Defined contribution(DC) plans have become increasingly popular in recent years as the main retirement savings vehicle for employees. As opposed to defined benefit(DB) plans where retirement income is predictable, DC plans put more responsibility on employees to make investment decisions and rely on investment managers to generate retirement wealth. This article analyzes the key factors that determine the performance of investment managers in DC plans.
Investment managers play a critical role in DC plans by constructing portfolios and generating returns
In a DC plan, employees contribute a portion of their salary into an account which is invested in various funds chosen by the investment manager. The ultimate retirement income depends on factors like employee’s contribution rate, investment returns, fees charged by investment manager and participant behavior. Among these, investment returns are clearly an important driver of retirement wealth accumulation and the investment manager’s portfolio construction and security selection abilities directly impact returns. Hence, the expertise and experience of the investment manager is crucial in determining retirement outcomes for employees.
Long-term performance track record reflecting ability to generate alpha is a key criterion for selecting investment managers
Plan sponsors such as employers look at the long-term performance track record as the primary criterion when selecting investment managers for their DC plans. Specifically, they want managers who can consistently beat their benchmarks and generate excess returns even after adjusting for risk over 3, 5 and 10 year periods. Generating alpha requires expertise in areas like asset allocation, security selection, risk management, behavioral psychology etc. Hence, investment managers with a demonstrated long-term track record of outperformance possess skills and experience to fulfill their responsibility towards DC plan participants.
Providing diverse fund choices catering to different risk appetites aids participant outcomes
While investment managers make the investment decisions in DC plans, participants get to choose which funds to invest in as per their risk appetite. Hence, having a diverse set of fund choices allows participants to construct a portfolio suiting their individual needs. The fund menu should include index funds tracking various asset classes for passive investors, target date funds providing one-stop diversified exposure as well as actively managed funds focused on specific sectors or geographies for tactical tilts. By providing choice and flexibility to meet varying participant requirements, the investment manager contributes positively towards long-term retirement wealth creation.
Maintaining competitive fee structure ensures participants retain larger share of returns
In addition to portfolio returns, the fees charged by investment managers also directly impact participant outcomes in DC plans. This includes expense ratios of the funds on the menu as well as any additional advisory or service fees. While some fee expense is justified by the expertise provided, investment managers have to strike a balance between quality and costs. Especially for index funds tracking standard benchmarks, participants expect fees to be low. Competitive fee structures ensure participants retain a larger share of returns over the long term to enhance retirement balances.
In summary, investment managers play an integral role in DC plans by delivering consistent long-term returns, providing diverse fund choices and maintaining reasonable fee levels. Plan sponsors should evaluate investment managers on these criteria before selection to ensure suitable participant outcomes.