We recently came across a large 401k plan with more than 30 funds in its fund lineup! Sadly, I wish I could say this was the exception, but we actually see this in many 401(k) plans when they first come to us from another provider. Why so many? Most likely, the fund offering grew through the hunt-and-peck method over a period of time, or the employer didn’t want to dismiss the old fund when a new one was selected. Either way, the real issue with plans like this is it's a sign of a poor investment management process or, worse, no structure at all. In these plans we frequently see the “extra” funds are concentrated in a particular asset class (like a Large-Cap Growth, Mid-Cap Core, or any other asset class), while other asset classes are completely missed or underrepresented. Examples include multiple Large Cap funds and only one or even no Mid Cap or Small Cap funds available to employees. While one can argue that a Large Cap-heavy fund array should generate more stable returns over time, it poorly reflects the investment needs and temperament of the younger workers with longer retirement timelines. For them, there is no opportunity to create a portfolio offering a higher risk-reward profile for which they may be more ideally suited.
According to a 2014 Towers Watson survey, the number of plans offering more than 20 fund options is declining with more than two-thirds now offering between 10 and 19 choices. Studies have shown that, when offered too many choices, participants have more difficulty making sound investment decisions and are likely to take on too much or too little risk for their needs. Potentially worse, too many funds can also cause a “deer in the headlights” effect that can cause many participants to delay enrolling in the plan, a large percentage of which never end up making it into the plan at all. However, reducing the number of fund options is only the first step in improving the fund array. The second, and far more important, step is to design your fund lineup in a way that meets the objectives of both the employer-sponsor and the participants.
Know Your Plan Participants
Before any selection of specific fund options is to be done, the fund array needs to be designed using participant needs as parameters for creating an overall framework. Actual fund selection can then be applied within the framework to ensure they meet the criteria. While there is no set formula for creating a framework – it should be based on the collective needs of your participants – plan design specialists will almost always consider three primary categories:
Premixed funds appeal to investors who have neither the time nor inclination to involve themselves in the managing and monitoring of their investment portfolios. Premixed funds offer set portfolios consisting of some mix of asset classes, such as stocks, bonds and cash equivalents, and can range from very conservative mixes to more aggressive mixes which are managed professionally to maintain the desired mix. The most popular type of premixed funds are Asset Allocation Funds and Target Date Funds.
Asset Allocation Funds
Asset allocation funds offer a diversified portfolio of stocks, bond and cash with the mix determined by the fund’s investment objective and risk parameters. A conservative asset allocation fund might be more weighted in large cap stocks and high-quality bonds; while a more aggressive weighting might include a broader mix of small, midcap and international stocks alongside large cap stocks. The funds are actively managed to maintain growth prospects while balancing the portfolios to maintain the desired investment mix. A fund array should include a few asset allocation funds with varying investment objectives and risk parameters.
Target Date Funds
Target date funds are a type of asset allocation fund that includes a mechanism for gradually changing the allocation as investors approach their retirement target date. The general concept is to start the target date fund with an allocation weighted towards growth and, at certain intervals, convert a portion of the allocation to a more conservative mix. Target date funds can be purchased in five or ten-year increments so investors can create a “ladder” affect with varying target dates.
Both of these options can also be used for fiduciary protection when used as Qualified Default Investment Alternative for plans with auto-enrollment features or for participants that fail to make an investment selection before contributing to their 401(k).
While premixed funds are appealing to a lot of people for their ease of understanding and management, single style funds offer the opportunity for greater diversification and upside potential for investors who prefer to design their own portfolio mix. Many fund arrays include both premixed funds and single style funds; however, ultimately, what is selected for the array should reflect the needs of the participants. A well-diversified fund array will include at least the following options:
Money Market or Stable Value Fund: A conservative fund option that focuses on principle protection
Fixed Income: Typically consisting of intermediate-term corporate and government bonds
Large Cap Equity Fund: Typically a broad-based fund that invests in large cap companies
Mid Cap Funds: A fund that invests in smaller companies with potential to grow
Small Cap: Investments in small companies with high growth potential but that also present greater risks
International Fund: Investments in non-U.S. stocks can provide greater diversification and growth opportunities, but can also entail greater risk.
In most plans, you will also have a mix of growth and value funds for the various equity funds that seek opportunities among companies poised for growth, or companies that demonstrate value in relation to their industry. A well-rounded fund array will offer both growth and value funds because they tend to perform differently depending on the market cycle.
Combining a few premixed options along with this menu of single-style options would create a well-diversified fund array consisting of 10 to 19 options that can address the needs of most investors.
When a cohesive investment policy statement, based on the investment needs and characteristics of a plan’s participants, is used to design an appropriate fund array, it should be very much like fitting pieces of a puzzle together, with the plan’s investment policy statement as its box top. Each piece should represent a specific risk-return profile that, when combined with other pieces of differing risk-return profiles, can allow a participant investor to create a well-diversified but not overly complicated portfolio of the desired asset classes. Too many choices and the participant risks “over-diversification” and an unwieldy portfolio that is too difficult to track and manage. Any less, and the participant risks “under-diversification” with the possibility of a portfolio that doesn’t reflect the participant’s own risk-reward profile.