. investment grade.
4. Provide the full opportunity set of U.S. equities, but keep the number of options low and minimize any overlap.
5. Offer a diversified international equities option.
6. Minimize sector and other specialty investment options.
7. Consider a self-directed brokerage approach to appeal to highly engaged participants.

As defined contribution (DC) plans continue to grow in prominence as the sole retirement income source for many participants, plan sponsors are facing important decisions about how to construct lineups. Sponsors must keep in mind that their decisions can significantly affect the interests of the employee population, while also executing their fiduciary responsibilities.

Any review of a lineup should consider regulatory and fiduciary issues, cultural and employee demographics, and research and industry trends. This paper addresses each of these areas and offers seven key best practice considerations.

Given the issues discussed in the preceding sections, plan sponsors may want to consider using a “building block” approach to lineup construction (Figure 1). Start with a QDIA, such as target date options and a limited number of core options, and then potentially add a brokerage window if the plan wants to provide access to additional options. The goal of the core options block is to provide a sufficient number of choices to enable participants to construct a welldiversified portfolio while limiting overlap and unintended risk concentration.

When evaluating the following best practice considerations, keep in mind that no two plans are exactly alike. Employee demographics and sponsor goals vary, and circumstances may evolve over time.

1. Offer target date options as the default option

Target date investment options can help satisfy the needs of participants who prefer not to make their own investment allocation decisions. They allow participants access to diversified portfolios in which professional managers make strategic and tactical asset allocation decisions. They also provide broad diversification and periodic rebalancing. Of course, diversification cannot assure a profit or protect against loss in a declining market.

The asset allocation strategy and underlying investments vary among target date investment managers, and plan sponsors should be aware of their target date investment option’s approach and ensure that it matches their goals for the plan.

Within equities, the majority of target date investment options have dedicated allocations to U.S. large-, mid-, and small-capitalization stocks; developed international markets; and emerging markets. Within fixed income, most have allocations to U.S. investment-grade bonds, and some have allocations to U.S. high yield and international bonds. Additionally, many target date investment managers have been adding allocations to alternative, or nontraditional, asset classes, such as real estate, commodities, and Treasury inflation protected securities (TIPS).

Target date investments offer access to certain investments—emerging markets, real estate, commodities, and TIPS—that may not be appropriate as standalone options in a lineup due to their complexity and volatility. The advantage of gaining exposure to these types of investments via a target date investment option is that a professional manager makes the allocation decision. Most managers have target allocations that restrict the amount that may be allocated to an asset class. This generally prevents the type of performance chasing and overallocating to “hot” asset classes that can be seen in participant-directed portfolios.⁴

2. Offer either a stable value or a money market investment option.

Stable value and money market portfolios are the most conservative options offered in DC plans, as these portfolios are managed to maintain stable share prices, typically with a net asset value (NAV) of one dollar per share.

While money market and stable value portfolios share the goal of capital preservation, their underlying investments are different. Money market funds invest in short-term instruments, such as Treasury bills, negotiable certificates of deposit, municipal obligations, and both unsecured and asset-backed commercial paper. They can also encompass more complex instruments, such as repurchase agreements (repos) and dollar denominated foreign bonds. Stable value funds, on the other hand, typically invest in short- to intermediate-term fixed income securities that are insulated from interest rate movements by contracts from banks and insurance companies. The contracts generally allow price fluctuations in the underlying securities to be amortized over the duration of the contract, helping to stabilize overall returns and maintain an NAV of one dollar per share.

The difference in underlying investments for the two types of funds results in different risk and return profiles. Even though both seek to maintain a stable NAV of one dollar, money market funds are generally considered less risky than stable value funds. This is due to the shorter duration (sensitivity to interest rate changes) of their underlying investments.⁵

Larger yield premiums for stable value funds over yields on money market funds are typically associated with low- and declining-rate environments for short-term securities. As those rates rise, however, the premium may diminish. For the yield advantage on stable value funds to actually turn negative would require an exceptionally harsh monetary climate, one in which short-term rates move higher than longer-term rates quickly and stay that way over a prolonged period. Such yield curve inversions have occurred but have been rare, short-lived, and only slightly negative.

The return difference is primarily driven by the interest rate environment.Both the level and direction of interest rates will affect the return differential. Stable value funds are less interest rate responsive, but their longer duration provides return advantages in low or declining interest rate environments. Money market funds are more interest rate sensitive, allowing them to respond more quickly to changing short-term rates (Figure 2).

Plan sponsors should consider offering either a stable value or a money market investment. Since the primary goal of each is capital preservation, there is little to no diversification benefit by offering both options. Also, equity wash rules, which are contractual provisions applicable to stable value, typically require transfers that are directed to a competing option (such as a money market fund) to first be directed to a noncompeting option for a set period of time.

3. Consider expanding the fixed income offerings beyond U.S. investment grade.

While fixed income strategies play a vital role in the portfolios of millions of DC participants, a survey conducted by T. Rowe Price shows that DC plan sponsors tend to devote more attention to other aspects of their investment lineups, with equity composing the largest asset class by a notable margin.

T. Rowe Price believes strongly that both DC plan sponsors and participants could benefit from a more intensive focus on fixed income investing. The growth and development of the U.S. and global bond markets over the past two decades has produced many attractive opportunities to enhance portfolio diversification and improve yield, as well as the risk/reward profile. Yet many of these strategies remain underutilized in DC plans.

U.S. investment-grade products like U.S. Treasury and government-related securities, mortgage-backed securities (MBS), investment-grade corporate bonds, commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS) typically compose what is referred to as the “core” fixed income market.

Core funds are typically benchmarked to the Bloomberg U.S. Aggregate Bond Index, which includes investment-grade, U.S.-denominated bonds in each of these sectors (Figure 3).

Most core fixed income investments employ relative value strategies to identify the cheapest sectors and bottom-up security selection to identify securities within each sector. Other drivers of performance may include duration management (adjusting the portfolio’s sensitivity to changes in interest rates) and yield curve positioning (forecasting moves in particular parts of the yield curve).

In addition to the core sectors described previously, the fixed income market includes out-of-benchmark sectors, such as nondollar bonds, leveraged loans, TIPS, emerging markets bonds, and high yield securities. These “plus” sectors are more volatile than “core” sectors and will have periods of extreme outperformance and underperformance, which could make them problematic as standalone options.

However, after taking a careful look at plan demographics, as well as changesin participant behavior, risk preferences, and engagement, plan sponsors may want to consider offering a few select core-plus options.

For example, the plan lineup might include a supplemental “plus” investment that provides broad exposure to domestic bond markets along with select exposure to high yield, nondollar, and emerging markets bonds on an opportunistic basis.

Alternatively, sponsors may want to consider adding a diversified global multi-sector bond option as a complement to a core offering. This would allow participants to gain exposure to broader fixed income sectors without adding standalone niche offerings such as individual international bond or high yield options.

4. Provide the full opportunity set of U.S. equities, keeping the number of options low and minimizing overlap.

The U.S. equity market is typically the largest segment of DC participant portfolios and therefore poses a larger set of decisions for plan sponsors. U.S. equities are commonly divided into nine subcategories based on market capitalization and investment style (Figure 4). Each subcategory has its own risk/return profile and generally can be expected to perform differently during various market and business cycles. The goal is to provide participants adequate exposure to the full opportunity set. How a sponsor chooses to accomplish this will vary.

5. Offer a diversified international equities option.

International equity markets have grown over time and now compose about 40% of the world’s market capitalization. This means that the asset class is becoming an increasingly important part of a welldiversified participant portfolio.

Recognizing the growing opportunity set outside the U.S., the 401(k) industry has increased its attention on international options. A number of plan sponsors have expanded their international offerings beyond the typical broad-based options to include those that are style-specific (growth and value), market cap focused, or dedicated to emerging markets.

While these offerings have investment merits, plan sponsors need to balance the benefits with the potential difficulties. Will participants have the ability to utilize the options appropriately? Will they understand the risks? Will the increased number of options cause confusion?

Plan sponsors who determine that the benefits outweigh the difficulties and decide to offer multiple international options should:

1. Avoid overlap with the plan’s other international options.
2. Provide additional education on the options’ differing risk/ reward profiles.

Education is crucial when adding dedicated emerging markets and small cap options, which are traditionally more volatile.

Plan sponsors who are not comfortable with the difficulties of adding more international choices should consider offering a single diversified international option. Preferably, the option would have a dedicated portion of its portfolio in emerging markets as those markets continue to grow and become a larger part of the global capital markets. Through this one international option, participants will have sufficient access to the benefits of international equities but without the confusion of multiple choices.

6. Minimize sector and other specialty investment options.

The objective of a sector fund is to invest the majority of assets in a single sector of the economy, such as technology, energy, or real estate. While these sectors can have high return potential, they are generally more volatile than the broad market due to their concentrations. Many have wide swings in performance that can result in large participant flows in and out. The same is true of specialty strategies like gold and precious metals.

A number of plans have recently added inflation-hedging options that focus on real estate, commodities, infrastructure, and TIPS. While these investments—as well as other sectors and specialties—have merits, providing them as standalone options may not be the best way to provide access in a retirement plan.

The concern is that participants will misjudge the risks associated with these funds and overallocate to them, resulting in undiversified portfolios with large unintended levels of risk. It is better to allow participants exposure to the various sectors of the economy through diversified funds. This way, professional managers are deciding the sector and specialty allocations and generally limiting sector concentrations.

7. Consider a self-directed brokerage approach to appeal to highly engaged participants.

The final block of the plan lineup is the self-directed brokerage option. This provides access to additional investments for more sophisticated investors while reducing the number of options that might confuse or increase allocation risks for less sophisticated investors. Those participants who want dedicated allocations to sector or regional funds can find those via the brokerage option.

Plan sponsors may want to limit the brokerage window to only mutual funds, since individual securities introduce new levels of risk for participants. This capability to limit the access may not be available through every service provider. Offering a brokerage window may result in additional fiduciary oversight obligations, and so, as with all potential lineup enhancements, the pros and cons must be thoughtfully considered.