Steering plan sponsors through investment customization

November 13, 2019

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Lisa Swatkoski

Lisa Swatkoski

Custom glide paths. White-label funds. Alternative asset classes. The conversation around custom investment solutions in retirement plans is broader today than ever.

In the simplest sense, a custom investment solution packages one or more investment strategies into a single fund and strikes a daily net asset value (NAV) at the portfolio level. The goal of a custom solution is to improve outcomes for participants, either through better investment performance or by simplifying a plan lineup to help participants make better investment choices.

When I talk to plan sponsors about the pros and cons of customization, I encourage them to think about the three Cs:

  • Consolidation. Could your defined contribution (DC) plan participants benefit from a consolidated, easier-to-understand investment menu?
  • Control. Do you hold investment beliefs or preferences that require greater control over investment design for your DC or defined benefit (DB) plan?
  • Cost. Will the all-in cost of customization fit into your fiduciary budget?

Answers to these questions should help a sponsor decide whether customization is right for their plan. But the three Cs aren't the only criteria that can affect their plan. For a sponsor who expresses interest in customization, I walk them through another set of considerations.

Where does customization fit in a retirement plan?

Plan sponsors can create a custom investment solution to fit into any tier of a DC plan lineup—including a single-fund solution tier (e.g., a custom target-date fund), a passively managed building block tier (e.g., a custom global equity index fund), or a supplemental choices tier (e.g., a custom U.S. active equity fund).

DC plan sponsors can leverage the power of customization to streamline a plan's investment lineup. The illustration shows how funds that cover distinct sub-asset classes could be combined into a single, broadly diversified custom option. Simplifying the investment menu in this way can help participants more easily understand the role that specific funds play within their portfolios, potentially leading to better investment decisions and outcomes.

Consolidation of investment options

Consolidation of investment options

Custom solutions can also simplify the portfolio construction process for DB plans. For example, a DB plan sponsor could create a fixed income strategy that combines long-term corporate bonds and Treasuries to hedge the specific interest rate sensitivity of the plan's liabilities.

The ability to use lower-cost trust vehicles rather than mutual funds provides another potential rationale for creating a custom solution for a DC or DB plan.

Building a custom investment solution

Asset allocation is the primary driver of return variability in a diversified portfolio, so it should be the primary focus when building a custom multiasset solution. For many plan sponsors, it may be central to the decision to customize in the first place. For example, a custom glide path may be more appropriate than the glide path of a standard off-the-shelf target-date product if the demographics of the participant population are materially different than those of the average plan. A plan sponsor may also have a preference for adding asset classes that are not included in an off-the-shelf product, which could prompt the decision to adopt a custom approach.

Customization also allows a plan sponsor to apply specific preferences within asset classes and sub-asset classes through the creation of a white-label fund. At the asset class level, this could mean a country home bias relative to market-cap weight or the inclusion of alternative investments. At the sub-asset class level, it might be combining a plan's large-cap domestic equity options into a single large-cap fund, overweighting emerging markets within an international equity fund, or overweighting investment-grade corporate bonds within a fixed income fund. Regardless of the specific approach, sponsors should weigh their own preferences with the risk-reward trade-offs of these investment decisions, and with their appropriateness for plan participants as a whole.

Customizing for unique investment preferences

Sample investor preferences

Customizing for unique investment preferences
Customizing for unique investment preferences

Implementation considerations

Investment selection is critical and plans may benefit from partnering with a provider open to all investment types, such as alternatives, commodities, and private real estate. When considering nontraditional investments, keep in mind that liquidity, transparency, and higher cost may pose an additional set of administrative challenges.

Custom options are often thought of as being actively managed. However, plan sponsors may choose an implementation approach that is passive, active, or a combination of the two, depending on their objectives for return, tracking error, and cost.

Custom fund structure is another consideration. A single-manager structure can work well for plan sponsors seeking simplicity and diversification, typically in a passive, multiasset portfolio. Multimanager structures provide enhanced investment capacity, greater diversification, and the potential to reduce factor exposure and volatility. Fund-of-funds structures offer advantages similar to those of a multimanager approach. The difference is that a fund of funds is created from existing stand-alone funds.

A final consideration for custom solutions is the use of proprietary funds versus an open architecture framework.

Partnering with a co-fiduciary or going it alone?

Fiduciary and oversight responsibilities tend to grow with customization. While plan sponsors with sufficient in-house resources may choose to serve as their plan's sole fiduciary, others may decide to draw on the expertise of a co-fiduciary, such as an investment manager or consultant.

Working with a co-fiduciary never eliminates the sponsor's fiduciary responsibility. But it can free up the sponsor's time, allowing them to focus on the bigger picture—whether that's increasing DC plan participation and savings rates, DB plan concerns, or broader organizational health.

ERISA legislation states that a co-fiduciary can serve a plan in one of two ways:

  • As a 3(21) advisor that provides advice on strategic asset allocation, investment managers, and multimanager options. In this relationship, plans retain the right to accept or reject the advice.
  • As a 3(38) advisor that serves as a delegated fiduciary and discretionary investment manager with the authority to implement, monitor, and replace funds and investment managers. In this relationship, the plan sponsor still carries a fiduciary duty to monitor the advisor.

I compare the fiduciary role to that of a driver and passenger in a car. A plan sponsor can choose to take the wheel and drive all the investment decisions, with a little guidance from their passenger. Or they can choose to ride shotgun and allow someone else to drive. The sponsor may offer guidance along the way, but ultimately the driver (or co-fiduciary) makes the final decisions. In either scenario, the plan sponsor never relinquishes their full fiduciary responsibility.

Putting the custom solution into play

Custom investments can require substantial administrative services. Plan sponsors may rely on investment managers and consultants to implement, manage, monitor, and explain a custom investment to plan participants. Sponsors may also choose to assume these duties if they have in-house expertise and resources.

Serious thought should be given to valuation—striking the NAV—and how to account for illiquidity, which can have significant implications for a portfolio's ongoing cash-flow management and rebalancing strategy. A disciplined process is necessary to reduce risks associated with accounting and rebalancing.

The elements of custom fund administration

The elements of custom fund administration
The elements of custom fund administration

Our experience and expertise

Vanguard has provided discretionary advisory services to institutional clients for more than 20 years. Our team of strategists and specialists employs the deep investment research and expertise of Vanguard Investment Strategy Group to build custom portfolios for institutional clients based on their unique objectives and preferences. Our services also include administration—from valuation to implementing systematic rebalancing—for more than $210 billion in custom fund-of-funds portfolios.

Our expertise in customization is informed by our experience partnering with world-renowned asset management firms since 1985 on multimanager funds, pairing distinct yet complementary investment approaches to build solutions for clients under the Vanguard brand. Today, we manage more than $230 billion in assets across 15 multimanager funds.

Building an effective custom solution requires a wide range of capabilities and expertise. Vanguard's customization services cover the full spectrum of support—from investment design and management, to manager selection and administration. We're flexible in our approach. Whether a plan sponsor chooses to be in the driver's seat or ride shotgun, we can help them reach their destination.

Contact your Vanguard representative to engage our investment experts and learn whether our approach to customization is right for your plan.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • Past performance is not a guarantee of future returns.