Occasionally, we are asked about the use of custom portfolios, whether target date or target risk portfolios, for use in defined contribution plans. This blog post discusses both the reasons for and considerations that committees need to explore before deciding to offer custom funds to their participants.
Creating custom funds for a defined contribution plan can be appealing for several reasons, including:
- There are monitoring efficiencies generated by use of custom funds since the funds offered in the custom funds are also offered as stand-alone options. For example, a committee only needs to select and monitor one large-cap growth fund that can be used in both investment tiers.
- Custom portfolio construction has the potential to reduce investment fund fees. As described above, a plan will use single fund per asset class for both custom portfolios and stand-alone options. The use of a single fund per asset class allows for increased inflows to that fund and for the plan to reach investment fee breakpoints sooner. This can lower investment fees for participants utilizing either the custom portfolios or the stand-alone options.
- In 2013, the Department of Labor (DOL) provided plan sponsors a series of ‘tips’ for the selection and monitoring of target date funds. The DOL promoted the idea that committees should understand how their participant demographics align to the assumptions used to develop the comparable ‘off-the-shelf’ target date fund options. This idea is used to justify the creation of custom target date portfolios if a plan’s participants have a sufficiently unique set of circumstances such as an active defined benefit plan, unique retirement dates, salary levels, etc.
The items listed above offer compelling reasons for the use of custom portfolios. Before deciding to implement custom portfolios, we work with our clients to review the potential drawbacks of these investment structures.
- Committees should consider the amount of time and resources they dedicate annually to committee meetings. I refer to this as their ‘governance budget.’ Committees should anticipate an expansion of their governance budget due to additional activities required for custom funds (e.g., creation, implementation, and monitoring). In some cases, but not all cases, new vendors (such as a custodian/trustee or communications consultant) will be utilized by the plan.
- Creation of custom communications will be required to support participant education. This can include fund fact sheets, general plan education material updates, and plan website updates.
- Custom portfolios are more operationally complex than offering ‘off-the-shelf’ mutual funds or commingled funds. Depending on the plan’s recordkeeping vendor, the committee may need the services of a custodian/trustee to strike a daily net asset value and asset safekeeping services.
- Access to non-core fund lineup asset classes. Many plan sponsors limit the investment options that are available to participants to a distinct set of assets classes (e.g., intermediate fixed income, U.S. large-cap equity, etc.). However, there is a strong argument to offer asset classes within a multi-asset class fund, like a target date or target risk portfolio, that a committee might not be willing to offer on a standalone basis for a variety of reasons (e.g., high volatility, economic sensitivity, concentrated portfolios, etc.). By not offering these funds as both stand-alone and components for the custom portfolios, the Committee loses some of the fee and monitoring benefits discussed earlier.
In the end, committees considering custom portfolios need to weigh the benefits and drawbacks of the custom solution. Committees should engage in a process to demonstrate that the expected benefits are sufficient to overcome the development and ongoing ‘costs’ of offering custom portfolios to their defined contribution plan participants.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.