Investment line-up tune-up

next issue no. 12

When it comes to a retirement plan’s investment lineup, employers and consultants ask themselves and one another a remarkably similar set of questions:

• Does the plan still offer the right funds?
• Are they performing as they should?
• And most importantly, are participants invested properly to meet our fiduciary responsibility?

All worthy questions, but not so simple to answer.

That’s because the questions can’t be answered in isolation. Investment reviews need to look at everything from the economic environment to the manager’s decision making to participant behavior to evaluate whether the plan’s lineup is running well or needs a tune-up.

Start with the macroeconomics

The last few years have been a tumultuous ride for financial markets, with:

• 2022’s correlated declines across both bonds and stocks
• 2023’s rapid climb in interest rates and rebounding equity markets,
• now 2024’s concerns around a potential recession and the volatility of an election year to consider.

So, plan sponsors should not be making quick changes to retirement plan menus simply based on changing economic circumstances, any more than participants should be trading in and out of their 401(k) balances to attempt to time the market. But some awareness of changing macroeconomic environments and ways to best capitalize are reasonable areas for discussion.

How should sponsors think about their participants in times of economic uncertainty? High inflation has impacted the ability of some workers to make ends meet, especially lower-paid employees, while the market volatility of 2022 and ongoing talk around a potential U.S. recession through 2023 and 2024 has caused a lot of investors to gather their cash balances on the sidelines rather than risk investing into a further downturn.

We see this as a mistake. Investors are better served by investing in their retirement plans, at least to take advantage of the tax benefits. In turn, investing logic emphasizes the power of compound interest in driving returns over time.

Care should be taken to discuss investing confidence with employees to ensure that they are allocating to their retirement plans and still saving, while also working to alleviate concerns around budget challenges. Consideration on this point can also be made to where employees are in relation to retirement — those who are rapidly approaching retirement are more likely to be concerned about immediate market performance impacting their retirement savings and elevated inflation levels, as they look to the switch to a more fixed income regime.

A well-constructed plan should have some safeguards to answer these questions, as the very nature of a target date fund would hope to alleviate some market volatility, but communicating with those near retirement about catch-up contributions or potential ways to help mitigate volatility could be worth considering.

Gauge your managers

The fundamental process and aim of investment analysis remains the same, regardless of the market environment. Specific questions asked of asset managers can vary, and pinpointing where the best value might be found will shift with the economy.

While rates remain elevated, at least until the U.S. Federal Reserve begins cutting rates, we see significant value to be found in fixed income. We think that the time is right for plan sponsors to ask questions of their asset managers, making sure they are capturing the most yield that they can from the asset class without taking undue risk, or being unduly defensive. 

Similarly, with inflation still generally high, plan sponsors should also be asking their asset managers about allocations within equities. A good starting point is finding out an investment manager’s view on sectors that could be insulated during a potential recession or stand to particularly benefit if rates were to begin falling.

It is also worth examining asset classes that stand to benefit if rates do not start to fall but remain elevated for some time. If this happens, our global investment committee thinks investors should look beyond the traditional 60/40 portfolio and consider real assets, including real estate, infrastructure and private credit.

Public real estate appears to be well positioned for the current environment, particularly industrial properties. Infrastructure should benefit from still-elevated inflation and is usually relatively insulated if the economy were to slow. Private credit sees continued demand, and health care, software and insurance brokers should also withstand any potential economic downturn.¹

Making sure that an investment manager has the capabilities to look beyond just the traditional core asset classes and reach for yield and value across sectors that are able to benefit from higher rates can be a boon to participants during these periods. The underlying cash balances being held in portfolios are also worth questioning, as while cash-equivalents do have a relatively high yield in this environment, adding marginal credit risk can significantly increase underlying yields.

Responsible investing continues to raise some committee eyebrows, but it’s a different story among younger workers who embrace those options with solid enthusiasm. Companies need to be cognizant of their employees’ desire to have their retirement plan assets reflect their views. However, the shifting regulatory landscape makes this a tricky needle to thread, so sponsors may need to examine these options with care.

The evolution of the default

It is worth having plan committees examine the target date funds that probably make up the default investment option within the plan. While target date funds are well established, there is still innovation happening within the product, and there could be options available that might be worth consideration.

For the growing number of participants nearing retirement age, plans need to consider the need for lifetime income options. The SECURE Act created a more favorable regulatory environment for lifetime income, and the industry has recently started to align in terms of product offerings and technology. While it can be a significant shift to add an income element to a retirement plan, the actual transition and implementation can happen quite seamlessly. Integrating a lifetime income option into a target date-like structure allows for the allocation to an annuity to automatically rebalance over time and provide participants the option, but not obligation, to annuitize upon retirement.

The ability of plan sponsors to find the right lifetime income solution is becoming simpler, as the number of record keepers and asset managers offering integrated lifetime income solutions continues to grow. Product needs will vary, depending on industry, size of the plan, participant demographics, and historical comparisons to defined benefit plans, among others. But adding a lifetime income component to a qualified default investment alternative (QDIA) merits sincere consideration in 2024.

Personalization

The personalization of retirement plans is a growing and important trend. With increasing options to incorporate emerging technologies such as AI (Artificial Intelligence) and robo-advice, plan sponsors can make retirement plans feel more customized than ever. Personalizing financial literacy programs and education can also provide a great benefit to plan participants. By linking prior financial knowledge and readiness and tailoring potential education modules to the right level, plan sponsors can make strides in engaging participants and ensuring that they are approaching retirement with the right knowledge in hand.

Simply targeting firm-wide financial literacy would be too broad an approach, leaving behind employees who need more basic financial readiness training, and not offering advantages to those who are already relatively experienced. For example, TIAA Institute research shows that only 37% of 22–34-year-olds in the U.S. are confident that they will be able to retire when intended. Boosting financial literacy at earlier career stages can help build this confidence.²

The growth of managed accounts is one area where plan sponsors should be paying attention. These products offer a range of potential benefits to participants, including personalization, income offerings and more customized risk tolerances, though they can be more complex than traditional target dates or basic investment options. The way that fees are structured and how the portfolio is built can have a huge impact. While we believe that managed accounts are an interesting growth area and will continue to gather assets within the defined contribution space, plan sponsors should consider whether these solutions are right for the majority of plan participants rather than just a smaller portion of the plan population. With the limited time available to plan committees, would that effort be better spent in an area that can help more employees?

One eye on the future

The investment options available to participants should remain as consistent as possible, especially with regard to QDIAs. Ensuring that the underlying asset managers are making the most of the economic situation and have awareness of the potential shifts through this year and next should also be a priority. 

Plan sponsors should expect ongoing regulatory updates following SECURE 2.0, particularly with the fiduciary five-part test for any potential changes to consultant/advisor relationships.

Cybersecurity continues to be a growing area of concern for anyone who manages data, and plan sponsors are a part of the ecosystem that needs to protect employee data. Record keepers have a significant role in this space, but plan sponsors need to examine what they can do to help protect data, as litigation risk continues to grow. The Employee Benefits Security Administration (EBSA) has a cybersecurity checklist available. It underlines the ERISA obligations of plan sponsors to “ensure proper mitigation of cybersecurity risks.”³ It is well worth examining the guidance to make sure that proper steps have been taken.

The decisions a plan committee makes are never static. So many of these items can be reviewed periodically to make sure they are still current. Above all, documentation and process management remain vital watchwords for plan sponsors.