Target-Date Strategies

Target-date strategies are also known as life-cycle, age-based, or dynamic-risk strategies. They generally follow a glide path that reduces risk as a participant gets closer to retirement age; Figure 3.1 shows how a glide path may be structured over time to move from growth assets to capital preservation assets, with allocations changing as participants age and move closer to retirement.

Typically, these funds are offered in 5- or 10-year retirement year vintages (e.g., 2050, 2045, and Income funds for those near or at retirement). As the QDIA, participant assets generally are defaulted to the target date based on the participant’s expected retirement date. For example, a 30-year-old participant may be defaulted into the 2050 fund assuming a retirement age of 65. These strategies are used in many markets although their asset allocation structure may differ significantly. For instance, in the UK the National Employment Savings Trust (NEST) offers single-year target-date funds that manage investment risk over three phases throughout members’ savings careers. When members join NEST, their contributions are invested by default into a NEST Retirement Date Fund unless they make an active investment choice of a different fund. The default single-year Retirement Date Fund will match either their State Pension age or age 65, depending on their date of birth. Each of the three phases sets allocations to both growth and income-seeking assets in varying proportions to meet the different objectives throughout members’ time savings (Figure 3.2).

In Morningstar’s 2016 “Target-Date Fund Landscape” research paper, lead authors Jeff Holt and Janet Yang comment:

Target-date funds continue to play an increasingly crucial role in delivering successful retirement outcomes for investors. Target-date fund assets have grown from $116 billion to $763 billion in the past 10 years, as the retirement landscape has shifted to defined-contribution over defined-benefit plans. However, target-date series often vary significantly from one another, as managers impart their different philosophical approaches to balancing risks and implementing their asset-allocation decisions, among other factors. These differences may cause investors’ results to diverge, and target-date funds’ relatively short history combined with their decades-long investing horizons can muddle the assessment of those results. Still, the U.S. Department of Labor stressed the importance of evaluating target-date series in its “Target Date Retirement Funds—Tips for ERISA Plan Fiduciaries.”²

Target-date strategies are offered as mutual funds or collective investment trusts (CITs), or they may be customized using separate accounts. In Chapter 4 we will consider the DOL’s “Target-Date Retirement Funds—Tips for ERISA Plan Fiduciaries” and will delve into the types, structures, and considerations for target-date strategies.

Balanced or Target-Risk Strategies

Many plan sponsors and consultants prefer offering a single balanced fund or a series of funds that target a specific risk level. For instance, they may offer a set of three: a conservative, moderate, and aggressive fund. This target-risk series also may be referred to as lifestyle funds. (Note: this label may be confusing as in the UK they call target-date-like strategies that modify risk over time “lifestyling.”) Plans that offer these types of strategies may believe it more appropriate to default participants into a risk level that will not change over time—they may believe that the participant is the one who should decide whether they should change their risk by moving their assets to a different fund or creating their own asset allocation. While this group often views target-date strategies as too paternalistic, they are in the minority. The majority of plan fiduciaries have moved away from defaulting to balanced or target-risk strategies as they worry participants may take on an inappropriate level of risk given their time horizon for investment.

Over the past decade, plans that offer target-risk or balanced funds increasingly have migrated to target-date funds. PIMCO’s DC Dialogue in October/November 2013 spoke with Sharon Cowher, Director of Trust Investments, and Christine Morris, Assistant Treasurer at Halliburton, about how to evolve from custom target-risk to custom target-date strategies. They explained:

We had four risk-based funds, with the moderate risk-based fund serving as the default fund. Because it had a substantial amount of assets, we did consider whether or not to offer both target-date and risk-based options, but decided that it would be too confusing.

To gain confidence with the decision to eliminate the target-risk strategies, we evaluated whether participants in these strategies changed their asset allocation over time. Not surprisingly, we found a high level of inertia. The default allocation was approximately 60 percent equities and 40 percent bonds. When we looked at our population by age bands in 10-year intervals, we found the vast majority stayed in the default strategy. This was true until we looked at participants over 50 years of age.

Target-risk funds require action by the participant, because the risk of a moderate fund always stays moderate and the aggressive fund always stays aggressive, etc. What we saw, based on the asset allocation of our participants, is they aren’t taking action until they were in their 50s.

And then, when they did change, they swung it too far on the conservative side—often fully to stable value.

While rare, some plans offer participants both target-date funds as a default and target-risk funds as a core investment option. The 2015 survey from the Plan Sponsor Council of America (their 58th Annual Survey of Profit Sharing and 401(k) Plans, reporting on the 2014 plan year experience of 592 companies) shows that while only 16 percent of plans offer target-risk/lifestyle funds, 56 percent offer a balanced or asset allocation fund. Consultants in PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey said they expect growth in the custom target-risk/balanced category; this growth expectation may be surprising given the shift from target-risk to target-date offerings. We believe that for many plans, the increase in balanced offerings may reflect the addition of a single balanced strategy such as a global tactical asset allocation (GTAA) strategy. Nearly two fifths of consultants (39 percent) recommended the addition of such strategies as a core investment option, while even more (61 percent) suggested adding GTAA to a blended strategy (i.e., multimanager/white label or in a sleeve of a custom target-date/risk portfolio). We will return to the topic of how GTAA strategies may fit into plans in Chapter 9 when we consider additional strategies, including alternatives.

Managed Accounts

In PIMCO’s 2015 Defined Contribution Consulting Support and Trends Survey (referencing 2014 data), 60 percent of consultants showed support for managed accounts as an opt-in choice, but few (7 percent) supported them for the QDIA or opt-out option (note: this dropped to zero in the 2016 survey). Consultants shared various concerns about managed accounts, including the additional cost versus the potential alpha (the excess return over a benchmark) available, the appropriateness and relative impact of personalization factors, the inability to use multiasset portfolios, and biases toward or away from active management and diversifying asset classes.

While assets overseen within U.S. managed-account programs now exceed $150 billion, plan fiduciaries also raise concern about how best to benchmark these strategies. The importance of evaluating these strategies was noted in a June 2014 report by the U.S. Government Accountability Office (GAO) entitled “401(k) Plans: Improvements Can Be Made to Better Protect Participants in Managed Accounts.”³ In PIMCO’s February 2015 DC Design article, DC experts Steve Ferber and Michael Esselman shared both the need for and approach to benchmarking managed accounts:

The GAO report stated that plan sponsors often have had limited or insufficient information to evaluate potential providers and monitor ongoing services. Importantly, the GAO also noted that participants face similar challenges. The good news is that these challenges can be overcome. Providers typically disclose basic aspects of their offerings, such as fees and service levels. And when advice providers disclose details of their methodology, the evaluation can be fairly straightforward.

Interest in managed accounts is expected by many to increase over time as improvements are realized in technology, cost efficiencies, participant engagement, and benchmarking. Yet, the majority of interest may come from those who opt-in rather than default into this option. Also worth noting as the managed-account market develops is the rise of robo-advisors, online wealth management services that provide automated, algorithm-based portfolio management advice, including for DC plans. While the robo-advisor offering is still new and developing, some observers expect that robo-advisor offerings and approaches will increasingly be integrated into managed account offerings, meaning plan participants may come to rely on a mix of managed and robo account services.

DC Plan Investment Choices: Farewell to Company Stock?

Plan fiduciaries often ask how to manage company stock in the core investment lineup. Plans that do not offer company stock are unlikely to add this option, given the risk that participants may overallocate to an undiversified security, plus the added risk of being overexposed to that company—for instance, if the employee is laid off and the value of the stock falls at the same time. That’s a double whammy fiduciaries try to avoid. Given this risk and company stock litigation, fiduciaries are wise to not add company stock to a DC plan. For plans that offer stock, fiduciaries consider how best to manage this risk.

The Plan Sponsor Council of America’s 58th Annual Survey of Profit Sharing and 401(k) Plans reflecting 2014 plan experience found that 19.0 percent of all plans make company stock available as an investment option and 16.0 percent of all plan assets are invested in this option. Company stock is most prevalent among the largest plans (5,000+ participants) where 43.8 percent of plans make the option available and 17.2 percent of plan assets are invested. About a third of plans (30.4 percent) limit the amount of plan assets that can be invested in company stock, while over a third (36.7 percent) make contributions in company stock. Among plans that offer company stock, 42.1 percent of them have less than 10 percent of plan assets invested in the stock, while 6.6 percent of plans report that more than 50 percent of plan assets are invested in company stock.

In 2014, we sat down with James O. Fleckner, Partner and ERISA Litigation Practice Leader at Goodwin Procter LLP, to talk about defined contribution litigation, how plan sponsors reduce the risk of litigation, and how company stock fits into DC plans.

According to Fleckner, there are two primary DC litigation areas: first, lawsuits involving fees, and second, cases involving company stock, which often relate to a drop in the stock price and are thus referred to as “stock-drop” cases. In order to protect themselves against lawsuits, Fleckner comments:

Plan sponsors should understand and fulfill their fiduciary duties. These include the duties of loyalty, prudence, diversification, and fidelity to plan documents. Loyalty focuses plan sponsors on doing what is in the best interest of participants, rather than on what may be of value to themselves or their company. We’ve seen this duty raised in cases that have alleged that the plan fiduciaries cared more about saving money for the company than they did about doing what was right for the participants.

Stock-drop lawsuits arise when a company DC plan includes company stock, which then drops in value. Most often, claims in these cases allege imprudent selection and maintenance of a sponsor stock on a 401(k) lineup, improper monitoring of other fiduciaries and investment options, and concealment or misrepresentation of material facts. In 2014, a Supreme Court decision on a stock-drop case was issued in Fifth Third Bancorp v. Dudenhoeffer, which was about offering company stock to DC plan participants.

Fleckner told us that the best litigation defense against a stock-drop case is “having a documented, conscientious process for evaluating company stock. Process is an important defense for fiduciaries. Documentation should reflect the deliberation and process followed by the fiduciaries in making a decision about company stock. With the Supreme Court saying, in the Fifth Third case, that prudence trumps the plan document, a plan sponsor would not have a complete defense to a stock-drop suit in saying that ‘I just followed what the plan said.’ ”

Companies may also want to consider hiring an independent fiduciary to oversee the ongoing evaluation of the stock and its appropriateness for the plan. Unlike other investment options in the plan, company stock has no obvious benchmark. Hiring an independent fiduciary allows a disinterested professional to evaluate the stock, and it eliminates the concern with inside information. It is important to note, however, that courts have also said that a plan sponsor who has some fiduciary responsibility under a plan document cannot fully offload its responsibility by hiring an independent fiduciary. Instead, the sponsor would likely still need to evaluate, hire, and monitor the independent fiduciary’s work.

The issue or risk of company stock in DC plans can also be seen when the stock is removed from the plan. Comments Fleckner, “We have seen stock-drop cases alleging that the plan sponsor forced the participants to sell and forced them to lock in losses, claiming that the participants were robbed of a future increase in the stock’s price.”

Reduce Company Stock Exposure with “Sell More Tomorrow”

Plan fiduciaries often ask how they can help reduce participants’ allocation to company stock. As noted above, about a third of plans may limit the percentage of assets that may be allocated to company stock. Others may consider ways to help reduce the stock allocation over time. One idea from behavioral economists is to implement a dollar-cost averaging way to slowly sell out of company stock over time.

In PIMCO’s June 2007 DC Dialogue, and updated at the time of writing, University of Chicago Professor Richard Thaler told us about the work he had been undertaking in this area with his fellow behavioral economist colleague Shlomo Benartzi, at the UCLA School of Management. In particular, Dr. Thaler told us that “plan sponsors who find that participants have high concentrations of their retirement wealth invested ought to work on reducing that.” He added, however, that many plan sponsors are reluctant to announce a major sell-off of their stock by employees, either because it appears to show a lack of confidence in the stock or employees might complain if the timing were unfortunate. “That is why I think the best approach is to help participants reduce their positions in company stock gradually,” he noted. He explained:

To address this, Professor Shlomo Benartzi and I have come up with the program “Sell More Tomorrow.” We’re looking for a plan sponsor willing to try the approach. The idea is gradually to sell off stock automatically over several years until the participant divests down to a reasonable holding—say, a 10 percent cap. The money earned by selling company stock would be invested in the firm’s default investment fund (unless the employee chooses something else).

This plan addresses plan sponsors’ concerns of a sudden sell-off, as well as the fear that removing it from the plan sends a negative signal about the stock. We suggest sponsors implement Sell More Tomorrow as an opt-out. Given a gradual stock sell down, people won’t worry about divesting at exactly the right or wrong moment. Rather, they benefit from dollar-cost averaging. Effectively, this can reduce the risk of holding a single security and prevent the unfortunate situation we saw at Enron.

As plan fiduciaries decide how best to address company stock issues, they may be best advised to seek assistance from ERISA counsel.

Evolution of Investment Menu Design

With balance in mind, many plans have migrated from a style box approach to an asset class or even an ultra-simplified risk pillar approach, in which the primary driver of returns is identified. As shown in Figure 3.8, the number of diversifying asset classes increases, yet the number of choices decreases as the menu shifts from the style-box focus to an asset-class focus and finally to a risk-pillar approach. In considering the approach to offer, plan fiduciaries may ask, “If a participant allocates evenly across the core investment lineup, what portfolio would result?” Then, the fiduciary can consider the risk and return characteristics for this naive diversification portfolio.

Comparing the three approaches on a naive diversification basis gives us the following characteristics as shown in Figure 3.9. As you can see, in the hypothetical example risk-adjusted returns improved as core lineup design moves from the style-box focus to an asset-class focus and then to the risk-pillar focus. While the risk-pillar shows lower return at 3.63 percent, volatility is also significantly lower at 7.71 percent. Notably, the risk of loss dropped in half from 21 percent in a single year to 10.51 percent. Also, you can see the lower correlation to the equity markets in the risk-pillar approach.

Active versus Passive Approaches: DC Consultants’ Views

Once the number and types of investments are identified, plan fiduciaries may then consider whether each investment choice should be actively or passively managed, or rely on a blend such as multimanager or white-label approaches. Data from the PSCA (2014), shown in Figure 3.10, shows that plan sponsors commonly offer both active and passive investment choices. While 77.7 percent of plans offer passively managed equity such as the S&P 500, only 53.9 percent of plans offer passively managed fixed income. This difference is partly explained by relative performance: The median active intermediate U.S. fixed income manager has historically outperformed the benchmark (i.e., the Barclays U.S. Aggregate Bond Index), whereas the median active U.S. large blend manager has failed to beat the S&P 500 Index benchmark.

Looking specifically at investment choices for fixed income, there are many reasons that passively investing in fixed income is suboptimal and must be differentiated from equity index investing. In a 2014 PIMCO Viewpoint by James Moore, PhD, titled “Sorry, Mr. Bogle, But I Respectfully Disagree. Strongly,” Moore summarizes five reasons why, in his view, active bond investing should be viewed distinctly from passive equity investing. These are: the variety of investor objectives other than maximizing total return, the mechanics of bond index construction, the importance of the new-issue market for bonds, the predominance of over-the-counter transactions, and the highly skewed returns on individual bonds versus stocks.

Consultants agree with Dr. Moore on the importance of actively managed fixed income globally. As shown in Figure 3.11, nearly all of the consultants (98 percent) surveyed in 2015 believe it is very important or important to actively manage non-U.S. bonds, while 92 percent believe the same for U.S. bonds. Notably, the majority of consultants also say active management is very important or important for emerging-market and small-cap equity as well as target-date, balanced strategies, commodities, and real estate investment trusts (REITs); however, the group views active management of TIPS and U.S. large-cap equity as less important. This data underscores the importance of including active management among the core and particularly within the default investment strategies, for example, target-date funds.

Consultants also shared their views on which asset classes should be active only, passive only, an active/passive blend, or provide multiple active and passive strategies or mirrored active and passive (e.g., a large-cap passive and a large-cap active fund). As show in Figure 3.12, the majority of consultants (80 percent) recommend active only for capital preservation. In fact, not one suggested passive only for fixed income, and instead over a third (37 percent) recommend active only while another 25 percent suggested a blend. These responses were similar for equity and inflation-protection assets; the majority suggests either a blend or multiple active and passive equity options, while over a third suggest active only for inflation protection (37 percent) or an active/passive blend (42 percent). Notably, a fifth or fewer of the consultants suggested offering a mirror of active and passive fixed income or equity choices.

Active versus Passive: Reduced or Heightened Litigation Risk?

Plan fiduciaries often ask whether they may be more insulated from litigation if they offer passively managed index funds, versus actively managed investments. ERISA attorneys tell us that plan sponsors should focus on prudent choices with “reasonable”—not necessarily the lowest—fees. Plans are not required to offer passively managed or the cheapest investment choices.

In the October 2014 PIMCO DC Dialogue, ERISA attorney James O. Fleckner told us that “the focus in the cases challenging investment management fees is usually on the fund itself, not necessarily on whether it is actively or passively managed. At the same time, fiduciary committees may have specific views about whether active management is worth the additional cost; and may decide that active management is the best way to allow participants to maximize outcomes and minimize downside risk, or that participants should be given a choice between active and passive investing. Those all seem to me to be perfectly defensible decisions,” comments Fleckner, “and judges [in lawsuits arising on investment management fees] typically do not like to second-guess informed fiduciaries.”

The DOL requires plan fiduciaries to understand plan fees and expenses. In support of this outcome, the DOL has published a guide, Understanding Retirement Plan Fees and Expenses (available online at the DOL website at www.dol.gov) to help plan sponsors understand their responsibilities. The guide explains why to consider fees:

Plan fees and expenses are important considerations for all types of retirement plans. As a plan fiduciary, you have an obligation under ERISA to prudently select and monitor plan investments, investment options made available to the plan’s participants and beneficiaries, and the persons providing services to your plan. Understanding and evaluating plan fees and expenses associated with plan investments, investment options, and services are an important part of a fiduciary’s responsibility. This responsibility is ongoing. After careful evaluation during the initial selection, you will want to monitor plan fees and expenses to determine whether they continue to be reasonable in light of the services provided.

There are many types of fees that may be imposed within plans. The DOL outlines three categories for plan sponsors to consider: plan administration such as recordkeeping, investment fees generally charged as a percentage of assets, and individual service fees such as loan initiation. Investment fees tend to be the largest percentage of total plan fees; it is important to evaluate and confirm that the fees are reasonable for the value of the management. Evaluating value, in turn, should take into consideration both the opportunity to deliver returns as well as to manage risk. Plan sponsors should use their buying power to get the best price for the investment strategy and structure desired. The larger the plan assets, the greater the buying power. Plans with sizable assets may seek institutionally priced vehicles, including institutionally priced mutual funds, collective investment trusts, and separately managed trusts.

Plan sponsors can also work to leverage the organization’s buying power to add investments with the highest perceived value at the lowest price. In PIMCO’s March/February 2015 DC Dialogue, we spoke with Cindy Cattin, Managing Director of Investment Operations and Risk Management at Exelon Corporation, about how Exelon used the scale of their $35 billion retirement and other assets to drive down DC investment costs:

We have the processes and procedures in place to identify best-in-class managers, and we have the scale to drive down cost. . . . We believe that over a market cycle, best-in-class active management will outperform passive management. We believe the investment management fees are worth it given the opportunity for improved risk-adjusted returns of active managers. Despite our belief in active management, we acknowledged that some participants prefer passive management and value the lower cost of this approach. That recognition drove us to offer both active and passive choices in the core.

We spent a lot of time educating our participants on the changes and the cost differences. We explained the difference in active and passive management as well as the fees. We also showed them a comparison of costs they might incur in the retail market relative to our plan. They could see the significant cost savings our plan offers. Again, leveraging our scale drove down our costs, and we made sure participants understood that advantage.

For plan fiduciaries who select passively managed investments, there’s more work to do than simply comparing fees. Josh Cohen, CFA, Managing Director, Head of Defined Contribution at Russell Investments, comments in a January 2016 “A Conversation” article, “Going Passive Is Still an Active Decision”:

I’ve observed some sponsors pick passive investments based on the belief it can reduce fiduciary risk and due diligence requirements and obligations. But, there are still a lot of active decisions being made when passive investments are implemented, and thus meaningful due diligence requirements remain. We have identified eight of them here.

1. Review the index provider’s organization
2. Review the index provider’s methodology
3. Review the passive fund manager’s implementation quality
4. Review the fund manager’s ability to replicate the index and the costs to do so
5. Review the fees charged by the passive fund provider
6. Determine whether active management opportunities might be more prudent
7. Review Target Date Fund glide path methodology^*
8. Review Target Date Fund asset allocation^*

• ^*Additional considerations for Target Date Funds.

For a detailed look at each of the above decisions, see the November 2015 guide provided by Russell Investments on their website (at www.russell.com/institutional) called “Passive Management and the False Premise of Fiduciary Relief: Going Passive Is an Active Decision,” by Josh Cohen and Kevin Knowles. The Russell Investments January 2016 piece also points out:

One of the most important things to remember is that low fees don’t necessarily translate to better outcomes for participants. Passive funds with low cost have opportunity costs—that’s the cost of giving up potentially higher returns that active management aims to provide for some asset classes. For example, there could be a fairly significant wealth differential if participants’ actively managed funds generated 50 basis points more per year than their passive counterparts, compounded over a 40-year working career. Our analysis finds it could generate up to seven years of additional spending in retirement.

One consideration that may significantly influence fees is the investment structure selected. Plan fiduciaries should understand the alternative structures.

Investment Structure: Mutual Fund, Collective Investment Trust, or Separately Managed Account

In general, DC plans tend to invest in investment structures that pool the assets of many investors. Mutual funds are the most prevalent investment-pooling vehicle used within both DC and retail individual retirement accounts (IRAs). Each investor in a mutual fund owns shares of the fund that represents the mutual fund’s holdings. Mutual funds typically offer many share classes for different types of investors and fee arrangements. They may carry sales charges, including front-end or back-end loads and ongoing sales fees labeled “12(b)1” fees. Large DC plans tend to seek funds that carry no sales charges; rather, they seek the lowest-cost, institutionally priced share class that covers the fund’s management and administrative fees.

Unlike retail retirement accounts such as IRAs, ERISA plans including 401(k)s have the ability to invest in bank- or trust company–managed trust funds; these include collective investment trusts (CITs) and separately managed trusts. Similar to a mutual fund, a CIT pools investments of tax-qualified assets such as DB plans, profit-sharing plans, government employee benefit plans, and again 401(k)s. (Note that non-ERISA plans such as 403(b)s and endowments/foundations are generally excluded from participating in CITs.)

Each CIT investor has a proportionate interest in the trust fund assets. For example, if a collective investment fund holds $10 million in assets and your investment in the fund is $10,000, you have a 0.1 percent interest in the fund. As with mutual funds, collective investment funds may have a variety of investment objectives. There are no front- or back-end fees associated with a collective investment fund, but there are investment management and administrative fees. As shown in Figure 3.13, CIT fees may be considerably lower than mutual fund fees, yet this is not always the case—so each available investment structure should be considered. Notably, CITs allow investment managers to vary their fee based on account size; this is not the case for mutual funds which hold the management fee constant, but may vary the distribution, operation and, other costs. The Callan Investments Institute estimates that 70 percent of DC plans offer at least one CIT-structured investment choice. Assets in CITs in 2015 were estimated to exceed $2.3 trillion according to the Coalition of Collective Investment Trusts.

While operationally CITs and mutual funds function similarly, there are other considerations for CITs relative to mutual funds. Most importantly, there is a difference in the regulatory oversight of mutual funds, which are registered with the Securities and Exchange Commission (SEC) and follow SEC rules and guidelines; whereas CITs are regulated by banking authorities; for federally chartered banks, by the Office of the Comptroller of the Currency (OCC), an independent bureau within the United States Department of the Treasury; and for state banks, by the state banking authorities (which largely defer to the OCC rules). Notably, CITs are subject to ERISA law while mutual funds are not. DOL, IRS, and potentially Commodities Futures Trading Commission (CFTC) rules/law also apply. To participate in a CIT, the plan fiduciary must adopt the terms of the CIT through the execution of a participation or joinder agreement. This requirement does not exist for mutual funds. Given these different governance structures, trading restrictions, redemption fees, and SEC 22c-2 regulations (which govern specific mutual fund redemption fees) do not apply in CITs as they may for mutual funds.

For more information on CITs, readers may want to visit the website of the Coalition of Collective Investment Trusts website (www.ctfcoalition.com).

Another type of trust structure that large plans may consider is a separately managed trust or separate accounts. This type of offering allows the plan to tailor the investment guidelines of the fund, and not pool assets with other investors. Separate accounts may pool both ERISA DB and DC assets via a master trust arrangement, thereby gaining pricing and oversight advantages for both plans. Typically, fees for separate accounts are on a sliding scale, declining as assets grow. These fee schedules often level off at around $300 million in assets under management, according to the Callan Investments Institute. Keep in mind that investment management fees are just one component of separate account costs; additional fees for trust services or other costs may range from four to over ten basis points.

Understand Revenue Sharing: Consider Paying Administration and Other Plan Fees

For plans that select mutual funds, they need to carefully consider the share classes available and whether revenue sharing, which is commonly used to help offset recordkeeping or other plan costs, is offered. Revenue sharing may be available from mutual fund share classes that include fees such as distribution 12(b)1, subtransfer agency, shareholder servicing, profit-sharing payments, or other fees. The DOL refers to these fees as indirect payments. Note that plaintiff attorneys may often view revenue sharing as padding a mutual fund’s expense ratio with general plan administration, marketing, and other noninvestment-related fees, then passing these expenses to participants—often without ensuring they understand the costs.

Mutual funds typically offer a range of share classes that may or may not offer revenue sharing. For instance, a Class A share class may include a 12(b)1 fee based on a percentage of assets (typically 0.25 percent, paid annually by investors). Alternately Class R, also known as retirement-class shares, may include, for example, an administrative services fee of 25 basis points; this fee income, based on DC assets allocated to the funds, is often shared directly with the recordkeeper to offset the cost of services. For instance, if recordkeeping costs total $500,000, this cost may be reduced by the revenue sharing from funds (e.g., $100 million invested with 0.25 percent revenue sharing provides $250,000 in revenue, thus reducing plan fee costs by 50 percent).

Mutual funds often offer Class I shares, also known as institutional-class shares, typically available only to institutional investors making large fund-share purchases. With minimum investments often of $1 million or more, this class of shares is out of reach for most retail investors—but not DC plans. By pooling the assets across participants, the DC plan may thus offer these institutional share classes to all participants regardless of their individual DC account balances. What plan sponsors need to be wary of, however, is whether revenue sharing is attached to these share classes; while they are institutionally priced, they may nonetheless include a small amount of revenue sharing (e.g., 15 basis points or less) to recordkeepers or others. In 2012, Congress enacted fee disclosure requirements with ERISA 408(b)(2). These rules support a plan sponsor’s ability to gather and evaluate all fees and revenue-sharing arrangements. In fact, 408(b)(2) made it clear that plan fiduciaries have a duty to monitor and control service provider fees.

While revenue sharing may appear attractive, plans increasingly are moving away from any revenue-sharing funds, seeking rather the lowest cost for investment management and managing other plan costs such as recordkeeping separately. In fact, consultants suggest both evaluating fees and moving away from revenue sharing as two of the most important actions plan fiduciaries can take, both to fulfill fiduciary duty and to reduce litigation risk. In PIMCO’s Defined Contribution Consulting Support and Trends Survey, 2016, in order to manage fiduciary risk, the vast majority of consultants (86 percent) suggest benchmarking plan costs; and over half (54 percent) recommend that plan sponsors move away from revenue sharing funds. Some plan sponsors not only have moved away from revenue sharing, but also have decided to cover plan fees as a benefit cost—they may cover administration or include all costs, even investment management. Karen Barnes, former ERISA Counsel at McDonald’s Corporation, shared with us in PIMCO’s December 2007 DC Dialogue:

Our company covers all plan administrative fees, except for loan origination, which the participant pays. Participants pay the investment management fees of the funds in which they invest. We try to use separate accounts or institutional funds to minimize investment management expenses. So plan participants cover investment fees, which are disclosed to all participants in our annual explanation-of-fees report, but don’t cover administrative fees.

While rare, some companies cover not only DC administration fees, but also investment management costs. For instance, Gary Park, Director of Trust Investments at Schlumberger, shared with us in PIMCO’s September/October 2015 DC Dialogue:

The U.S. [DB] plan closed in 2004, and our international DB plan closed in 2014. In exchange for DB, we have enhanced our DC plans, including increasing the employer contribution and covering all DC fees—investment management and administration. While our total cost of running the DC plans may be higher than the DB plans, we prefer the known cost of DC relative to the unknowns of DB, such as the volatility in pension expense, liquidity requirements and balance sheet impact. The trend is in just one direction—toward DC plans.

To offset DC plan cost coverage, plan sponsors may consider offering a lower employer match. However, reducing a match may be viewed as a “take away” (of a benefit previously offered to employees) so the communication to participants requires conveying the value of the employer-covered fees. By covering fees outside the plan, participants’ accounts may grow more rapidly over time. Employers who are closing a DB plan and considering compensating with an unmatched or higher-matched DC contribution may thus consider cost coverage and a lower contribution increase.

Blended Multimanager or White-Label Investment Options

Many plans offer one or multiple blended core options. In PIMCO’s 2015 Defined Contribution Consulting Support and Trends Survey, over two-thirds of consultants said they actively promote or support client interest in fixed income (70 percent), equity (72 percent), and real asset (69 percent) multimanager/white-label core structures. Support for multimanager/white–label alternative strategies is weaker, but still promoted or supported by over half (53 percent) of consultants.

In PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey, respondents reported a total of $330 billion in white-label/multimanager assets across their clients. They anticipate, at the median, that another 10 percent of their clients will implement these strategies in the next three years. The majority of consultants suggest plans with over $500 million in assets consider a white-label/multimanager approach.

In summary, there are many potential benefits to these types of strategies, including the following.

• Simplicity: Mutual fund names can be confusing, and sponsors want to consolidate the number of options. White-labeling can help simplify the core offering and enhance clarity for participants, leading to increased likelihood of better decisions.
• Improved diversification: Single-manager risk can be reduced while improving diversification and increasing the potential for higher alpha by combining “best-of-breed” managers. White-labeling also allows the addition of more volatile asset classes (e.g., emerging markets) without exposing participants to the risk of investing directly in these higher-risk options. Increased diversification may lead to reduced volatility, which can also help guard against behavioral mistakes of chasing high performance or fleeing from a fund or the plan altogether given poor performance.
• Reduced costs: Plans can potentially reduce costs by:
  • Using a combination of active and passive investment strategies, and
  • Benefiting from relationship pricing by leveraging the same managers (e.g., those used in a DB plan if available)
• Increased flexibility: Plan sponsors have increased flexibility to add or replace fund managers within a white-label/multimanager structure without altering the lineup from the participant perspective or requiring broad communication that can be onerous, time-consuming, and costly. Due diligence and investment monitoring may also be eased by using white-label structures.

Figure 3.15 outlines the traditional and white-label/multimanager approaches, including the potential drawbacks of the traditional approach and the benefits of the white-label/multimanager approach.

Plan fiduciaries must also consider some potential concerns with white-label/multimanager approaches. These are summarized along with potential solutions in Figure 3.16.