Are you a plan sponsor or consultant looking to create a great investment lineup for a defined contribution plan? David Blanchett, head of retirement research for Morningstar Investment Management, offers this advice: Don’t start with a goal of building the best lineup possible. Instead, start with your end point in mind: building the lineup that will give your plan participants the best opportunity for success. Why? Because every participant population is different, and what’s best for one group of participants may not be best for another. Their education levels, engagement in the investment process and their experience with investing should all factor into your decisions.
Easier said than done, right? Well, yes. But there are some fundamental guidelines to follow no matter what your participant demographics and circumstances may be, Blanchett said in a presentation at the 2013 SVIA Fall Forum.
Morningstar helps build investment lineups for all types of plan sponsors, Blanchett said, and in each case it starts with the basics required to comply with Section 404(c) of the Employee Retirement Income Security Act, which requires that plan sponsors offer at least three different, diversified investment options with materially different risk and return characteristics. At a minimum, Blanchett said, this means offering a cash option, a stock option, and a bond option. In plans that it designs, he added, Morningstar almost always includes at least five options: a cash fund, a bond fund, a large-cap stock fund, a small-cap stock fund, and a foreign stock fund.
Morningstar will often include investment options beyond those basics, Blanchett noted, but he cautioned sponsors to think carefully before adding too many investment choices to their plans, since having too many options could confuse plan participants. Sponsors also should consider whether they want to offer funds that are actively or passively managed; the latter are generally cheaper. One bad idea, he said, is to offer funds that invest in a specific industry; they concentrate risk and can be highly volatile.
In choosing specific investment options, Blanchett recommended that plan sponsors look for investments that are high quality with reasonable risk, and make sure that any funds of funds, such as target-date funds, follow similar criteria when selecting the funds in which they invest. All funds should be analyzed relative to asset allocation targets and performance benchmarks, he said. In terms of quantitative screening, sponsors should look at performance and style consistency, manager tenure and expenses. But they should also perform a fundamental analysis, looking at things like the people and processes behind a fund. Target-date funds merit special scrutiny, he said, requiring not only all the normal due diligence, but also a review of other factors, such as the “glide path” they follow as they become more conservative over time.