Friday, April 13, 2012

Simplify the Defined Contribution Fund Menu

Nicholas Zaiko
Investment Consultant
Bridgebay Financial, Inc.

Fiduciary committees of most 401(k) and 403(b) plans agonize over the selection and monitoring of the best in class investment options for their retirement plans yet ultimately the investment decision to incorporate those funds in an appropriate asset allocation is in the hands of the individual participant.  In many cases participants have neither the knowledge nor skill to build optimized, diversified portfolios.  Plan sponsors have wrestled with the problem of providing enough investment options to allow participants to achieve this goal, yet the sheer number of investments often times overwhelms and confuses plan participants.  Striking the proper balance between too many and too few choices while at the same time walking the tight rope of fiduciary liability can be vexing for plan sponsors.  In many cases offering too many funds is just as bad as offering too few.

Growth of the Fund Menu
Proper diversification is the goal of any optimal portfolio, particularly for retirement assets which must endure the volatility of a long investment time horizon.  With that in mind, plan sponsors have diligently added numerous market-cap and style specific equity funds causing the average number of funds in an investment line-up to rise dramatically.  Today, the average 401(k) plan has more than 18 different investment options.  In the case of 403(b) plans, the average is more than 30 investment options.  Many participants may invest in one or two funds at most and therefore miss out on the benefits of diversification afforded them by the full fund menu.  Despite having access to a diverse fund menu, many participants still have concentration risk.

When a participant is overwhelmed with investment options they may react in several different yet equally inefficient ways.  They may invest all of their retirement savings in a single fund and be exposed to concentration risk.  A participant may simply evenly distribute their savings among all of the funds, resulting in overlap and inadvertently large exposures to volatile asset classes like emerging markets and small cap equity.  This confusion results in either under-diversified or over-diversified portfolios, neither of which are suitable to achieving the participant's retirement goals.

Allocation Funds
Many plan sponsors have sought to help participants invest in optimized portfolios by adding target-date or risk-based allocation funds.  While good in theory, a poor communication and education program has often caused participants to fundamentally misunderstand how these types of vehicles are intended to work.  This is evidenced by those participants who contribute money to multiple target-date funds, thus negating the effect of the glide path and resulting in duplication of sectors and holdings.  Most target-date funds are engineered to be the sole and primary retirement savings vehicle and are asset allocated with that assumption in mind.  An ill-informed participant who invests in several target-date funds alters their individual risk profile in ways they may not expect or intend.

Over the years, participant behavioral research has shown that the vast majority of participants do not have the time, understanding or interest in learning proper investment techniques, and nor should we expect them to become experts.

Virtues of Simplicity
The best solution to the information overload experienced by many participants lies in the hands of the plan sponsor.  Through a methodical and comprehensive selection process, the plan sponsor should develop a fund line-up that includes an array of well diversified investment options managed by investment managers that are best-in-breed among their peers.  Many sponsors have found it useful to segment the plan investments based on the type of investor.  While all options are available to all participants, this segmentation creates a framework for the participants based on their level of sophistication and involvement. 

Typically, asset allocation funds such as target-date or target-risk funds are intended for participants who want a one-stop solution.  These structures offer diversification across multiple asset classes and are managed by professional asset managers.  Target-date funds are professionally allocated and slowly reduce exposures to volatile asset classes in favor of less volatile asset classes as the participant approaches retirement age.  Over time, the intended risk profile gradually declines as the fund approaches the target retirement date.   

The second group of investments represents the core funds and is intended for the do-it-yourself investors who want more control over their individual risk profile. The core funds are broadly diversified funds investing in specific and defined market capitalizations and styles.  Plan sponsors can employ multi-manager or diversified single manager strategies to provide exposure to a wide range of asset classes including domestic equity, global equity and fixed-income.  Communicating the intended investment strategies and goals of each fund to participants is the plan sponsor's primary concern, in order to ensure that participants can make informed allocation decisions.  Sponsors can utilize best-in-class managers for each asset class and retain the flexibility to replace underperforming managers. 

Some sponsors may offer a third group of investments beyond the traditional equity and fixed income asset classes.  This typically includes a brokerage window and/or professionally managed accounts.  The brokerage window gives sophisticated investors access to a wide range of funds, stocks or ETFs.  Brokerage windows may provide exposure to specialist and esoteric investment strategies that may not be appropriate for all investors.  Participants with substantial balances and a higher level of sophistication tend to use this feature.  The segmented framework allows participants to navigate the plan more easily and select the solution that is most appropriate for them. 

With the average number of funds in the plan lineup swelling over the last 5 to 10 years, today's participants are bombarded by a cacophony of investment options that many find simply overwhelming.  The freedom to choose has instead been transformed into confusion and inaction.  Changing participant behavior is much more difficult than simply optimizing the plan fund line-up to accommodate plan participants' natural inclinations.  Though many other factors will influence plan participation, providing a clear, organized and simplified fund lineup will result in one less hurdle for your plan participants and move them one step closer to achieving their retirement goals.