A decade after the financial crisis, the market landscape looks radically different: lower interest rates, much more debt, pervasive influence of new technology and a strong U.S. economy driving stock performance but also causing worry about future risk. For defined contribution plans, some key challenges remain the same: low savings rates, risks tied to investment selection and the search for ways to protect participants against a severe down market. Still, an evolution of ideas and plan structure is gradually having a transformative impact. Here are three key trends that we see as particularly significant to the DC marketplace.
1. Target-Date Funds Move toward Customization
In a basic sense, target-date funds have been a home run over the past 10 years. Though criticized for crisis-era losses, TDFs have benefited from the 2006 legislation to create safe-harbor Qualifying Default Investment Alternatives, where participant dollars are placed absent active investment selection. Growth has surged: assets in target-date mutual funds have increased from $158 billion in 2008 to over $1 trillion in 2017.1
Still, the focus of this growth has been on “off-the-shelf” target-date funds, which typically invest in a proprietary set of investment strategies offered by one asset manager–in a sense, a step back from the open architecture multi-manager investment mindset that existed in the early 2000s when many fiduciaries realized that it is difficult for a single manager to outperform in all investment strategies, and moved away from offering an investment menu from one provider. As target-date funds grow in usage, it makes sense for fiduciaries to look beyond a single-manager solution, just as they have for their broader menus.
This need for manager diversification has led to interest in TDF customization, which can help plan sponsors build a more diversified option outside a provider’s proprietary investment options. For example, a custom TDF can look at cost-effective investments like put writing, which have the potential to generate equity-like returns over time with lower volatility—an appealing combination for participants nearing retirement. All told, we believe that customized TDFs can provide a sweet spot of efficiency and nuance to improve potential outcomes.
2. ESG Catches on with Institutions. Is DC Next?
In recent years, Environmental, Social and Governance (ESG) investing has gained traction among institutional investors, but the DC marketplace, while it has shown interest, has lagged in its adoption. A recent survey lays open the disparity. According to Callan’s 2018 ESG Survey, 43% of 89 institutions said that they incorporated ESG into investment decisions—up from 22% in 2013—but just 13% of DC plans include an ESG option in their plan lineup.
Why the disconnect? It may have to do with worries over fiduciary liability tied to including fund options based on non-performance criteria. Recent guidance by the Department of Labor created a stir when it reiterated that economic performance should be considered ahead of any social impact related to investing in ESG funds. DC plan sponsors could also be skeptical as to the level of potential interest among participants. In the Callan survey, those DC plans with an ESG option found that it attracted only a 1% allocation from participants.
However, we feel the misgivings are not well placed. Modern ESG portfolios have moved beyond the simple screening of sectors like tobacco or alcohol, toward conducting bottom-up analysis of the financially material ESG risks and opportunities. We believe that the once-vigorous debate over the ESG’s performance impact should be largely settled: Over time, real-world track records have demonstrated that, when effectively applied, bottom-up ESG analysis can in fact be a driver of attractive long-term investment performance.
On the employee side, Millennials have shown an acute interest in social investing, something that plan sponsors can harness to increase participation rates. As for older investors, educational programs that clearly articulate the value of ESG to the investment process may attract new adherents.
In the next decade, we believe that ESG will eventually catch on among DC plans. In our view, rather than exposing plan sponsors to liability, the inclusion of fund options that integrate ESG methodologies may be prudent, and not including such options may actually create fiduciary risk.
Reasons for Incorporating ESG Into The Investment Process
Source: Callan 2018 ESG Survey.
3. Bracing for Volatility
With a bull market close to 10 years strong, it would be easy for many plan sponsors and participants to grow complacent about portfolios and forget the potential impact of a serious downturn—particularly for near-retirees. In fact, despite the roughly 55% downdraft of equities between 2007 – 09, more plan participants held equities at year-end 2016 versus year-end 2007 and a larger percentage had higher concentrations in equities.2
With potentially more volatility on the horizon, plan sponsors need to make sure participants have access to diversification and options that are designed to provide downside mitigation in their portfolios. Customized TDFs, as noted above, could be a viable approach to this issue. In terms of a la carte plan options, including a broader mix of funds that takes into account current market realities could help participants deal with volatility.
A common issue involves fixed income choices. For many plans, they consist largely of passive or near-passive fixed income strategies, which tend to be heavily weighted in low-yielding, high-duration government securities. Although often effective at absorbing volatility in past cycles, they may not provide as much cushion today against the upward reset in market yields tied to monetary policy.
Active/passive considerations also affect plan lineups. We believe selectively deciding where and when to go active or passive becomes especially important in an environment of heightened volatility. Passive investing can potentially carry more risk in some asset classes, including ESG, small-cap equity, emerging markets and fixed income. In these areas, we believe that the managers that carefully consider securities’ quality within the portfolio construction process are likely to be well positioned going forward.
The next 10 years may bring more volatility as well as opportunity. Keeping ahead of these and other trends will help plan sponsors build investment lineups that attract participants and help them prepare for a more successful retirement.
