To Build, or to Buy: That is the Question

Intel Corporation is a leader in the area of custom lifecycle funds

Taken from the February 2007 issue of PIMCO DC Dialogue™*(DCD), PIMCO talks with Stuart Odell of Intel Corporation about the company’s custom target retirement-date, or “lifecycle,” strategies.

In 2004, Intel led the way for plan sponsors by creating its own custom strategies using its plan’s core investment options. Today, Intel remains delighted with that direction as the company enjoys the investment flexibility and lower cost gained by having built rather than bought an off-the-shelf product. Join us as we learn about the innovative and market-leading Intel approach, as well as recent and planned enhancements.

DCD: Stuart, thank you for joining us for PIMCO DC Dialogue. We understand that Intel is one of the pioneers in creating custom “lifecycle” or target-date strategies — that is, offering a set of asset-allocation strategies such as 2015, 2025, and so on, that are made up of your plan’s core investment options. We’d like to learn about what you’ve created and why. Let’s start with your basic plan structure. Can you tell us about your defined contribution plans? 

Odell: Sure. The Intel plans are a little bit different in that actually we offer two retirement plans: a 401(k) and a profit-sharing plan. The profit-sharing plan represents the Intel contribution to its employees’ retirement and is equivalent to an employer 401(k) match, except that Intel manages the asset allocation on its employees’ behalf, with a guaranteed-minimum-floor defined benefit. Part of the reason for offering a profit-sharing plan instead of a 401(k) match is that the company wants to provide an equal benefit to all employees, regardless of participation. Despite the “free money” offered in a 401(k)-match concept, a small percentage of employees in a 401(k) match voluntarily choose not to participate. The profit-sharing plan allows Intel to provide a discretionary annual contribution — which has been higher historically than even a typical 6-percent 401(k) employer match — to all employees, regardless of whether they choose to participate in the 401(k) plan independently.

Today, our plans cover about 50,000 participants and, even without an employer match, 401(k) participation is close to 75 percent, which isn’t bad. Total combined 401(k)-plan and profit-sharing assets are close to $9 billion, which means the average participant balance across both plans, combined, is about $170,000.

DCD: Now let’s talk about the 401(k) plan’s investment structure and how lifecycle strategies fit.

Odell: In April 2004, we rolled out a new three-tiered investment lineup in our 401(k) consisting of five core asset-class funds, five lifecycle funds, and a mutual-fund window.

The core funds, comprised of commingled trusts and separate accounts, generically are named “Stable Value Fund,” “Total Bond Fund,” “Large Cap US Stock Fund,” “Small Cap US Stock Fund,” and “International Stock Fund.” There are only five core funds, but each core fund may contain one or more underlying managers. For example, the International Stock Fund contains both passive (index) and active managers. The combined approach of active and passive management allows the fund to generate some potential alpha while keeping our overall investment management expenses low.

Generically naming the core funds and using commingled trusts with underlying multiple managers also permits us to control individual manager selection. The flexibility allows us to offer a “best of breed” in manager selection and is an important consideration when deciding whether to build or to buy your own lifecycle funds.

With those five core strategies alone, participants can put together a well-diversified portfolio for themselves. Alternatively, they also can choose from a premixed selection of the five core funds, also known as a target retirement-date or “lifecycle” fund. Intel actually calls them “Lifestage” funds. Intel offers five Lifestage funds, duly named Lifestage Retirement, Lifestage 2015, Lifestage 2025, Lifestage 2035, and Lifestage 2045. The number associated with the fund represents the year we presume the participant will begin to need his or her retirement money.

Each Lifestage fund has its own unique “glide path,” which defines the mix between the various core funds at various points in time. As participants grow closer to retirement, the lifecycle fund becomes more conservative primarily by increasing the proportion of bonds to stocks. The Lifestage funds really are designed to serve as an investment vehicle for all, or nearly all, of the participant’s 401(k) assets. Otherwise, participants inadvertently may defeat the lifecycle funds’ purpose, which is to become more conservative gradually over time.

Glide Path Definition:  A “glide path” is simply the asset allocation of a particular lifecycle fund at a particular period of time.  For instance, if you are a 25-year-old participant and you put your money in the 2045 strategy, the initial asset allocation of that fund might be 90 percent stocks and 10 percent fixed income. However, 10 years later that same fund will have a different asset allocation that is more appropriate to that participant at age 35. The glide path then has shifted downward in equity from 90 percent to 80 percent for example, and the fixed income has increased from 10 percent to 20 percent.

And, finally, for participants who may seek a more specialized investment strategy — perhaps to complement a core-fund asset allocation — Intel offers a mutual-fund window with 65 investment options, primarily institutional mutual funds and commingled trusts. We offer both active and passive alternatives in most major asset classes; the window also allows participants to take advantage of very specific strategies. So, with emerging markets for example, we offer both debt and equity individual options within the window. Similarly, we have funds that take advantage of small-cap stocks, developed international, commodities, and real estate. 

For most people, the core or lifecycle strategies provide all that participants need to develop a well-diversified portfolio, regardless of their investment horizon. While there are diverse and sophisticated underlying investments within core and lifecycle, we present the investments simply and basically in terms of their names, descriptions, and accompanying fact sheets.

DCD: We’re seeing this type of three-tier structure more often in DC plans. Are participants enrolled automatically and defaulted to an investment?

Odell: Historically, Intel hasn’t felt the need to auto enroll simply because it didn’t offer a match and our participation has been strong. That said, I think we realize participants need even greater encouragement to save more in their 401(k) plans, and we’ve started this year to auto enroll new employees. We default into the appropriate lifecycle fund, by age, participants who don’t make their own investment elections. 

DCD: How many lifecycle strategies are in your plan? I know some companies may want a strategy for every 10 years, while others may want one for every five years. 

Odell: Since initial strategy rollout in 2004, we’ve offered five target retirement-date strategy years. Our lineup is based on the assumption that we want to keep it as simple as possible. And since our participants historically have made their own investment elections, they can — if they choose — mix a fund that matures between any of the given 10-year periods. For instance, they can allocate 50 percent to 2035 and another 50 percent to 2045 and synthetically create a fund that matures five years between the two 10-year funds — effectively creating one for 2040. This approach, however, many not be best suited for the inertia-bound participant who needs everything done for them automatically. 

With the launch of auto enrollment, we’ve decided to add funds that mature five years apart. So we end up with 10 lifecycle strategies. We did this because we want to get closer to the proper asset allocation based on a participant’s age and target retirement date, assuming retirement at age 65. 

DCD: Stuart, as a custom retirement-date strategy pioneer, why did you go this direction? Clearly the market is following, and the Pension Protection Act of 2006 supports auto enrollment with a default to target retirement-date strategies. More plan sponsors are establishing target retirement dates in the way Intel has, rather than offering target-risk strategies — that is, conservative-, moderate-, and aggressive-type funds — whose allocations don’t change over time. 

Odell: We developed our lifecycle funds largely in response to behavioral finance findings. Academics and others started to produce a lot of research around 2002, 2003, and 2004 that suggests that, no matter how much education, advice, or telling people “this is the right thing to do; you need to change your asset allocation,” generally participants don’t take action. Rather, academics found that inertia drives behavior and is a very powerful force. In other words, doing nothing is more powerful than taking action. 

Risk-based funds can achieve the right objective for a large portion of a participant’s working career, particularly if the participant invests in the right risk-based fund at the right time in his or her life. But participants need to re-evaluate those choices as their financial needs change over time. As retirement planning evolves and, particularly as they get closer to retirement, when a risk-reduction strategy may be most prudent, the risk-based funds don’t offer an automatic mechanism for moving participants away from that inertia. In this case, participants need to review their investment strategies to confirm whether the strategies still are appropriate or may require a change to lower-risk alternatives. What you may find is that a participant takes too much risk at a stage in life when he or she isn’t able to recover from an investment loss. 

DCD: So you decided that offering a retirement-date, or lifecycle, strategy makes more sense because the approach is more prudent from a behavioral and risk-management standpoint. How did you decide to create your own, rather than select a packaged retirement-date approach like those offered by mutual-fund companies? 

Odell: In 2003, our evaluation period, when we looked at providers of these types of target-date retirement, or lifecycle, funds, we found that their products were fairly simple. That’s not bad, necessarily. What concerned us was how little thought they’d put into the products’ actual underlying asset allocation, or glide paths. We also were concerned with the underlying assets or particular funds used. 

We were worried that if we “bought” one of the packaged solutions, Intel would be tied to the provider; then if we weren’t satisfied with the provider’s asset allocation — glide path — or an underlying manager’s performance, we wouldn’t have a lot of recourse beyond pulling and replacing every single fund. With our built strategies, Intel can replace a single underlying manager if it needs to — without disrupting the rest of the fund. 

DCD: In the buy situation, Intel would’ve been stuck with the glide path and provider’s investment-management decisions. Consequently, relinquishing control was a show-stopper for you. Did you consider fees as well?
Odell: Absolutely. We discovered off-the-shelf providers’ fees vary widely. Some charged a fee on top of the underlying active manager’s fee, while others focused primarily on passive index products, and, thus, featured lower management fees. There weren’t a lot of institutionally-priced products that you could buy off the shelf. 

By building the strategies ourselves, we took advantage of competitive institutional pricing right from the start and kept our overall fees lower than most off-the-shelf products. Our strategies’ all-in investment management fee is just 10 to 12 basis points. 

DCD: That’s low. Do you know how much you saved, relative to the packaged products at this time? 

Odell: The lowest-cost passive funds were in the 20- to 25-basis-points range. However, our funds feature both active- and passive-management components, so it’s not quite an apples-to-apples comparison. Off-the-shelf active target-date funds had much higher costs — as high as 100 basis points or more. So we brought the cost down 50 to 90 percent compared to the mutual funds. 

DCD: What about other costs associated with custom strategies — trustee fees, communications, and additional administrative expenses? 

Odell: The added expenses are reasonable given the overall cost savings and other advantages — maybe one basis point. 

DCD: As you considered building your strategies, was the ability to blend active and passive investment approaches an attractive benefit? 

Odell: Absolutely. By building one’s own, the plan sponsor both has the flexibility to determine the active-passive mix, and maintains control over the offered asset classes and allocations by age group. You determine your plan’s glide path. 

You also have the flexibility to add asset classes that some managers may not choose to provide because the manager isn’t qualified to provide a particular asset class, or it doesn’t have expertise in real estate or commodities, for example. Providers may exclude an asset class from their off-the-shelf product simply because they don’t have professionals to manage it; whereas, when you build it yourself, you have the flexibility. In the future, as part of a well-diversified lifecycle asset allocation, you even can consider alternative investments — hedge funds, private equity, or direct real estate, for example, which traditionally have been unavailable to DC participants. 

DCD: What’s the main reason to consider adding alternative or non-traditional asset classes? 

Odell: Diversification. We looked at a lot of alternative asset classes. We have fairly muted return expectations when it comes to adding these asset classes; however, in terms of diversification and higher risk-adjusted returns, the asset classes do offer significant value. 

DCD: So then, you’ve considered adding some assets that aren’t priced on a daily basis. 

Odell: Yes. We’d allocate only a small portion as a percentage of a participant’s overall diversified lifecycle portfolio, but there aren’t any major concerns about the lack of daily pricing for that aspect of the portfolio. Over time, more plan sponsors will embrace alternatives in DC structures — particularly within lifecycle strategies. 

DCD: At this point, are you pleased with your decision to build rather than to buy? 

Odell: Very pleased. If a plan sponsor is willing to put in time up front to create its own strategies, the approach provides a lot of flexibility. You need to put some thought into your glide path, your manager selection, working with your trustee and custodian, et cetera. What we like most is the ability to add managers or change an asset allocation without disrupting our participants. For a large plan sponsor that has a dedicated investment staff monitoring its DC core funds all the time anyway, this kind of flexibility is very beneficial. 

DCD: What about smaller plans? Should they consider creating their own strategies as well? 

Odell: Smaller plans may have limited internal staff to create and oversee the strategies. Yet, with even just a couple hundred-million dollars in assets, it might make sense to consider this approach. Many consultants are well-equipped to help plan sponsors establish and monitor these strategies. Whether a consultant does all the heavy-lifting analysis work, or whether you do that yourself, depends on your level of expertise and the internal resources available. For instance, some plan sponsors have portfolio-modeling and optimization tools available to them, while others don’t. 

Even if you use a consultant, you need an investment professional on staff to oversee the project and support it on an ongoing basis. You can’t just turn it on and walk away. 

DCD: Do you have other suggestions for plan sponsors? 

Odell: Plan sponsors should consider “restarting” their plan upon launching their custom strategies. A restart defaults all participants into the new custom strategies unless participants actively choose to direct their investments elsewhere. The approach allows plan sponsors to negotiate the most competitive pricing on behalf of participants. 

If investing in the lifecycle funds is a voluntary choice, you can expect your take-up rates to be extremely low no matter how aggressively you market and communicate to participants. That’s because most people, when given the option of doing nothing, will do nothing. So restarting your 401(k) is a good idea if you actually want participants to invest in the lifecycle strategies you’ve created for them. 

DCD: In the coming years, do you believe most DC plans will offer a default approach using custom strategies? 

Odell: These types of retirement-date or lifecycle funds are the future in DC plans. The Pension Protection Act of 2006 and Department of Labor encourage this type of investment approach. More and more plan sponsors will create custom strategies in order to take advantage of the greatest amount of flexibility over the long run. 

DCD: Stuart, you should be proud to be a leader in creating these custom strategies. Thank you for sharing so much with us! 

Odell: You’re very welcome. 

Stacy Schaus, CFPAE, is Senior Vice President and DC Strategist at PIMCO. Stuart Odell is Director, Retirement Investments, at Intel Corporation. 

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