Although plan sponsors may think that offering more choices is beneficial to plan participants, we believe that structuring a tiered approach, each tier targeted to specific participant types, as well as a more focused lineup, provide participants with the best chance of success.
The Current State
According to the PSCA’s 53rd Annual Survey of Profit Sharing and 401(k) Plans, the average number of investment options available for participant contributions in all plans in the survey has grown from 10 in 1998 to 18 in 2009. The same survey reported that the average number of funds in smaller plans is even greater, averaging 21 for plans with fewer than 200 participants [Profit Sharing/401k Council of America. PSCA’s 53rd Annual Survey of Profit Sharing and 401(k) Plans Survey, September 2010].
What is clear is that lineup expansion has grown much faster than participant utilization. The average participant in a plan record-kept by Vanguard used 3.4 funds in 2009, just slightly higher than 3.1 at the beginning of the decade [How America Saves 2010: A Report on Vanguard 2009 Defined Contribution Plan Data, https://institutional.vanguard.com/iam/pdf/ HAS.pdf (“How America Saves”)].
Large investment menus can have detrimental effects on participants. The first is what is known as the “fear effect,” under which participants do not actively par- ticipate in the plan due to the confusion experienced when confronted with too many choices. Second, par- ticipants may unintentionally create portfolios that are mismatched with their time horizon and risk profile by allocating investments evenly across all options. [See Bernartzi, Shlomo and Richard H. Thaler, “Naïve Diversification in Defined Contribution Savings Plans,” American Economics Review 91(1) (2001): 79-97. (“Bernartzi and Thaler”).] This could be the result of a desire for diversification, but participants may suffer also from a lack of understanding of all of the invest- ment alternatives, which is, of course, exacerbated as the number of the alternatives increases.
Given the disparity in financial literacy and engagement of participants, there is a better approach to constructing an investment lineup.
A Better Approach
At a high level, it is important to recognize that there are different participant types, each with its own needs and preferences. For this reason, an investment lineup should be divided into three tiers: (1) a full suite of target date options, (2) a small set of passively managed or index funds, and (3) an array of actively managed funds.
The design begins with a full suite of target date fund options. These products give the participant the ability to choose one fund that will provide an all-in- one approach to investing. All required asset classes are represented within this fund in suitable proportions. The fund is managed to a target retirement date. These funds may be appropriate for any participant that does not have the desire to research all of the various options that are available, or participants that believe strongly in the diversification benefits that these funds offer.
Research suggests that, over the long-term, participants who choose to invest in target date funds will outperform participants who choose to construct their own portfolios. In fact, the power of ongoing contributions and disciplined asset allocation can be seen even in shorter time periods. In a Vanguard study of participant balances for the two-year period ended September 30, 2009, 71 percent of target date fund investors had balances equal to or greater than their balances two years prior while only 60 percent of nontarget date fund investors had fared as well [How America Saves].
This option may be beneficial for the majority of employees, as most participants do not have significant experience in portfolio construction. In a study conducted by Deloitte, the average participant scored less than 4 out of a possible 10 in regards to investment knowledge. In that same study, about 80 percent recognized the possibility of losing principal in a stock fund, while only 40 percent were aware of the possibility of a principal loss in a bond fund, even though such a loss is possible in either type of fund [Deloitte Consulting LLP, “Annual 401(k) Survey Retirement Readiness,” Deloitte 2010, http://www.deloitte. com/assets/Dcom-UnitedStates/Local%20Assets/ Documents/us_consulting_2010annual401kbench markingsurvey_121510.pdf. (“Deloitte Study”)].
The passive tier provides a low-cost method to fully diversify a portfolio with as few investment options as possible. This can be accomplished with three or four options: S&P 500 Index and Extended Market Index or Total Domestic Stock Index, Total International Index, and Bond Index.
The S&P 500 Index and Extended Market Index Funds provide full capitalization coverage of the domestic equity market. A plan sponsor could also consider a total domestic equity market index fund as an alternative. An index fund benchmarked against an index such as the MSCI All Country World Index x US Index, which has a majority of assets in developed foreign markets and a minority allocation to emerging markets, provides diversity and manages the risks of an emerging markets stand-alone option. Rounding out the list of the index funds is a high quality inter- mediate duration fixed income index fund, typically benchmarked against the Barclays US Aggregate Index.
Index funds provide a number of benefits. First, index funds should have much lower costs than actively managed funds, which can aid in reducing overall plan costs and potentially provide a buffer to fiduciaries in this age of fee sensitivity. In addition, these options will be style pure and offer investors who believe in indexing the options they need to construct a diversified portfolio.
The active tier gives participants the ability to over- or under-weight specific investment styles (growth and value, in the case of large cap) and market caps (large and small-mid cap domestic), and to participate in active alpha-seeking strategies, as they see fit. In addition, this option is most appropriate for participants who expect to perform a significant amount of research to carefully select an investment mix.
A suggested lineup of actively managed funds could be: large cap value, large cap growth, small- mid cap blend, foreign equity (a manager that has the flexibility to invest 25 to 35 percent in emerging markets) and core-plus fixed income fund (a manager that can invest in high quality domestic and foreign issues as well as developing markets).
It is a good idea to find managers in the foreign and fixed income spaces with wider mandates in order to prevent the lineup from expanding too much as well as providing the best chance for an appropriately diversified portfolio. Said another way, we suggest avoiding asset classes that stand alone as very risky asset classes, prone to returns-chasing behavior.
Finally, rounding out the Tier 3 menu would be a stable value or money market fund. Thus, proper diversification can be achieved with as few as seven options for this tier.
Putting It Together
Counting the target date funds suite as one option, a powerful lineup can consist of no more than 12 total options.
Each tier, by itself, can be used to construct a fully diversified portfolio, or tiers can be combined to provide participants with the ability to mix active management with low-cost passive solutions. In addition to providing multiple options for participants, this lineup is designed to capitalize on different behaviors exhibited by participants when considering an investment strategy.
Key to the success of this construction is how this structure for an investment strategy is communicated to participants. Aggregating all of the options in one list and handing it to the participants is a recipe for confusion. However, if participants can understand each tier’s purpose, they will have a better chance of knowing where to go and will, therefore, have a better chance at success.
Features that can support added success in the asset accumulation phase are advice tools and managed accounts. Data continue to show that, although utilization of these features is much lower than participa- tion in target date funds, they do increase the chance of participants creating a plan and a diversified age- appropriate portfolio.
A likely change in DC plans in general will be the addition of a guaranteed option, be it an annuity option for plan participants at retirement or investment options with a built-in guarantee. Plan sponsors remain concerned over the liability of selecting such options, as well as the cost and necessary education, but it seems very possible that, since the market place has seen an evolution and acceptance of asset accumulation products, it will soon embrace solutions that assist participants in their retirement years.
In addition to assisting participants to make better and clearer investment decisions, the compressed investment lineup also reduces the number of funds plan sponsors need to monitor. Spending less time on the investment menu allows more time for plan sponsors to engage in conversations with their consultants and vendors to focus on participant retirement readiness, the ultimate goal of retirement plans.
A structured three-tiered approach to retirement plan options provides participants a focused lineup. This new focus may increase the chance of participants meeting their investment objectives. The combination of these three tiers provides each participant the option to select from a suite of diverse funds that can lead to successful planning, a common goal for participants and plan sponsors alike [How America Saves].