Quantitative Review of Retirement Plan Investments: The Criteria Set

Under ERISA, retirement plan fiduciaries have a duty to ensure that the menu of investment options available to plan participants is prudently selected and monitored over time. To this end, the Department of Labor highly encourages plan fiduciaries to establish an Investment Policy Statement (IPS) to outline the plan’s investment strategy and guide investment decisions. An IPS will typically define the plan’s investment objectives, outline responsibilities for fiduciaries, and define the process for how investment options are to be selected and monitored. One critical component of the IPS process is establishing the criteria set—the set of metrics by which investments are to be quantitatively considered.

To help you effectively manage the quantitative review of retirement plan investments, I’ve outlined some insights and considerations regarding the criteria set, focusing on three areas: best practices for building a criteria set, metrics for quantitative evaluation, and implementation considerations.

When approaching a quantitative review of retirement plan investments, consider the following best practices.

Evaluate against a period of at least three years. While market cycles can vary in length, three years is generally a sufficient amount of time to evaluate how a portfolio manager has performed in different market environments.

Compare performance metrics relative to a peer group. A holistic fund evaluation goes beyond measuring a fund's own performance to comparing the fund's performance relative to a universe of similar investment options. This context acknowledges broader opportunities when making investment decisions.

Determine risk-adjusted returns. Although a fund’s returns may be marginally better than those of its peers, the portfolio manager may have achieved this by taking on significant risk. It’s important to understand how much risk was involved in producing returns to show that you're not simply chasing high returns. Various metrics, including alpha and Sharpe ratio, are often used for this purpose.

Don’t chase top-quartile performance. "The loser now will be later to win, for the times they are a changin.'" For fund evaluation, this is typically the other way around, but Bob Dylan’s lyric still applies. At some point, every fund will likely falter. It's a matter of monitoring to what degree and for how long, as well as following the guidelines of the IPS.

Requiring that funds maintain a top-quartile standing can lead to frequent scoring fluctuations, more qualitative due diligence than may be necessary, and potentially excessive turnover. When setting thresholds for evaluations, consider allowing funds to land in the first or second quartile (i.e., screen better than 50 percent of their peers).

Limit the number of unique criteria sets. There is no one right way to develop a criteria set, and working with multiple criteria sets, across plans, can become challenging to implement, monitor, and justify. So, instead of developing a unique criteria set for each and every plan, consider establishing a limited number of unique criteria sets that can be applied to plans that share similar investment objectives, lineup styles, or participant demographics.

Once you've established your best practices, it’s time to focus on the metrics for quantitative evaluation. Here are a few you should consider as part of a comprehensive criteria set.

Expense ratio. The cost of investing, as represented by the expense ratio, can have a substantial impact on participant balances. Even marginal differences in expense ratios can lead to significantly different outcomes over the long term. For this reason, as well as the prominent focus on expenses from within the retirement plan industry, criteria sets should include a metric for evaluating investment expenses. Typically, the net expense ratio metric is used for this purpose, as net expense ratio reflects any applicable discounts, such as fee waivers or reimbursements, and represents what an investor actually pays.

Manager tenure. While longer-term performance metrics, such as total return, can show how a fund has performed over a variety of market cycles, they may not reflect the practiced skill of the fund's current portfolio manager. Monitoring manager tenure helps to align the actions of a fund's current portfolio manager with its applicable historical performance. A drop in manager tenure indicates that a new portfolio manager has been provided with some degree of investment discretion and can be an early signal that further qualitative review is necessary.

Standard deviation. Even when already measuring risk-adjusted returns, it’s still important to evaluate a fund’s historical volatility through a stand-alone metric as a gauge for the amount of volatility to expect in the future. Standard deviation is the most commonly used statistical measure of how much variation exists around the mean return of a portfolio.

Style. Often overlooked, style is a crucial part of investment monitoring. Since retirement plan investment lineups are often constructed through the framework of asset classes, it’s important to confirm that a fund is an appropriate representation of its applicable asset class and to ensure that it continues to be going forward. R² (R-squared) is an often used metric for this purpose, indicating to what degree a fund’s performance patterns have been in line with an asset class-specific index.

Last but not least, it’s time to put it all together—keeping these key implementation considerations in mind.

IPS. Ultimately, the IPS should guide all investment decisions. The criteria sets being used, for investment monitoring purposes, should be documented and agreed upon within the executed IPS.

Investment monitoring tools. When developing a criteria set, consider what investment monitoring tool you will use to implement a quantitative analysis and the universe of metrics available to you through that tool. If the IPS defines 3-year R² as a metric of the criteria set, the tool will need to perform a quantitative analysis that includes R².

Qualitative aspects. Quantitative analysis is an important part of comprehensive investment monitoring, but it should not be the only piece. Qualitative due diligence should also occur, on an ongoing basis, to evaluate if a manager’s philosophy and/or investment process has changed.

Expectations. Seek to enhance the client experience by providing upfront education on what to expect from quantitative evaluations. For example, scoring fluctuations will occur. Providing some early discussion around this will help match a client’s experience to his or her expectations.

Of course, this is just a brief “nuts and bolts” overview of the quantitative evaluation process. But I think you will find these strategies can serve as a valuable framework for delivering the best value to plan participants.

What other best practices do you follow for quantitative evaluation? Do you consider style to be a worthwhile metric? Please share your thoughts with us below!