Guiding DC participants with a simplified menu

Most participants in defined contribution plans are not on track to achieve retirement income adequacy. A key reason is that the investment lineups in most DC plans are structured in a way that reduces participants' likelihood of implementing well-diversified and age-appropriate investment strategies. Since they are not investment experts, most DC participants would benefit from a simplified lineup, guiding (but not forcing) them into professionally designed portfolios.

Target-date funds are not for everyone. Therefore, it is beneficial to build the core lineup on the same tenets and investment principles as the custom target date funds. Consistency in investment philosophy and construction provides participants with better resources, and sponsors with more efficient governance.

Can the core funds take a page from the diversification and communication benefits of target date funds? The answer is “Yes,” provided that they are combined to clearly highlight and define their investment objectives.

Today's most common DC investment lineups confuse participants with about 13 asset-style funds, most of which are named with technical investment jargon, making it difficult for most participants to effectively build portfolios. It is not surprising that plan data shows participants using today's investment lineups have poorly diversified asset allocations. Aon Hewitt studies show that 14% of participants select only one or two asset classes to build their portfolios. Too much choice doesn't result in improved diversification for participants. The DC lineup of the future will mitigate this problem by replacing today's core options with the optionality of a simple passive tier and a custom multi-asset class objective-based tier that are professionally managed to improve outcomes. These improvements to participants' asset allocations are critically important to retirement outcomes, as asset allocation drives roughly 94% of investment returns.

Succinctly stated, objective-based funds are multi-asset class funds that are designed to meet specific investment objectives. As shown in Exhibit 1, we believe that a DC investment lineup can include as few as four options to span the broad array of objectives for the vast majority of participants. These objective-based funds are:

1. Growth. Generating capital appreciation (equities and higher-octane assets)


2. Income. Producing returns through dividends and interest payments (predominantly high-quality fixed income)


3. Capital preservation. Preventing investment loss (stable value or money market)


4. Inflation. The investment maintains purchasing power against inflationary shocks (TIPS, real estate, and other inflation-linked assets)

Unfortunately, today's traditional investment lineup make it difficult for participants to have line of sight into how the funds translate into objectives. Even the participant who has the investment savvy to understand the relationship between the objectives listed above and the funds' asset styles must still determine the right mix of funds to best meet the objective. Take, for example, the more knowledgeable participants who see that both a large cap index fund and an international equity fund are designed to meet the “growth” objective. They must still determine how much to allocate to each fund to best meet the overall growth objective. Additionally, they must see if there are other funds in the lineup that also meet the growth objective. If so, the allocation process starts anew.

Objective-based funds are designed to remove these friction points. Plans with objective-based funds make participant success more likely by offering a streamlined menu with each of the investment options offering a specific objective. What's more, objective-based funds allow for new investments that plan sponsors might not offer in a traditional asset-based lineup.

Consider the growth fund, a fully diversified return-seeking option guarding against return shortfall. The diversification is derived from the fund's ability to access global equity as well as diversifying growth assets such as core real estate, return-seeking fixed income, real assets, or possibly even hedge funds, which might not normally be available to participants through a standard core menu lineup. Implemented the same way as custom TDFs by blending best-in-class active managers with low-fee passive managers, objective-based funds add value by keeping the participant interface simple while employing a professionally designed portfolio construction underneath. This is accomplished via more effective participant communications, sophisticated diversification, and optimal pricing. All three are important factors for encouraging participants to build more efficient asset allocations.

Return chasing and loss avoidance are reducible behavioral risks. Exhibit 2 illustrates that reducing three asset classes into a single diversified objective-based growth fund is straightforward. With limited options, there is less “grass is greener” temptation for participants to switch funds. Offering too many choices facilitates a situation in which participants chase “green” lights while running from “red” lights when reviewing their accounts online, and fuels buy-high and sell-low behaviors.

Behavioral finance research demonstrates that too much choice within DC plans harms participant decision-making. On average, participants select only 3.6 investment options. This selection concentration is a primary reason why sponsors should limit the plan to a small number of efficient options.

In Exhibit 3, we start to see a 3%–4% dip in participation when fund menus have six or more investment options. Today, this experience is still the case for those plans not using automation post-Pension Protection Act of 2006. We also see history repeating itself with health savings accounts that have oversized investment lineups. Providing a reasonable number of investment options helps participants invest more over long periods of time.

Custom target date funds and objective-based funds are forms of “white-label” funds, which are generically named funds that have no association with a fund company and are branded by their asset class, strategy, or objective. They can be constructed as either a single investment strategy or as a portfolio of multiple underlying investment vehicles structured to the fund's objective and related to any asset class, asset style, market capitalization, or geographic region.

Technology advancements have made it easier to incorporate white-label funds within plans. White-label funds can be organized in different ways to satisfy plan sponsors' goals and participants' needs. The components of these funds are the building blocks for custom investment solutions, often created by utilizing a plan's existing investment options and supplementing them as needed with other offerings to complete the portfolios the sponsor is trying to construct.

Based on an Aon Hewitt 2014 Pulse survey of plan sponsors, almost 25% of plans currently offer some level of white-label funds. White labeling investment options is the foundational starting point for custom investment solutions. It allows sponsors the structural framework to label plan investment options with a more basic, user-friendly name such as “Inflation” or “Growth” fund, instead of “the XYZ Asset Management Fund.” The reasons sponsors are making the change to these structures include :

• to combine multiple managers (71%)


• ease of changing managers (64%)


• ease of participant communications (57%)


• lower total fund fees (43%)

In some sense, white labeling is already a practice adopted by all sponsors who currently offer a TDF, since TDFs are diversified multi-asset class structures with intuitive names like “XYZ 2025 TDF.” If you believe in TDFs, then in concept you already believe in white-label funds.

While this paper represents the DC lineup of the future, we also acknowledge that not all plan sponsors are prepared to implement all of these proposals immediately. Nevertheless, there are substantial benefits to a gradual implementation that moves toward simplicity and customization.

This might mean implementing only a custom target-date fund or reducing the core lineup to have fewer, more thoughtful options. Progress can be made in many ways—perhaps it is white labeling within an asset class structure or changing the lineup without re-enrolling.

Plan sponsors and participants are in the retirement readiness business together. Sponsors can help participants achieve their retirement “objectives” through a custom DC investment lineup design. This includes re-enrollment, a custom target date fund, and a streamlined set of objective-based funds in the core lineup.

William Ryan is an associate partner at Aon Hewitt Investment Consulting, Inc., Chicago.