Investment Selection and Monitoring: A Practical Approach to Best Practices
By Donald Stone, AIF®. Mr. Stone is President of Plan Sponsor Advisors, LLC, an investment consulting firm and registered investment advisor that works exclusively with qualified retirement plans. You may reach Don at: email@example.com, call 312.214.1500 or visit their website at www.psaretire.com.
As investment consultants, Plan Sponsor Advisors, LLC deals with these questions every day. In meeting with plan sponsors and reviewing plans, their oversight process (or lack thereof) and their asset allocation, we have become convinced of the need for a best practices approach. A recent study by Elton, Gruber and Blake of 400 plans found that:
These statistics are particularly disturbing when you realize that assets in a 401k constitute the single largest financial asset for 50% of all plan participants. Any plan utilizing a best practices approach to fund selection and monitoring should avoid each of these pitfalls.
Below we have outlined what we believe is a best practices approach to investment oversight, including:
Plan sponsors may legally be able to (and often do) do less. We are not lawyers, but as investment consultants we feel obligated to consider those elements that may mitigate fiduciary liability, head off potential costly litigation before it happens, and provide participants with a superior benefit plan.
What ERISA Requires
Plan Sponsors often struggle to understand what they need to do to fulfill their duties as a fiduciary. The Employee Retirement Income Security Act of 1974, better known as ERISA, says that plan fiduciaries are held to the standard of a "prudent expert" unless they hire a professional "with knowledge of such matters" to assist them (§404(a)). In §404(a)(1)(B) ERISA requires fiduciaries to determine a reasonable asset allocation and ensure that the investment furthers the purpose of the plan.
The Department of Labor (DOL) has made it clear that in enforcing ERISA they will not judge fiduciaries on the results they achieve but rather by their process they follow. But process is not static. What might have been a reasonable process in 1974 would almost certainly not be today. And best practices of just a few years ago, may not be today. Fred Reish, a nationally known ERISA attorney, recently commented, "the expectations of the performance of plan fiduciaries and committee members, is increasing." This evolving standard may catch some plan fiduciaries unaware and expose them to unnecessary liability because they have not reviewed and revised their process.
At the time that ERISA was enacted, most retirement plans lacked professional management. Security selection was often an informal process conducted by company executives on a part-time basis. Even professional money managers lacked many of the analytical tools available today. ERISA's enactment jump-started the move to professional asset management, while the development of a broad range of software tools over the succeeding decades has created a much more rigorous and demanding process than was followed in past years.
It is hard to believe (even for those of us who witnessed each step along the way) that when ERISA was enacted there were no personal computers to crunch the numbers. The investment analytics that were available were computed by hand or on a mainframe computer. The Sharpe Ratio, developed in 1965, was not yet in general use and the ubiquitous nine style boxes devised by Morningstar were years away from invention. In the mid '80's when 401k plans were being formed, investment returns were reviewed, but true investment analysis was typically done only for defined benefit plans.
What we have seen in the 30 years since ERISA's enactment is an evolving process and a continuing growth of, and accessibility to, sophisticated investment measurement tools. The regulatory and litigation environment continues to evolve as well, most notably with the enactment of Sarbanes-Oxley and its governance requirements. Sarbanes' requirements for public companies are rapidly being adopted, in limited form, by many private companies, and the governance issues are applicable to the oversight of virtually all retirement plans. In addition, there are a number of high-profile on-going lawsuits pertinent to participants and their retirement plans, including Enron. Enron is establishing precedent on who is a fiduciary in addition to addressing issues around company stock in the plan. Whether a company is public or privately held, these are watershed events for plan sponsors of retirement plans. In short, what was considered a good process in 1980, or even 1990, might well be considered imprudent today.
A Best Practices Approach for Today
So if the standards have changed over the years, what is a best practice approach for today? That is, what combination of process and analytics will provide fiduciaries with the knowledge they need to make informed decisions, and what is most likely to withstand challenge by the Department of Labor or plaintiff's counsel? By best practices, we are including not only investment analytics that should be used to choose and monitor investment managers or funds, but also non-technical processes or actions taken by fiduciaries to fulfill their duty and thereby mitigate liability. That process is supported by the analytics, but neither part can stand alone.
A best practices approach lends itself to a natural breakdown into three areas: 1) procedural process, 2) asset allocation, and 3) on-going monitoring analytics. Procedural process deals with how the fiduciaries go about the process of selection and oversight. Asset allocation deals with the actual selection of asset classes for the plan and how they relate to each other. On-going monitoring analytics focuses on how funds or managers are actually measured over time.
A best practices fiduciary process should include each of the following:
Too often plan fiduciaries simply view the 404(c) requirement to offer a broad range of funds as simply a numbers game - offer enough funds, the thought goes, and fiduciary liability is mitigated. From an investment best practices point of view, we believe that this approach is flawed. Simply offering a lot of funds does not necessarily mean that participants are being offered a broad range of funds in the sense that broad connotes funds fulfilling different points on the risk-reward spectrum. In fact, based on the study by Elton, Gruber and Blake cited earlier, most plans may not offer a broad selection of funds in the investment sense, even though the average plan offers 12-14 funds according to most studies.
The process of analyzing investments is not a disjointed exercise that only evaluates each manager or fund independently. Rather, the process is a more elaborate construct that evaluates not only each manager/fund against a number of relevant metrics, but also evaluates how the various managers/funds fit together as a coherent whole (or not).
In a defined benefit plan this allows the construction of an efficient asset allocation to meet the needs of the plan. In a self-directed plan [401k, 403(b)] it provides participants with the raw material to construct a reasonable asset allocation across the risk-reward spectrum. This helps ensure that participants will not inadvertently increase risk by choosing multiple funds with the same securities, or a different asset class than they expected. It also provides participants with the opportunity to choose funds that are not highly correlated with each other, mitigating volatility in the participant's portfolio. Utilizing mostly funds from one fund family should generally be avoided for this reason. A 2004 New York University - Emory University study found a very high correlation among funds for many of the largest mutual fund families.
Plan fiduciaries should construct an investment menu (or review the current menu) to see that:
We have identified ten measures that fiduciaries should evaluate on an on-going basis as a best practice. We have also indicated the frequency for monitoring each. As noted above, each of these measures should be tied back directly to the investment policy. None of these should be seen as absolutely determinative as to whether a manager should be replaced. If one member of a team of investment managers leaves a fund, the fund should be placed on a watch list and further investigation performed. Similarly, if a fund under-performs for one or more quarters, the reasons for the under-performance need to be understood.
In a brief paper such as this, it is impossible to cover in detail how investment oversight and selection should work in a best practices approach, and this paper is not meant to be exhaustive. Even so, we recognize that what we propose may represent a significant change from the current practices for many plan fiduciaries, and many will be reluctant to change.
But in a decade that may well see single digit average returns, plan fiduciaries face increasing scrutiny from participants and regulatory agencies. Implementing a best practices process for investment selection and on-going monitoring can mitigate fiduciary liability. Just as importantly, a sound investment monitoring process will ensure that participants have a better chance of reaching their retirement goals.
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