A Fund Monitoring Methodology for Plan Fiduciaries

Plan sponsors should implement a systematic process to monitor plan funds

Defined contribution plan sponsors continue to incorporate fund monitoring policies into their investment policy statements. A fund monitoring policy provides fiduciaries and fiduciary committees with guidance on how to exercise their ongoing supervision of plan investments as required by ERISA. When designed correctly, fund monitoring policies provide for a streamlined, efficient, and consistent decision-making process. This article discusses the key elements of a fund monitoring policy and how best to maximize such a policy for your company.

Optimal Fund Monitoring Discipline Explored
There are six key criteria plan fiduciaries can use to successfully evaluate their fund alternatives. They can be addressed by asking the following questions for each investment option. Has the investment alternative:

1. Underperformed its benchmark over the most recent trailing five-year period?
2. Underperformed its benchmark in three of the most recent four calendar quarters?
3. Adversely changed its investment strategy and/or portfolio characteristics?
4. Adversely changed its key portfolio management talent?
5. Received an unsatisfactory governance rating? See Exhibit 1.
6. Received an unsatisfactory manager research rating? See Exhibit 2.

The six questions are structured in a format that starts out with how participants typically evaluate fund alternatives and transitions to the forward- looking fiduciary issues. These forward-looking measures include topics such as the evaluation of the investment manager’s ability to govern themselves (i.e., governance rating) and the manager’s attempt to deliver on their promise of adding value relative to an index fund equivalent (e.g., research rating). These later assessments are the most critical from a fiduciary perspective in our minds as they represent the best indicator of important factors that help lead to future success. As a result of this thinking, many of our clients have adjusted their policy over time to indicate an immediate full review if the last two questions are given a “yes” response. As a result of the success of this review metric, many of our clients have made it a matter of policy and adopted specific language in their Investment Policy Statement to reflect this discipline.

Application of Fund Monitoring Policy
The table below provides a “Generally Indicated Status” based on the number of affirmative responses received to the questions noted above.

An example of such an application for a set of three U.S. equity investment alternatives follows on Table 2.

Facts to Consider When Developing a Fund Monitoring Discipline
As with any policy, there are advantages and disadvantages. We list below key observations of a fund monitoring discipline.

Benefits
The ease of the decision-making process and time-resource efficiency are two prime advantages of adopting a fund monitoring policy. Such policies answer the question of, “Where should I spend my limited time?” By simply looking at a color scheme, a fiduciary can quickly identify the challenges and proceed to evaluate the key data points and suggested next steps.

Drawbacks
Quite simply, these policies can be described as summarizing a fiduciary due diligence process into an efficient model that attempts to include all of the relevant issues and appropriate metrics. Questions, however, such as, “Is three-year or five-year performance more appropriate?” can easily be raised. We believe there is no right answer; but rather each client’s circumstance needs to be addressed individually and the preference of the fiduciaries reflected.

Conclusion
Generally, it is better to have a fund monitoring policy than not to have one, particularly for defined contribution plans. As a standard advisory position, we recommend that fiduciaries closely examine developing and retaining a fund monitoring policy with metrics similar to those we propose above. This will help define in advance a summarized review of fund manager monitoring while helping develop a proper course of action(s) to take when issues such as underperformance or governance challenges arise.