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next issue no. 5: Investment corner
Setting the foundation: expanding options to strengthen the default
As the “default,” default savings option in defined contribution (DC) plans, target date funds have done a good job of getting participants to save in a relatively cost-effective way. But since they were built primarily as a savings vehicle, they don’t effectively offer the tools that solve for spending in retirement. However, expanded Qualified Default Investment Alternative (QDIA) options and enhancements to target date funds can help plan participants become more retirement ready.
Historically, plan sponsors had to choose between active or passive management, with most plans using active. That has shifted over the years, as fees and related litigation claiming excessive fees have caused more plan sponsors to choose passive strategies. The emergence of blended target date funds, combines the best of both investment approaches, offering plans an option that may address inherent risks in an either/or approach.
Blended target date funds typically offer lower fees than their fully active counterparts due to the inclusion of index funds, but still deliver the potential for alpha because of their allocation to actively managed funds. When constructing the blended portfolio, the managers can choose from a wide set of underlying funds that may provide better diversification and exposure to different asset classes, such as direct real estate, small cap and emerging markets, to name a few.
They can also choose funds that encompass a variety of approaches to active management, including both fundamental and quantitative stock-selection techniques. In particular, these two approaches to investing tend to provide independent, uncorrelated sources of excess return relative to each other and their respective benchmark indexes. In addition, blended target date funds have the flexibility to allocate to asset classes that are better served by either passive or active management, such as fixed income.
Customization appeals to diverse participant segments
Managed accounts are another QDIA option that have gained traction in recent years, given their ability to be a more customized investment option for certain participants. According to Cerulli, the managed account category within DC plans has more than doubled in recent years, with total assets growing from $108 billion in 2012 to $266 billion in 2018 (see Figure 1).1
Unlike a traditional target date fund, managed accounts offer financial planning solutions based on a participant’s personal financial needs. Indeed, one of the key benefits of managed accounts is their ability to provide a tailored view of an individual’s financial situation, and to consider assets outside of the retirement plan. In contrast, target date funds only consider the participant’s age in the allocation of assets. In addition to personalized financial advice, managed accounts can include asset classes and strategies that may fall outside of the core investment lineup as a stand-alone option, such as alternative investments.
As participants near retirement, managed account programs can also help solve the difficult problem of decumulation. Many such programs typically have an advice element to guide participants during this complex stage by providing access to financial planners or registered financial professionals. While recent provisions from the SECURE Act recognize the importance of lifetime income, it’s something plan sponsors have long struggled with. According to a 2018 Cerulli survey of 800 401(k) plan sponsors, nearly 40% of plans that currently offer managed accounts do so because they “help participants with retirement income.”2
Managed accounts may be designated as a plan’s QDIA, but some plans choose to include them as an option for participants who are more engaged and want professional financial support. Another option to consider is a hybrid structure, where more than one default is chosen for the plan. With a hybrid structure, younger participants (e.g., younger than 45) are defaulted into a traditional target date fund, while older participants are defaulted into a managed account. As participants age and amass wealth, they have more risk and may need more tailored investment advice based on more variables than just age, and managed accounts can be an effective solution.
A combination of factors could spur additional growth in managed accounts, including increased attention on financial wellness, focus on retirement income options within DC plans, the growing desire for participant customization and fiduciary concerns.
CITs: Attractive benefits breed strong demand
Collective Investment Trusts (CITs) are nothing new: They have been available as investment options to both defined benefit and DC retirement plans for decades. But like managed accounts, the use of CITs is on the rise. Total CIT assets have increased to $3.1 trillion at the end of 2018, representing a compound annual growth rate (CAGR) of 7.25% over the five-year period. They also represent the second most prevalent investment type on the investment menu. According to Callan research, 70% of DC plans use CITs, just after mutual funds, which held the top spot at 86%.
So what’s behind the momentum for CITs? There are several factors that make CITs attractive, including:
- Lower operational expenses: By pooling assets, CIT sponsors can take advantage of economies of scale to offer lower overall expenses. Furthermore, because CITs are not registered with the SEC, there are lower compliance costs and other associated costs required of SEC-registered mutual funds, such as creating and delivering proxies, prospectuses and Statements of Additional Information.
- Lower fees: Given the lower operational expenses, CIT sponsors can offer lower fees and flexible pricing. In some cases, larger plans can negotiate fees. The prospect for lower fees can be appealing to plan sponsors not only because it has the potential to improve retirement outcomes, but it may curb litigation based on excessive fees.
- Greater diversification: CITs offer the appeal of a multimanager approach that may make it easier for participants to get exposure to a diversified mix of strategies within a single investment.
- Price transparency: CITs offer daily pricing so plan sponsors and participants get daily information about pricing and performance. In addition, some CITs have ticker symbols.
What plan sponsors may want to consider when adding CITs:
- Determine whether there is a favorably priced CIT comparable to current strategies in the investment lineup.
- Retail investors cannot invest in CITs, so they would not be available to participants who take an IRA rollover distribution.
- Choose a CIT that is advised by investment managers with well-established mutual funds.
As individuals increasingly become responsible for funding their own retirements, the DC investment lineup has a bigger job to do, especially the QDIA for those participants who haven’t actively chosen their portfolio. Fortunately, enhancements to traditional target date funds and more customized options like managed accounts can help plan sponsors offer solutions that take participants to and through retirement.
More choices, more questions
These increased choices give plans more flexibility to determine the best solution for their plan demographics, but it has also made the evaluation process and consideration set more complicated.
Thinking about making a change to the plan’s QDIA? Consider the following tips:
Assess the needs of the plan
- Plan objectives
- Participant demographics, including savings patterns, salary levels, average retirement age and withdrawal patterns
Research and evaluate investment options
- Available QDIA types
- Proprietary vs. nonproprietary QDIAs
- Third-party resources to be used for QDIA research, analysis and selection
Identify the most appropriate investment for the plan
- Alignment of plan objective and QDIA approach
- Investment strategy, risk and performance
- Fees and expenses
Choose an implementation method
- Decide whether to retain existing QDIA or convert to a new investment
- Conduct a re-enrollment versus a single addition/replacement
- Review available participant communications materials, tools and resources
In this issue
1 Cerulli Associates, “The Cerulli Report-U.S. Defined Contribution Distribution 2019: Opportunities for Differentiation in a Competitive Landscape,” 2019.
2 Cerulli Associates. “The Cerulli Edge, U.S. Retirement Edition, Issue #50,” 1Q 2019.
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The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
Please note that this information should not replace a client’s consultation with a tax professional regarding their tax situation. Nuveen is not a tax advisor. Clients should consult their professional advisors before making any tax or investment decisions.