DC Design

Designing Balanced DC Menus: Considering Equity Investments

Offering broader equity choices to retirement investors could help them reap capital appreciation and income from global equity markets.

Fourth in a series of articles exploring diversifying asset strategies, including capital preservation, fixed income, real assets and equities.

Offering access to the equity markets within a defined contribution (DC) plan is fundamental. What’s challenging is determining the number and types of equity choices. Whatever the number, the choices should provide participants with the opportunity to reap capital appreciation and income from equity markets worldwide. Broadening the opportunity set beyond developed markets opens the door to the world’s most rapidly expanding economies and return opportunities. Unfortunately, today’s DC equity lineups often lack broad access to global markets. What’s more, lineups are often shackled to market-capitalization-weighted indexes, which may further hamper returns and heighten volatility. By restructuring the equity lineup to include global, dividend and enhanced index strategies, plan sponsors may improve DC participants’ risk-adjusted return opportunity and the likelihood of retirement success.

Designing balanced investment menus
DC plan design historically has been driven by “filling the equity style box” and offering a range of equity choices, including U.S. large-, mid- and small-capitalization stocks, and possibly value or growth strategies. Typically, there is at least one index strategy – commonly the S&P 500 Index – plus a non-U.S. developed markets equity choice. While the style box approach provides many choices, it may saddle participants with inadequate diversification and return opportunities. Further, the long list of equity choices may unintentionally expose participants to excessive equity risk.

In designing equity offerings, sponsors may first consider the balance of investment choices within their plan. As covered earlier in this series, menu design will influence a participant’s investment decisions. Given 10 investment options, many participants will allocate an equal percentage to each, i.e., 10%, a tendency dubbed as “naïve diversification” or the “1/n heuristic.” Thus, a DC plan with 10 investment choices, including seven equity options, may encourage participants to weight 70% of their assets to equities.

Given these concerns, plan sponsors increasingly are moving away from the style box approach to either a risk pillar menu or, more commonly, an asset-class-focused core lineup.

Plans with a risk-pillar approach may offer a single equity choice, plus the three other risk pillars: capital preservation, fixed income and inflation-hedging assets. This may be refined further by folding inflation-hedging strategies such as Treasury Inflation-Protected Securities (TIPS) in to a broad income category, and risk assets such as real estate and commodities in to a growth bucket. Reducing the core investment lineup to three or four options may be too extreme for many plan sponsors – particularly if they are concerned about being perceived as taking away choice.

Plan sponsors with risk pillar lineups often have sufficient scale to create multi-manager, i.e., “white label” investment strategies that blend investment approaches and best-in-class managers within each strategy. For plans lacking the necessary scale or preferring to offer more choices, an asset-class-focused menu may be more desirable. This typically requires paring down equity choices, possibly combining equity styles and eliminating redundancies, and then adding more diversifying assets such as global equity, inflation hedging and fixed income (see Figure 1).

Simplifying a menu can help participants make better selections and improve their ability to stay the course – rather than chasing performance or, more likely, fleeing an investment, and thus locking in losses if the market suddenly drops. Combining investment strategies and styles may help dampen abrupt swings in performance.

Getting the most out of equities
Once sponsors have determined the structure, they may focus on selecting the best strategies for each asset or risk category. Prior articles in this series have considered capital preservation, fixed income and inflation-hedging choices. Here we consider equities.

When considering equity returns – which are driven largely by capital appreciation and possibly by income – the opportunity set is a good place to start. As Figure 2 shows, total global stock market capitalization was $62.9 trillion at the end of Q3 2014, according to the World Federation of Exchanges. Non-U.S. equities, including Asia-Pacific and EMEA (Europe, Africa and the Middle East), accounted for over half of global stock market capitalization.


To maximize capital appreciation opportunities, DC participants may benefit by accessing high-growth markets, including many emerging markets (EM). Figure 3 shows that many developing countries are projected to have faster GDP growth than developed countries in North America and Western Europe. Given that EM represent over half of the world’s GDP, investing in these markets – directly or via developed market companies that source earnings from EM – may offer a significant opportunity for capital appreciation.

These markets, however, also may expose participants to greater risk. Thus it may be preferable (and advisable given naïve diversification) to offer a blend of higher-growth markets and more stable – if slower growing – developed markets. Figure 4 shows that over the more than 15 years ending 30 September 2014, a strategy that blended U.S. large cap, non-U.S. developed and EM equities had lower volatility and maximum drawdown than an EM-only strategy. Notably, participants gained over 200 basis points (bps) in return relative to a blend without EM, with a slight increase in volatility.

DC participants also may benefit by seeking income, including via dividend-paying stocks. Amid low interest rates and slow growth, these may offer more attractive and more stable total returns than non-dividend-paying companies. In a low-growth environment, dividend payments may provide a larger percentage of equity returns. Even as rates rise, dividend-paying stocks may offer higher return potential than non-dividend-paying peers – and even fixed income (see Figure 5). Further, dividend-paying equities usually have lower volatility and lower correlation with broad equity markets.

Evaluating equity strategies
As discussed, DC plans may get the most out of equities by restructuring core menus to provide access to equities in markets globally, including dividend-paying stocks. Before doing so, we suggest plans evaluate a range of statistical measures, both historically and prospectively. The key measures are discussed below. Figure 6 offers a comparison across various slices of the global equity markets.

Risk-adjusted return measures the return delivered relative to the risk taken.

Correlation to the S&P 500 shows the potential diversification benefits of different equity strategies relative to a common core equity investment offering.

Downside risk measures potential loss. We suggest using a forward-looking measure of potential risk exposure, for example, Value-at-Risk (VaR), at a 95% confidence level. (VaR estimates the minimum expected loss at a desired level of significance over 12 months.)

Dividend yield can be an important component of total return from equities. Over the 15-year period, the MSCI ACWI High Dividend Index had an average dividend yield of 4.0%, the highest among the 14 equity indexes listed below.

In addition, plan sponsors should consider metrics for actively managed strategies. These include active share, which helps determine potential for outperformance relative to benchmarks, and the upside-versus-downside capture ratio, which shows whether, and how much, a strategy has gained or lost relative to a broad market benchmark during rising and falling markets.

Less is more: streamlining equity choices
Reducing the number of equity choices may help improve return and reduce risk. Assuming a naïve diversification, streamlining from six options to four provided a better risk-adjusted return, lower correlation to the S&P and a higher dividend yield than the current equity portfolio over the more than 15 years ended September 2014(see Figure 7).

Shift to asset-class menu may improve retirement outcomes
We suggest plan sponsors evaluate the current plan lineup relative to one that includes global equity and dividend strategies. For example, a lineup may include six equity options, two fixed income options, one capital preservation choice, one inflation-hedging strategy and one global balanced option. Figure 8 shows this typical DC lineup, which, if naïvely diversified, would have 60% allocated in equities, three-quarters of which in domestic stocks.

Consolidating domestic equity strategies and adding global equity options can give participants a more balanced DC menu with the potential for better risk-adjusted return, lower correlation with the S&P, lower maximum drawdown and lower VaR (95%) than the current portfolio under the “typical menu” (see Figures 9 and 10 and the appendix for asset allocation details).

Add fundamentally weighted equity exposure
Participant outcomes may improve further by investing in broadly diversified portfolios that de-link stock price from portfolio exposure. Traditional indexes weight stocks in proportion to their market capitalization. Because weights in a market-cap index are proportional to a company’s market value, distortions in stock prices flow into investors’ portfolios. Portfolios that select stocks based on fundamental measures, in contrast, gauge a company’s economic footprint on publicly available financial data, including, for instance, sales, cash flow, book value and dividends.

The primary source of outperformance over long periods for non-price-weighted portfolios is trading against the market’s most extravagant bets – which are those most likely to be wrong. As Figure 11 shows, adding fundamentally weighted U.S. equity indexes may provide notably better risk-adjusted returns.


Incremental alpha, compounded over the years, can be substantial. As Figure 12 demonstrates, a January 1999 investment of $100,000 in the consolidated portfolio with fundamental indexing could have grown to $301,887 by September 2014, compared with $261,760 and $269,561 in the current and consolidated portfolios, respectively.

Plan sponsors should consider designing core investment menus that offer equity choices that are balanced relative to other DC investment offerings, and maximize DC participants’ opportunity to gain from both capital appreciation and income. Often DC plans offer too many equity choices, yet fall short of providing sufficient opportunity to maximize returns and minimize risk. By studying historical and forecasted future risk/return relationships among equity markets – as well as between passive and active management – plan sponsors may craft a set of equity strategies that offers both total return and risk-mitigation potential and helps DC participants meet their retirement income objectives.

Steve Jones and Andrew Pyne contributed to this article.


The Author

Stacy Schaus

Head of Defined Contribution Practice

Ying Gao


Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.  Diversification does not ensure against loss. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

Hypothetical example for illustrative purposes only. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. We employed a block bootstrap methodology to calculate the correlation between assets. We start by computing historical risk factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, asset class volatilities and correlations are calculated as a function of their exposures to risk factors, and those underlying factors’ volatilities and correlations. Our models also account for non-factor risk (“idiosyncratic risk”).

Value at Risk (VAR) estimates the risk of loss of an investment or portfolio over a given time period under normal market conditions in terms of a specific percentile threshold of loss (i.e., for a given threshold of X%, under the specific modeling assumptions used, the portfolio will incur a loss in excess of the VAR X percent of the time. Different VAR calculation methodologies may be used. VAR models can help understand what future return or loss profiles might be. However, the effectiveness of a VAR calculation is in fact constrained by its limited assumptions (for example, assumptions may involve, among other things, probability distributions, historical return modeling, factor selection, risk factor correlation, simulation methodologies). It is important that investors understand the nature of these limitations when relying upon VAR analyses.

It is not possible to invest directly in an unmanaged index.

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