A main source of concern for plan sponsors we work with and talk to is the quality of their investments within their retirement plan. Retirement plan fiduciaries frequently express their lack of investment acumen when making decisions on investment options within the retirement plan, and often worry about making a wrong decision that can negatively impact employee retirement outcome. This blog is meant to address those concerns and how to structure a process that works towards positive results for fiduciaries and plan participants.
New members joining a retirement plan committee work quickly to get up to speed with the terminology and lingo of the group, and can be especially intimidated when it comes to investments. Talk of "excess alpha", "peer performance", or "active and passive" makes many fiduciaries shrink away from conversations due to lack of familiarity. One term that causes lots of heart burn for committee members is when an investment is deemed to be on the "Watch List". What does that mean and how concerned should one be when they see a fund or multiple funds show up on this so called list? First, let us back up a bit and give some context to a process around selecting investments and then evaluating them upon inclusion in the plan.
As the Department of Labor (DOL) provides oversight to retirement plans, a necessary reading to meeting your fiduciary responsibilities can be found here: The Meeting Your Fiduciary Responsibility Guide from the DOL. From this guide:
"...while a fiduciary may have relief from liability for the specific investment allocations made by participants or automatic investments, the fiduciary retains the responsibility for selecting and monitoring the investment alternatives that are made available under the plan. "
How do fiduciaries decide how to select and monitor the investments in the plan? The first step usually entails hiring an investment advisor to assist with the practice, and next working to create an investment policy statement (IPS). The IPS will create the process by which the committee will select, monitor and replace investments in the plan. Generally, the IPS will dictate the criteria used to evaluate all investments in the plan to criteria that the committee believes is reasonable in measuring an investment contained in the plan.
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Mechanically, an Investment Policy Statement that is too strict in its expectations of the 401(k) or 403(b) investments will cause frequent failures among the majority of investments. However, if the Investment Policy Statement is too loose in measuring money managers, then none of the investments may ever fall onto the watch list. Problem solved? Not so fast! A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard….The failure to make an independent investigation and fair evaluation of a potential plan investment is a breach of fiduciary duty. It may be difficult to defend making a fair evaluation of an investment if every investment could meet the prescribed thresholds of the IPS.
The funds that do not meet the criteria are generally placed on a "watch list" and are now under more scrutiny and close watch by the committee . If the committee believes that the reason why the investment is on the 403b or 401k watch list has caused the strategy to be permanently impaired, such as the investment manager leaving or fund assets declining below a certain threshold, the retirement plan committee may decide to eliminate the fund option from the plan. These types of watch list failures can be pretty clear as to when to eliminate the fund as an alternative available in the plan. In many instances , the 401k or 403b watch list failure may show underperformance to a stated benchmark or peer group but the underlying investment strategy has not changed. This can be the case with "active" investment managers, who are trying to get more investment performance than a benchmark or peers, as their strategy may oscillate back and forth meeting watch list criteria or not based upon the market cycle.
One thing to note with investments on a retirement plan watch list, there is not a prescribed time period that a committee must adhere to when removing a fund. As many of us don't like to see failing grades, the natural tendency of committees is to simply remove a fund as soon as the investment is placed on the watchlist. This can create several issues. 1) Operationally making a fund change can be difficult as a notice period is required to give participants notice of impending changes to their 401(k) or 403(b) investment options. 2) Participants can become confused by which options are in their plan if funds are changed too frequently. As employees have difficulty understanding the entirety of their savings options and how the investments work, making frequent changes can compound the confusion quotient of the 403b or 401k participant. 3) An investment's philosophy may simply be out of favor during the current market cycle. Changing the investment to a philosophy that is meeting your IPS criteria may lead the retirement plan committee to performance chasing just as the market cycle changes a different style coming into favor.
With our clients, there are many times that Guidance Point consultants preach patience for the investment manager that falls onto the watch list. If the underlying strategy is intact, the management team has not suffered employee turnover, and the strategy has proven to show outperformance, or alpha, relative to peers and their index over a full market cycle, we believe the investment option is sufficient to remain under close scrutiny unless other issues are created by cyclical underperformance (such as the fund manager is fired or investors are rapidly leaving the fund).
We hope this blog post provides you a solid starting place for thinking about watch list investments with your retirement plan committee. If you have more questions about your how to structure your retirement plan investments, and you're struggling with designing your plan investment menu and IPS, please download our free eBook Fiduciary Best Practices for Plan Menu Design.
Other blog posts you may enjoy:
The 3 Questions an ERISA Compliance Checklist Will Answer
How Much Does a 401k Plan Cost?* (Or How Much Should Your 401k Plan Cost?)
What Does It Mean to Hire a 3(38) Advisor / Investment Fiduciary?