DC Managed Accounts: Shining a Spotlight on Investment Advice

Transcription

1 DC Managed Accounts: Shining a Spotlight on Investment Advice February 13, 2015 by Steve Ferber, Michael Esselman of PIMCO Nearly one in three defined contribution (DC) plans offers managed account and automated advice services that attempt to enhance investment outcomes with personalized advice. As the Government Accountability Office has reported, however, plan sponsors often have had limited or insufficient information to evaluate and monitor automated advice engines, despite having fiduciary responsibility over advice provided to participants. Fortunately, there are simple investigative strategies to make more thorough evaluations, potentially improving participant outcomes and reducing fiduciary risk for plan sponsors. You can observe a lot by watching. Yogi Berra Managed account and automated advice services have made significant inroads in defined contribution (DC) plans. Buoyed in part by the 2006 Pension Protection Act, which designated managed accounts as potential Qualified Default Investment Alternatives (QDIAs), these services are found in nearly one in three DC plans and oversee more than $100 billion in invested assets. Plan sponsors have adopted them for two main reasons: One, some participants want or need investment assistance, and two, participants may benefit from services that attempt to enhance investment outcomes by personalizing advice. In our view, when the advice is consistent with sponsors goals and based on sound investment practices, advice can be a powerful aid to DC participants. However, fiduciaries have faced challenges in evaluating advice providers. These were highlighted in a June 2014 report by the Government Accountability Office (GAO), 401(K) PLANS: Improvements Can Be Made to Better Protect Participants in Managed Accounts. The GAO report stated that plan sponsors often have had limited or insufficient information to evaluate potential providers and monitor ongoing services. Importantly, the GAO also noted that participants face similar challenges. The good news is that these challenges can be overcome. Providers typically disclose basic aspects of their offerings, such as fees and service levels. And when advice providers disclose details of their methodology, the evaluation can be fairly straightforward. However, even when this information is not disclosed, the investigative strategies we describe here can enable plan sponsors to evaluate automated account services with the thoroughness, diligence and thoughtfulness commonly used in target-date fund analysis. Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 It is possible to observe a lot by watching. Put differently, much can be gleaned by methodically varying the parameters these advice providers use in generating model portfolios. The approach is actually quite simple: The first step is to enter in the tool the characteristics of an average employee, including age, income, current savings rate and account balance. This average employee should be representative of a typical participant in a sponsor s plan, one who is saving at levels assumed to allow her to reach retirement success. Then, by changing the age of the employee, one can observe how the advice changes, including the levels of risk and diversification throughout an investor s career. This testing generates a variety of asset allocations and a glide path. Additional tests can lead to inferences about a managed account provider s fund selection and personalization processes and assumptions. We suggest focusing on three criteria when evaluating advice services: Glide path analysis, including risk and diversification levels, especially at retirement Fund selection The level and appropriateness of personalization factors Glide path analysis The backbone of any target-date fund is the glide path. The glide path is the asset allocation advice embedded in a target-date strategy, and it is explicitly communicated by the target-date provider. While managed account providers may not explicitly have a stated glide path, given the unique nature of their advice, they do have risk, return and correlation assumptions that serve as direct inputs into an implicit baseline glide path. Our research shows that glide paths vary greatly among asset allocation services, including managed account providers. Plan sponsors should evaluate the allocations to and weightings of the various asset classes in managed account services, exactly as they would in their evaluation of target-date funds. Similar to a review of target-date funds, sponsors should ask the following essential questions: What is the level and mix of equity and other risk exposures throughout the glide path? Are the associated risks appropriate, particularly near and at retirement? What levels of diversification and inflation hedging are included at various points along the glide path? How does the advice compare with the target-date funds a plan may also offer? Is it consistent, or will participants receive advice that is misaligned with what is embedded in the target-date funds? As Figure 1 shows, different providers may generate diverse glide paths, even for identical individuals. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 In sum, sponsors who decide to offer advice should assess how well the implicit glide path matches their goals for diversification and risk management throughout an employee s career. Fund selection Managed account services generally create portfolios with funds in a plan sponsor s core lineup, which typically reflect the opportunity for growth and risk mitigation in a range of economic environments. Managed account services, however, may use only a portion of the investment options because of differing investment philosophies or beliefs. These beliefs, however, may or may not be consistent with those of the sponsor and/or the participant. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 To clearly identify and better understand the advice provider s investment beliefs, we suggest plan sponsors load a broad range of investment options, including money market and stable value funds, actively and passively managed funds, individual and multi-asset class funds, a range of equity strategies that complete the style box, commodities, TIPS, and REITs. This approach will provide insights into a managed account provider s investment beliefs related to critical issues, including: (1) the value of active management versus passive management, (2) the use of various specific investment strategies and investment vehicles and (3) the level of fees versus excess return generation. There are several key factors to observe and questions to answer: Does the provider have a strong bias toward active or passive strategies? Is this bias consistent with the sponsor s views and how the investment menu was created? How are returns likely to be affected? Can the provider generate portfolios that incorporate multi-asset strategies? This may be important for sponsors who offer multi-asset strategies rather than options for individual asset classes as part of the core menu. Is the advice restricted to specific types of investment vehicles such as mutual funds? Or does it also consider collective funds and separate accounts? Personalization Receiving personalized advice is a primary reason many sponsors and participants will pay additional advice fees, which ranged from basis points among the providers studied by the GAO. Given the additional fees, sponsors need to consider how and to what extent the personalized advice will lead to better outcomes. While certain advice providers may offer a summary of some or all items that are personalized, querying the advice tools can also help sponsors determine the actual level of personalization of the advice and the associated effect on a participant s portfolio. Sponsors will be able to have a clearer picture of the level of personalization by changing various inputs, notably the level of savings outside of the plan, marital status, a participant s risk tolerance, company stock holdings and, curiously, a participant s initial portfolio holdings. We suggest assessing personalization by two main criteria: 1. Degree of personalization Plan sponsors should evaluate to what extent the advice integrates personal information and to what degree the personal data affects the investment recommendations. Specifically, sponsors should consider whether a material change in the input leads to a material change in the output essentially, a measure of the level of personalization delivered by the advice provider. Small deviations from the implicit glide path, no matter how significant the changes to the inputs, suggest that the level of personalization delivered by the managed account provider is limited. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 Figures 2A and 2B show sample glide paths and the way these may vary based on personal circumstances. The glide paths in Figure 2A reflect greater personalization than those in Figure 2B. If providers claim personalization as a benefit, sponsors should be sure to understand how much personalization is actually implemented. 2. Quality of personalization Plan sponsors should understand which personal factors affect investment recommendations and whether they are likely to enhance outcomes. These factors likely include risk tolerance, savings outside the DC plan, health considerations, etc. For example, in our research one factor used by some advice providers a participant s prior asset allocation may not lead to optimal portfolios. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

7 As an example, Figure 3 compares how an advice tool varied its investment recommendations based solely on whether a participant s assets were invested 100% in a money market or 100% in a TIPS fund prior to engaging the advice tool. As you can see below, the resulting allocations were meaningfully different, even though the only variable we changed was the initial investment. Sponsors evaluating the value of advice should consider whether factors such as the initial allocations are an effective way to improve participant outcomes. Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.

8 Know thy provider Most DC professionals, ourselves included, generally agree that many participants would benefit from high quality, personalized investment advice. In addition, most agree that managed accounts and advice are likely to be a part of the DC market for the foreseeable future. As the GAO report suggests, however, enhanced transparency, due diligence and monitoring are the keys to future success for participants and fiduciaries. We anticipate that the GAO report, and the expected Department of Labor follow-up, will lead to continued improvements in the way these services are evaluated by DC plan sponsors and participants. Fortunately, there is little need for sponsors to wait for more government action. Sponsors can act now, as outlined in this paper, to enhance review and oversight of advice and managed accounts in ways that may indeed lead to better outcomes for participants and reduced fiduciary risks for plan sponsors. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.

9 tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government.management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Glide Path is the asset allocation within a Target Date Strategy (also known as a Lifecycle or Target Maturity strategy) that adjusts over time as the participant s age increases and their time horizon to retirement shortens. The basis of the Glide Path is to reduce the portfolio risk as the participant s time horizon decreases. Typically, younger participants with a longer time horizon to retirement have sufficient time to recover from market losses, their investment risk level is higher, and they are able to make larger contributions (depending on various factors such as salary, savings, account balance, etc.). Generally, older participants and eligible retirees have shorter time horizons to retirement and their investment risk level declines as preserving income wealth becomes more important. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax and/or legal questions and concerns. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. 2015, PIMCO. Page 9, 2018 Advisor Perspectives, Inc. All rights reserved.