Meet the Round Table Participants
Clinton S. Cary, FSAChief Investment Officer Hewitt EnnisKnupp, Inc. an Aon Company
Josh Cohen, CFAManaging Director, Defined Contribution Russell Investments
John ChilmanGroup Reward & Pensions Director FirstGroup plc
No one would argue that running a defined contribution plan is any simpler than running a defined benefit plan. Some would even contend that a DC plan, with more moving parts and with often hundreds of participants with individual accounts, is a far more complex management proposition than the pooled assets that form a DB plan. So why, one might ask, haven't DC plan sponsors availed themselves of the fiduciary management solution known as outsourcing?
DC plans are often run jointly by HR and treasury departments, and as more assets have flowed into these plans, demands on these department professionals have increased. At the same time, companies have become more aware of the need to provide more investment support to participants. With resources stretched thin, it can be hard to accomplish the current goals of institutionalizing the DC plan, while ensuring that it runs efficiently. Enter DC outsourcing, also known as fiduciary management or outsourced CIO.
P&I brought together two prominent providers of outsourced CIO services to DB and DC plans, along with a DC plan sponsor whose U.S. DC plan moved to a DC fiduciary model in late 2013. The lively conversation covered a wide range of topics including why a DC plan sponsor might want to hire an outsourcing partner, what the difference is between consulting and outsourcing, what benefits a plan sponsor and a participant might see,
what it costs, and the operational and governance considerations.
P&I: Let's start by understanding why a DC plan sponsor might want to work with an outsourcing partner?
John Chilman: FirstGroup is a bus and rail company that operates in the U.K., the U.S. and Canada. We operate 20 defined benefit schemes, most of which are now closed to new entrants and some that have been closed to future accruals for some time. We also operate various DC arrangements in these same locations. We look at arrangements like DC outsourcing largely because we recognize that we have fairly thin resources.
We like to get our local management engaged with the pension operations. One of the key issues for them and for us has been the bandwidth of the management team. We want them involved in the strategic decisions, but some of the detail required is a bit challenging, because they don't do pensions day-to-day. But secondly, they really don't want to go up the learning curve that would allow them to add value here. For those reasons we've been particularly interested in looking at outsourcing arrangements. We have used outsourcing in some, not all of our DB plans. In the U.S., within FirstGroup America, we moved to a DB fiduciary model in 2008 and in DC, in 2013.
Josh Cohen: Being a DC plan fiduciary is becoming ever more complex in a world where more employees are relying solely on the DC plan to meet their retirement income goals. There's a lot of scrutiny on DC plans from regulators, the media, academics and of course, from the employees themselves. The DC plan needs to be institutionalized to better meet participant needs and to protect the entire system. DC plan sponsors need to focus on the strategic issues around plan design. But the implementation – multi-manager solutions, overseeing recordkeeping partners and such – is a very complex and specialized task. That's why many DC plan sponsors are looking at outsourcing partners.
Clint Cary: Plan sponsors recognize their personal liability in the DC space as it's becoming more complex. The advantage of a fiduciary partner is in the alignment of expertise with responsibility. The idea that your experts share more of the burdens in an outsourced arrangement is attractive as well.
Josh Cohen: DC used to be a very retail marketplace. Ten or 15 years ago, plan sponsors probably thought they were outsourcing when they used a bundled retail provider. Over time they realized some of their investments weren't best-of-breed and fee issues arose. Recently, consultants and advisers have been pushing plan sponsors to understand they really need a new approach. There's a move to a more institutional model, but plan sponsors don't necessarily have the in-house expertise to make the transition
P&I: We've been throwing around some jargon here. Could you define the term fiduciary, in this context? And at the same time, explain the difference between consulting and outsourcing?
Clint Cary: The term fiduciary is covered in ERISA legislation. An ERISA section 3(21) fiduciary is an adviser, a consultant in pension terms, that brings ideas and recommendations to a plan sponsor. The decision, however, rests with the plan sponsor, as does the execution or implementation. An ERISA section 3(38) fiduciary provides outsourcing services. It brings ideas and recommendations, but also has the ability to make and implement investment decisions in certain circumstances.
One of the main differences is the time it takes to execute. Typically the traditional consultant approach takes longer. Say you wanted to change an underlying investment option in a menu. First it goes through a watch, then a search and finally a recordkeeping change. That process can take anywhere from three months to a year. Throughout that time, participants may not be getting optimal performance. In the delegated context, you would be able to move quickly, possibly replacing the manager in a matter of days. We think speed to action is an enhancement in an outsourced context.
A section 3(38) investment manager is effectively an outsourced chief investment officer (CIO) and the investment expert. In that context, we are able to make discretionary decisions around asset allocation. In many cases, plan investment menus have become too long and too specialized, consistent with the original 401(k) retail focus. Participants must build a diversified portfolio across all of a plan's investment choices. Many participants cannot do this well on their own and many plan sponsors do not want to take on the responsibility to simplify the asset allocation choices for participants. As a 3(38) investment manager we can do this.
Finally, there's an important operational component to outsourcing. We are able to assume some of the day-to-day operational responsibilities around recordkeeping, allowing the plan sponsor to focus on retirement strategy.
Josh Cohen: In ERISA nomenclature, section 3(21) is the fiduciary status that's used when you are a consultant. The Department of Labor has an initiative to potentially expand who falls into that category. Even as a consultant, we are taking a fiduciary role in the advice that we give our plan sponsor clients. The real distinction when it comes to section 3(38) is discretion. When you are a 3(38) fiduciary, you have discretionary authority over the decisions relating to the investment options in the plan.
P&I: John, does FirstGroup operate its outsourcing arrangements under section 3(38)?
John Chilman: Yes, and we chose this route for a number of reasons. We have a quarterly meeting cycle and we were finding that decision-making was taking at least 12 months. That was too slow because participants in a DC plan watch their accounts far more regularly than they would in a DB world. The fiduciary responsibility of the third party gave us increased comfort that we are able to move more quickly. We don't lose our fiduciary responsibility, but we are able to rely on the third party more in terms of risk.
What we are gaining is a firm that is working as a partner with us, as opposed to a consultant who can justifiably walk away from a problem, saying, 'We gave you the best advice at the time, but it's unfortunate that it didn't work out.' What we have now is a partner that actually owns the investment return in fiduciary terms as much as we do on the investment committee.
We have streamlined our investment menu, though not necessarily as much as we may do in the long term. We have started moving away from having a selection of large cap value, index and growth managers, to actually just saying this is the large cap fund, this is the small cap fund. Ultimately we may move to saying this is the blended equity strategy and even, this is the global equity and this is the U.S. equity strategy. Having an outsourcing partner means we have an enhanced skill set with which to make these changes.
P&I: What characteristics should a plan sponsor look for in choosing an outsourcing partner?
Josh Cohen: In terms of choosing investment managers, it makes sense to give discretion to someone who has experience in this area, such as an outsourcing partner. If you are going to give discretion to a partner they not only need in-depth manager research capabilities to understand what makes a good manager, but they should also have direct asset management expertise. This gives them the system and reporting capabilities to look at how a number of different managers fit together. They also know how to transition funds from one manager to another, how to handle cash flows, liquidity buffers and such. If you are using an outsourced partner to help select and monitor recordkeepers, you want one with expertise in picking the best administrator for your plan.
Clint Cary: A lot of plan sponsors are interested in extending their fiduciary partnerships. They are looking for proven expertise in all areas of plan management. This gives plan sponsors more confidence in exercising their own fiduciary obligations and allows them to focus on more strategic benefits issues.
John Chilman: One of the biggest issues is one that you can't measure through achievement. It's trust. You have to develop a trust and a belief that your outsourcing partner is working in your interest - your best interest – not their best interest. So it's important to look at agency issues, when, for instance, you change a money manager. What's the reason for the change? Is it because it gives enhanced profit to the third party? Say you replace a 85 basis points manager with a 50 basis points manager, who gets the 35 basis points? Is the fee reduction passing through to participants, or is the overall management fee higher? You have to make sure all these issues are resolved. It's a slightly different degree of trust than you would need for a traditional consulting relationship. Here you are building a relationship for the long term. You have to believe that your partner has the same goals in mind for the strategy that you developed together. It can be difficult to form a completely new relationship. It may be easier to move on and extend an existing relationship.
P&I: Do many of these fiduciary relationships grow out of consulting relationships?
Clint Cary: Certainly many do. Some grow out of a traditional consulting relationship on the DC side, or even a traditional or delegated relationship on the DB side. We do see there can be some value in having both the DC and the DB plan working with the same outsourcing partner. Often there's a lot of overlap in terms of managers between the two. It can help streamline the process and allows the company to develop a clearly integrated retirement strategy from an investment point of view but also in the aggregate.
Josh Cohen: We often call it harmonizing DB and DC approaches. There are many good reasons to consider this, not least because DC is moving closer to the institutional framework that DB plans have always used. So if sponsors are already trying to bring some of the best ideas from the DB side into DC, why shouldn't they consider the same fiduciary support mechanisms? Frankly, this approach can stand up to a lot of scrutiny because plan sponsors can demonstrate that they have a consistent approach across both plans. Of course, consistent doesn't mean the same. Sponsors wouldn't implement LDI-type investments in a DC plan or put a stable value option in a DB plan.
I think being a DC fiduciary is harder – and is open to more scrutiny than a DB fiduciary. So I am sometimes puzzled why plan sponsors look for support for their DB plan, but think they can do it on their own in DC. If anything, I see the reverse as more critical for many plan sponsors.
P&I: Why is being a DC fiduciary harder?
Josh Cohen: There are a lot of factors. For example, DC plan sponsors investment decisions regarding the menu involve participant interaction that is critical to their success in meeting retirement income goals. Recordkeeping is immensely complicated. And it is also visible to participants. DC is also high on the radar screen in Washington. There's much more scrutiny now that it is the primary retirement vehicle for most Americans.
P&I: John, would you agree that DC is more complicated and plan sponsors need more support here?
John Chilman: Corporates focus their attention on the DB plan because that's the one that the company will need to put money into if it blows up. To an extent, some of the original thinking about DC was that it was up to the individual. Obviously legislation has rather changed that focus. Now we recognize that we potentially have a generation of individuals who won't be able to retire if the DC plan doesn't deliver. That's quite a significant threat as well. It took awhile for that thought to click with corporates. DC is trying to get it right for every single member and that's much harder than it is with a collective DB pool, where you are just trying to fund one pool over 70 years. DC does need more attention. In the old days, when DB and DC were managed in one committee, DC only got the last 10 minutes of any meeting. Now it's different. It is about institutionalizing the process so that we can get great outcomes for individuals.
Josh Cohen: It is important to remember that a fiduciary or outsourcing partnership can only do so much. They are not the plan sponsor. The partner can't dictate the match policy or the auto-enrollment rules. They can provide strategic advice. The arrangement allows the fiduciary partner to use discretion where they have expertise - in the investments and on the administrative side – allowing the plan sponsor and committee to spend time on the important strategic issues that move the needle forward in terms of participants' retirement readiness.
P&I: Does outsourcing help develop better operations and governance?
John Chilman: We're still in early days, but there is now more time for management to have discussions about the match, etc. Or how people are looking at it in terms of income replacement ratios for retirement. We consider the big picture and what our peers are doing, rather than which small cap manager is better than the other.
Josh Cohen: When you look at the way DC plans were spending their time and money – or their participants' money, a lot was spent on asset management and perhaps not as much on asset allocation and other important matters. So redirecting some spend on governance should help improve matters.
P&I: How does the plan sponsor evaluate the performance of the outsourcing partner?
Josh Cohen: The committee and the plan sponsor do retain responsibility for ensuring that the outsourcing provider is doing the right things. Are we having meetings with managers? Are we overseeing the quality of service of the recordkeeper or administrator?
You need to base your evaluation on the reasons you chose to outsource in the first place. If you thought that you would get better investment outcomes by outsourcing, then you should evaluate whether the funds used performed better than their benchmarks, for instance. You also need to measure the manager selection capability, the portfolio management capability and the efficiency in implementing those solutions operationally. Additionally, there is the issue of how well participants are succeeding. A good fiduciary partner will provide you with strategic advice in this area. Monitoring needs to cover all those areas that the fiduciary partner has responsibility for.
Clint Cary: We have a scorecard approach with our sponsors on both the DB and DC side. On the DC side, it is important that there are some objective measures – the performance of the programs, how participants are utilizing the investment options, what the take-up rates are. We also include subjective measures, such as the timeliness of information and innovation. This is important. One of the big opportunities in an outsourced solution is the ability to bring truly institutional solutions to the portfolios. Innovation can be measured objectively in performance, but also subjectively in terms of its role within risk management.
John Chilman: You do have to make sure that the fiduciary manager is doing the right thing. Interestingly, when some of these relationships are put in place, you sometimes see a further consultant brought in to assess how well the fiduciary is doing. If I don't have the expertise to choose investment managers myself, then do I have the expertise to evaluate the success of the fiduciary manager in choosing managers?
P&I: What benefits would a participant receive as a result of the plan working with an outsourcing partner?
Clint Cary: There needs to be a benefit for the participant. The first one that comes to mind is the institutionalization of the plan. Migrating away from the retail mutual fund model to a more streamlined and simpler menu can help the participants make better decisions and help avoid negative outcomes. Helping to improve participant behavior is a big part of the goal of the institutionalization of these programs.
The intent is to reduce fees on the investment management side. Further, the fees will be tiered in such a way that the fees continue to decline as assets grow. For the first time, the participant will see the benefit of economies of scale rather than the provider.
We expect performance to improve, not just because the outsourcing partner is able to pick and combine managers better than participants, but also because we can bring in more institutional approaches to asset management and some of the innovation discussed earlier. The standard for the outsource provider is excellence, not just prudence.
We are able to sell the institutionalization of the plan as a simple, sophisticated solution, with simpler asset allocation choices. There may be many more managers underpinning these solutions than previously. So with just a couple of clicks you can build a well-diversified portfolio.
Josh Cohen: Communication plays an important role in the plan and the fiduciary partner is very involved in selling the benefits to the participants. This may or may not involve explaining the details of the new arrangements. To the extent that participants question the role of the fiduciary partner, the answer is we, the plan sponsor, are not investment experts. We operate a different kind of business. So, we've brought in experts who will enhance the plan for the benefit of our participants.
John Chilman: We told our participants that we were working with an outsourcing partner. We did a re-enrollment because we had a lot of participants who were in bad or inappropriate investment choices. We'd been trying to figure out how to get the 30-year-old out of the stable value fund, but it didn't work. So we took this opportunity to sell the positives. The first is the partner with real investment expertise. The second is that we were hoping to reduce the fee drag. This wasn't massive, but it's amazing how little reduction in basis points you need to start having a real compounding effect.
P&I: Speaking of fees, will overall plan fees reduce for the plan participant when a plan uses a fiduciary partner?
Clint Cary: We believe so. What we find with our solutions is that we are able, in the process of institutionalization, to use the scale of our relationships in the investment management industry to drive down the costs. That reduction in fees and improvement in the fee structure is such that it typically offsets the marginal costs of hiring the outsourced fiduciary. We expect participants to see fee savings today and potentially even more fee savings in the future.
Josh Cohen: We need to separate two different benefits here. One is a move to a more institutional DC approach, which involves getting out of the bundled retail model. Plan sponsors can do that whether they are with an outsourced DC provider or not. The other benefit comes from working with an outsourced provider. They can use their buying power to drive down fees beyond what the individual plan sponsor could do because the outsourced provider places assets from a range of investor clients with these managers. More efficient implementation also has an effect.
P&I: Is outsourcing appropriate for a particular size of plan?
Josh Cohen: Outsourcing or fiduciary solutions can come in different formats. Smaller plans - $200 million to $1 billion – probably will look for a total solution that includes a series of multi-manager funds, and some support on the recordkeeping and administrative side. Larger plans may want portions of their plan outsourced, or more customized solutions. Many plans of this size still have a pension staff that can handle many of these issues, but need help with implementation issues in specialty asset classes. Maybe they don't have the scale or the expertise or the time to implement; real assets is a great example of one that they might want to outsource to a third party. Custom glidepath management is another form of fiduciary management; many mega-plans that have implemented custom target-date solutions have decided to hire a section 3(38) fiduciary manager for that task, while retaining some of the other manager selection decisions in-house.
Clint Cary: When you get to the larger end of the market, you're extending your expertise in a more discretionary framework rather than an advisory framework. For some of the largest organizations, in order to deploy a truly institutional approach, they may find that this involves a fair amount of complexity. Perhaps they bite off more than even they can chew within their own infrastructure. So being able to borrow some operational excellence through an outsourcing provider can be a helping hand. This can be in glidepath management and construction, or alternatives in DC, for instance.
We also see an opportunity to bring the institutionalization of DC into the middle market. These plans didn't really have access to these solutions so far, so they had to settle for what the mutual fund industry manufactured for them. We highlight to these middle market plan sponsors that it is time that their plan graduates to an institutional solution.
P&I: John Chilman, do you have any questions you would like to ask Clint Cary or Josh Cohen?
John Chilman: Is there any opportunity to get illiquidity as a source of return baked in the DC investment environment?
Clint Cary: The best way is through pre-mixed portfolios. Target-date funds are a natural place for illiquid assets. Broader growth portfolios are also an option, because they offer the opportunity to lend liquidity from other sources. Certainly the managers of illiquid assets see a very large investment pool in DC programs and are innovating in terms of their ability to access that marketplace. So it's absolutely a trend.
Josh Cohen: One of the impacts of the original retail-ization of DC was this need for daily valuation liquidity because that's really the mutual fund model. That precluded the use of some alternative investments like private equity, hedge funds and real estate, where many institutional investors have found value. They have been off the table thus far because we've been in this daily valued world.
Although these asset classes have been readily used in DB plans, there's a hesitancy among DC plan sponsors to bring them into DC plans. Part of the reason may be sticker shock in the cost of these investments. But as we move to a more institutional framework that leverages the scale of an outsource provider to bring costs down, I think these asset classes can find roles in multi-asset class portfolios like target-date funds. We are already seeing some of the more liquid alternatives in plans. Over time I expect that other types of investments will be used by plan sponsors and their fiduciary partners to provide better outcomes for participants.
P&I: May I ask each of you for some final comments?
Clint Cary: The trend today is to use section 3(38) fiduciaries, which I see continuing. There's plenty of runway for that part of the business as plan sponsors are looking to delegate part of their fiduciary responsibilities.
We are just starting to see discussion of commingled funds, on an industry or national basis, akin to those starting in the U.K., or superannuation funds in Australia. These could come to America, but the big question there is one of governance. Who has responsibility for oversight and who is looking out for the participants? One of the big reasons that employers stay involved in pensions is to make sure their participants really are getting the best they can possibly get. So I don't see the end of employer sponsored plans anytime soon.
Josh Cohen: Plan sponsors are at an awkward spot of wanting to retain ownership and control of plans, but without having the necessary expertise. We see many plans that are striving for excellence and not just solutions that are what we call, “good enough”. But we also see plans that are not really sure how to get to that level of excellence. The solution may be consideration of additional fiduciary partnerships and outsourcing arrangements.
There is plenty of scrutiny – some deserved, some undeserved – of DC plans. And because of this, it may become increasingly difficult to defend employer-sponsored DC plans against those who want to replace this system with non-employer driven models or government driven models. So if plan sponsors want to retain control, they will need to pursue excellence and may need help to get there.
John Chilman: I'll just leave you with the words of my U.S. CFO when I go to Cincinnati to visit him. He says he loves to see me, but he'd like to see me less and spend less time on pensions. What that says to me is that the trend will be toward more outsourcing in a structured way, where we place more trust and reliance on co-fiduciaries to do the right thing. The strategic direction will still be set by the company in order to make sure that there's going to be enough in the pot for the participants to retire.