Plan Fiduciary Investment Oversight Considerations and Methodology

Learn about your role as a retirement plan fiduciary, the laws that govern fiduciary responsibilities and how you can help protect yourself and your business.

Fiduciary Investment Oversight

Tom and Dan cover ERISA guidance and regulations on fiduciary duties and how to elevate the investment oversight process.

Tom Conlon:     Thank you so much for joining everyone.  Really, appreciate you taking the time today.  My name is Tom Conlon.  I head sales for our Retirement Solutions team within Morgan Stanley at Work.  And I'm joined today by Dan Hunt, who's the head of Retirement Solutions and Investment Tools.

And today we're going to talk to you about a few things.  First, we're going to talk about our fiduciary investment best practices and methodology.  And we're going to break today's session down to three parts.  Number one is I'm going to talk a little bit about ERISA guidance and regulations on fiduciary duties.  Dan is then going to talk about elevating the investment process and really standard for defined contribution plan fiduciaries.  

So what is a fiduciary and how does that relate to a retirement plan?  So if you have oversight over a retirement plan, ERISA requires that you operate in the best interest of retirement plan participants, and that is your fiduciary duty.

You also have a duty to have oversight over your 401K plan and make sure that only reasonable expenses are paid from plan assets.  You're required to act with care, skill, prudence and diligence in carrying out your duties as a retirement plan fiduciary.  And as you all know, if you sponsor a retirement plan, there are many documents in specifically a plan document that prescribes how the plan is to work, and you have to make sure that the operations and the oversight of your plan are done in accordance with your plan document.

So how do you carry this out?  So we bring up this ERISA framework really as an introduction to get you to think about your fiduciary duty, think about oversight and what it means to carry out that oversight.  So what we're showing you here is a way to break down this oversight.  And Dan is going to speak to some of how we do this when we're assisting our clients in this fiduciary capacity.  Our global investment manager analysis team, they're the ones who oversee our fund menus and recommendations that we make to our clients.

Your investment process as a fiduciary on a retirement plan should start with an investment policy statement.  It doesn't need to.  There's no law that requires you to have an investment policy statement, but it is definitely a best practice to have an investment policy statement.  And what is in that document?  That document lays out a process, a prudent process that you would follow as a plan fiduciary for oversight of your retirement plan.  And that prudent process really keeps you honest in acting in that duty as a fiduciary to your retirement plan participants.

So the proprietary investment manager analysis that we do covers a multitude of asset classes.  It covers a multitude of products, certainly mutual funds, certainly exchange-traded funds.  We also do analysis on stable value funds.  Stable value funds are very specific, usually to retirement plans.  So today is really focused on mutual funds and exchange-traded funds.  And Dan's going to give us a little bit more information on that later.

So when we think about asset allocation, it is really the number one driver.  The number one attribute of overall outcomes.  So a lot of times we focus as investment professionals or plan fiduciaries or retirement plan managers.  We spend a lot of time focusing on what are the fees within the funds, focusing on actual security selection of each of the individual securities that we offer to retirement plan participants.  But the number one driver of outcome is actually asset allocation and how well a retirement plan participant allocates their overall assets.

When we look at our investment committees and we think about all of the time that we spend on talking about fees, talking about individual securities or funds that we offer within the plan, all of that is great.  But who is assisting your participants with these asset allocation strategies and how do we build confidence with retirement plan participants that they are allocated appropriately?  Because again, this is the number one driver of outcomes as it relates to participants.

So now at this point, I'd like to introduce Dan Hunt.  Again, Dan is the head of Retirement Solutions and Investment Tools, and he's going to talk about elevating the investment process.  So Dan, over to you.

Dan Hunt:         Thank you so much, Tom.  I think the place to start when people think about Morgan Stanley, obviously, we are an investment institution But a DC plan is not an investment account.  What it actually is, is something that delivers retirement benefits to participants.  And it's a distinction that's important because when we think about the fiduciary standard that Tom just articulated, a lot of times historically this has been articulated by – the way fiduciary oversight has been administered at the plan level is how is my fund doing and what are the expenses and things of that nature.

If we look at the actual standard, it has to do with providing benefits for participants, not necessarily providing certain level of competitive returns.  Now, of course, that's a component of how we judge what we deliver.  But I think that becomes critical and especially when you look at some of the lawsuits and things that we've seen that have come up.  

If we think about a defined benefit plan on the left-hand side, the investment decisions that get made in terms of most importantly, the asset allocation, that big 85% of all outcomes coming down to asset allocation piece, as Tom showed.  But also all the way down to any tactical asset allocation decisions we made or manager selection decisions bottom box on the bottom left of this slide, they all ultimately are accountable to funding status, which is the ability of the plan to provide retirement benefits for participants.

Theoretically, the same thing is true of defined contribution plans.  However, logistically it doesn't work quite as easily.  And so when we talk about elevating the investment process, what we're really talking about is getting to that fiduciary standard where we center benefits to participants in the context of every decision that we make.  

But in general, all the decisions that we make rolling up to retirement readiness should be a similar goal, analogous goal for DC relative to DB.  And so what does that mean?  Well, the first thing that means is that, again, when we talk about the 85% of return as asset allocation, some of that is skill and creating a diversified mix of investments that reduce risk and improve return.  That's kind of asset allocation 101.  But most of that big number is coming because it is a determination of how much risk we take in the first place, which ends up being really important.

Now how do we determine what the right asset allocation is?  So therein is where it gets more complicated in DC than it is in DB.

The DOL highlights is important to do is to look at the demographics of your participants, look at all of their specifics, look at any other benefits they might have available to them to begin to draw that line back from the QDIA back up to retirement readiness.  So in other words, the benchmark that we choose for this, in this case, the qualified default investment alternative, and that's the most important decision.  Because that's where most of the assets are going to go to the extent that the plan does have a QDIA, and even if it doesn't, oftentimes these options, these balanced options will be generating the line, attracting the lion's share of flows from your participants.  

What type of QDIA do I use and how does that relate to what my participants need based on who they are, based on the preferences that we can ascertain?  And that's how you get that 85% right.  And if we have the right benchmark, we can solve backward into what types of funds and products and other types of whatever the case may be, might be the right fit in this case for the QDIA.  And of course, the context is different for a QDIA as it is for other funds on the lineup.

So this is where I think, DC has an opportunity to be more valuable as a benefit to participants and also where it's a risk.  And it will be something that you all are very familiar with, which is there's a lot of control that a DC participant continues to be able to exert relative to a DB participant.  

The good news here is that those participants that are making these decisions, what we call them periodic rebalancers that are not using the self-serve the autopilot solution of the QDIA and the balance fund that's on the lineup.  They're engaged.  And an engaged participant is going to potentially be able to make use of any educational material that you're providing and that your advisors are helping to provide for you.

Also in the DC context, we can offer some additional services that are also potentially very value-added, such as guidance around how much to save or spend, what's the most tax efficient way to withdraw when we get to retirement and things of that nature.

as with the QDIA, you are still making decisions that again, you have to relate back to the provision of benefits for your participants.  You are making decisions about whether to put – what types of asset classes to put into the fund lineup, which types of vehicles are you going to be using to allow them to implement those asset classes?  Are they going to be passively managed vehicles or actively managed vehicles?  And then finally, you're going to actually have to determine, qualify and determine which products themselves will be used?  

And on the other hand, you have the QDIA decision.  In the QDIA decision, you have the asset allocation call that needs to be based in the demographics and preferences of your specific participants.  But on the engage participant side, you need to be providing the education so that they can do that themselves.

That minimum standard for what the DOL is calling for when we talk about the fiduciary standard, like how are we giving them exposure to the right asset classes that match the provision of ultimate benefits that they're going to need in retirement?  How do we give them the right asset classes, the right exposures, the guidance on the asset allocation or the QDIA asset allocation and how do we do that?

There are also investment-centric opportunities for adding value, and those would include things like asset allocation, which in a managed account structure it's something that a plan sponsor can assist beyond just the strategic can we help them decide to over underweight asset classes on a tactical basis?

And then I mentioned the active-passive decision in the manager selection decision.  And the final one is the portfolio construction decision.  How do we think about how those things play together in the sandbox?  And those things can be complementary and each of these levers can add additional value, but there is expense in some cases associated with that.  So we have to weigh that potential value against the non-expense in making that decision in a fiduciary compatible way.

So when we talk about active management versus passive management, and this is very important both for the QDIA structure itself because some of these QDIAs will be all actively managed at the sleeve level and they will have differing fees regardless and different philosophies, regardless.  Like even among the passive, for example, target date funds.

Some passive target date funds have an actively managed asset allocation where there's pretty dynamic rebalancing of asset classes, one or the other, and those are typically charging higher fees.  And you have a very truly passive PTDFs that kind of stay put in a single asset allocation that glides down over time and everything is passive underneath the hood.  There are also the hybrid blend-type products to consider.

And when we think about the lineup itself, how do we start thinking about how do you blend active and passive?  It's important to keep in mind that both of these things have things that commend them to us and both of these things have drawbacks.  So if we talk about active first and foremost, in our studies about active management, we see a couple of things.  We see, one, that active managers actually have a greater opportunity to add value on a risk-adjusted basis after expenses in down markets than they do in up markets.

That actually has a lot of value for retirement investor when we think about the behavioral, the psychological impact of losses, especially near retirement and some of the potential negative behaviors that are associated with that.  Active management, any additional return, any incremental return that it can add, especially when it's coming in those markets can be particularly valuable.

But the nice thing about actually thinking about allocating to active is if you do that selection judiciously, you can find active managers that are more likely to outperform and do provide that value sometimes in up markets and more especially in down markets.

The flip side, of course, is that your passive managers are obviously going to be much less expensive.  There are extremes of markets that can cause that to actually not be true.  In the case of like the top of the market in 2000 where it was – and really kind of the recent peak in the market where you have a lot of concentration in a few names that are the FANG stocks and things like that.  Generally speaking, passive can oftentimes contain more securities and more diversification than active.

How do we think about making that decision?  The way we think about it is there are both certain types of asset classes where active is likely to be more helpful than others.  So let's think about if we want to do active, let's do more active over here and maybe less over there.  And likewise, there are also circumstances, market circumstances under which active is more likely to be profitable.

The latter is less likely to be useful in DC context because it is a slightly higher frequency, but it can influence our decisions at the margin.  But certainly, paying attention to which asset classes are less efficient and have a history of being able to have better active management performance is an important component of this.  So that's active versus passive.

So that piece will determine do we want to go passive or active in any individual asset class that we want to put into the lineup and together with other analysis, can help inform the QDIA selection and monitoring process.  How does it work when we come to figuring out which managers belong there?  We're devoting a lot of resources picking which active managers we want, we consider appropriate.

So if we think about our process and generally any process that we would commend as an approach to doing active management, you have to have a broad scope of manager research.  The way we're going to do that is we start mostly with a quantitative oriented analysis.  We have several proprietary quantitative tools that allow us to shrink a very large universe of candidate solutions to a smaller one.

And then within that, we have a team of due diligence analysts close to 100 who are actually meeting with – understand and doing the fundamental work around selection.  And they're further whittling that number down to the ones we have good quality investment processes coming from good firms that have some consistency in their management structure and a good corporate governance model.  And we call them our focus list.  And then within that, we will end up choosing the funds that will go into the lineup.  

So that is the manager research process that's ours that we speak from.  But I think it rhymes with any appropriate manager research process that you would be using to document a decision around active managers, as we believe is an important and useful way to live up to the fiduciary rule.

So the final bit is how do these managers that we end up choosing, how do we go to that from that list of high conviction managers with an asset allocation to a final list of the ones that go into the lineup?  We have to be aware of the fact that our participants, who we're going to be providing advice that are engaged, that are choosing not to use a QDIA and we're going to be providing advice and helping them determine what their asset allocation will be, to the extent that they seek that advice.  They're going to be using these funds to create an asset allocation to help them ultimately get retirement benefits.  

So we have to think about how they come together in a portfolio, not just how they operate on a standalone basis.  We believe that that is also a process that can add risk-adjusted return and value for participants.  So if we think about the way we do that, so especially with respect to active managers.  Active managers oftentimes have style biases invested in things about their investment process that perhaps lend them to specific factors like momentum or growth or capitalization tilts.  We're going to want to think about neutralizing as we combine them.

So we don't want to have all of our managers on the lineup to potentially have a growth bias or a secular growth bias.  And those may look really good in a quant screen because that factor has done well in this last cycle, but it will not always do well.  And that's not actually how we pick managers.  We pick managers based on their ability to intelligently select securities in a way that is truly about the analysis of those securities, not about this idea that this particular sector of the market is going to outperform forever.

When we combine these managers that potentially have differing exposures, what we can do is we can – depending on what happens to that factor, will not affect our ability for these managers to add some incremental risk-adjusted return for our participants.  So that is again, an important component of the final selection process for active.  And that traces out something of an efficient frontier, which some of you may have seen.

So I hope that this kind of very quick journey through what is a complicated investment process, I understand was helpful for you in beginning to think through how do we center participant benefits in the decisions that we make.  

Tom Conlon:     That's great.  So in closing today, I do want to thank all of our participants for joining today's call.  We truly appreciate it. We talked about a few things during our call today.  number one, we defined what a fiduciary is in the obligation to their participants in that capacity as a fiduciary.  Dan went through a fiduciary that ensures prudence and ensures you're meeting your obligations as a retirement plan fiduciary.  We also talked about manager selection, and Dan provided some very insightful information on that.  So with that, we thank you all for joining today's call.  

 

Disclosures

This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  This material has been prepared for informational and educational purposes only. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley Smith Barney LLC (“Morgan Stanley”) recommends that investors independently evaluate particular investments and strategies and encourages investors to seek the advice of a Morgan Stanley Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

When Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors (collectively, “Morgan Stanley”) provide “investment advice” regarding a retirement or welfare benefit plan account, an individual retirement account or a Coverdell education savings account (“Retirement Account”), Morgan Stanley is a “fiduciary” as those terms are defined under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and/or the Internal Revenue Code of 1986 (the “Code”), as applicable. When Morgan Stanley provides investment education, takes orders on an unsolicited basis or otherwise does not provide “investment advice”, Morgan Stanley will not be considered a “fiduciary” under ERISA and/or the Code. For more information regarding Morgan Stanley’s role with respect to a Retirement Account, please visit www.morganstanley.com/disclosures/dol. Tax laws are complex and subject to change. Morgan Stanley does not provide tax or legal advice. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a Retirement Account, and (b) regarding any potential tax, ERISA and related consequences of any investments or other transactions made with respect to a Retirement Account.

Investment advisory services discussed herein are offered through Morgan Stanley Smith Barney LLC (“Morgan Stanley”) Advisory Programs only.  Please see the applicable program disclosure document for more information, available at www.morganstanley.com/ADV or from your Financial Advisor. Advisory relationships may not be appropriate in certain situations.

The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a target date fund is not guaranteed at any time, including or after the target date. These funds are based on an estimated retirement age of approximately 65. Should you choose to retire significantly earlier or later, you may want to consider a fund with an asset allocation more appropriate to your particular situation.

© 2023 Morgan Stanley at Work and Shareworks services are provided by Morgan Stanley Smith Barney LLC, member SIPC, and its affiliates, all wholly owned subsidiaries of Morgan Stanley.

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What are your responsibilities as a retirement plan fiduciary? Listen as Tom Conlon, Head of Retirement Sales, and Dan Hunt of Morgan Stanley’s Global Investment Office as they share insights to help retirement plan fiduciaries better understand their fiduciary role, including the duty to oversee fund managers and prudently select and monitor investment menus in a retirement plan. 

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