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.
Conclusion
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.
