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Retirement Perspectives

Before plan sponsors begin the process of selecting investments, they first should consider the design of the investment menu—and how each of the choices offered could play a role in a participant's portfolio.

 

In Brief

  • Sponsors of defined-contribution (DC) plans should carefully map out their process for designing the plan’s investment menu, and the subsequent selection and monitoring of investments.

  • Building an investment lineup involves a number of factors, such as an assessment of participant needs and objectives, construction of a plan-specific menu of investment options, and the selection of investments for each lineup.

  • Investment options within a DC plan need to balance an effective array of choices to enable participants to build a personally relevant portfolio, with a concise number of alternatives. 

  • Menu design begins by considering investment objectives first. Investment objectives communicate the function of different asset classes and help shape participant expectations of the role that asset classes may play in a portfolio.  

  • The key takeaway—By following some key principles, plan sponsors can design an investment menu that promotes employee participation, fulfills sponsor fiduciary responsibilities, and enables participants to structure portfolios that promote improved retirement outcomes.

 

How should a defined-contribution plan sponsor go about constructing an investment menu? What kinds of investments should be made available? How many options should the plan offer?

These are important questions for plan sponsors to consider when designing their plan’s investment menu. And while the answer to each depends on a number of factors, and will likely vary from one plan to the next, plan sponsors should focus their attention on the decision-making process—and the effect of each decision on the participants within the plan.

This article, the first in our “Building Better Lineups” series, will explore a number of items worth considering when plan sponsors work through their own process for designing their investment menu. (The next two articles will look at selecting equity and fixed-income lineups for a DC plan.)

The Starting Point
Designing an investment menu is a very important responsibility and not one that should be taken lightly. With regard to qualified retirement plans, this responsibility may result in fiduciary liability and fiduciaries could potentially be held personally liable for their investment decisions.1 It is important to exercise prudence throughout the decision-making process. So what are a plan sponsor’s responsibilities with regards to the investment menu? At base, a retirement plan may construct an investment menu with as few as three investments and still meet its fiduciary responsibilities.2 What’s important is that each of these three investments 1) represents a diversified portfolio, 2) offers materially different risk and return characteristics from one another, and 3) when combined with one another, minimize risk through diversification.

In the end, while three investments may likely be too few for most plans, sponsors should carefully consider each additional investment. Whether the number offered is three or 33, the goal is to design a menu that promotes successful retirement outcomes. 

Plan Participants: Assessing Their Needs
Before ever considering a specific investment, plan sponsors should first take the time to understand the demographics of their plan and assess the investment needs of each participant. Basic factors such as age, education, and risk tolerance can help guide asset class selection.

Age will drive preferences toward capital preservation options for an older workforce, or toward higher risk/return alternatives for a younger population. The level of participant education may reflect the level of investment knowledge or access to sources of investment knowledge and expertise, suggesting the complexity of investment options can be adjusted accordingly. Risk preferences are often difficult to assess, but plan sponsors should offer enough choice to allow participants of similar age and background to construct a portfolio matching their unique investment objectives.

Throughout this discovery process, two things should become clear to plan sponsors: the kind of investments and the number of investments needed to satisfy the largest percentage of the participant population.

Behavioral Profiles
While the above factors should influence the design of the menu, plan sponsors will likely find themselves constructing different investment lineups to meet the needs of two distinct participant behavioral profiles:

  • Profile 1: The Portfolio “Buyer.” Also known as “do it for me” investors, participants in this category want professional management for their investment options. They do not desire to build their own investment portfolio. Instead, they prefer an investment “solution” to a stated investment objective. This may best be accomplished by including a lineup of professionally managed multi-asset solutions, like a suite of target-date funds, risk based funds, or a managed account option within the plan.

  • Profile 2: The Portfolio “Builder.” Participants within this group (also called “do it with me” investors) welcome the opportunity to construct their own investment portfolio from a menu of investments. Unafraid of choice, these participants may be best served by a lineup of individual investment options.

A lineup of individual investments, equity and fixed income, as well as a roster of professionally managed multi-asset solutions, should satisfy the needs of both investor profiles and most participants. Beyond this, there is always a chance that a few participants within the plan will be unsatisfied with the available investment options. To serve this group, plan sponsors may consider offering a self-directed brokerage account option within the plan. The advantage of this approach is that it may help limit the size of the investment menu.

That may be useful, as too much choice may seem daunting to many participants. Studies have shown that the number of plan options can have a significant impact on participation levels--and the quality of investment elections. For example, while the average retirement plan today offers 19 investments,3 one oft-cited study found that plan participation rates dropped by 1.5–2% for every 10 additional investment options added to a plan.4 An overabundance of choice has also been shown to lead participants to invest more conservatively than they may have otherwise.5

As a result, plans should carefully consider not just the kinds of investments, but also the number of investments they make available to participants. This is especially true as it relates to the construction of the plan’s lineup of individual investments. With this in mind, we’ll explore a few key considerations for constructing this subset of the broader investment menu.

Individual Investments: Two Key Factors
Building a lineup of individual investments should begin with a basic understanding of the potential benefits of portfolio diversification, including the correlation and historical risk/return characteristics between and within asset classes. Embedded in modern portfolio theory, these concepts underlie efficient portfolio construction and, as such, should inform the design of the lineup and a plan sponsor’s decision to add specific investments.

Correlation
As the foundation of asset allocation and diversification, correlation speaks to the statistical measure of how two securities move in relation to one another. Innumerable factors play into how different investments behave over time. It’s important that investors avoid owning only asset classes that tend to react similarly to one another under various market conditions. Correlation is a first-cut observable measure of the way two securities move over time. A correlation of 1 would suggest that the two assets move in lockstep. A correlation of 0.50 would indicate that they share significant similarities in their price movements. The movements of two assets with a correlation of 0 would be indicated to be unrelated, while a correlation of -1 would suggest that the two would move opposite one another. A good mix of assets with different correlations to one another has the potential to reduce risk, as measured by volatility, significantly, without reducing return.

As such, the foundation of the individual investment lineup should begin with choices among asset classes that have a low to negative correlation (see Table 1).

 

Table 1. How Are Major Investment Categories Correlated with One Another?

Source: Morningstar. As of 09/30/2014. Large Value is represented by the Russell 1000 Value Index. Large Growth is represented by the Russell 1000 Growth Index. Mid Cap is represented by the Russell Midcap Index. Small Cap is represented by the Russell 2000 Index. International is represented by the MSCI EAFE Index. Taxable Bond is represented by the Barclays U.S. Government/Credit Bond Index. Cash is represented by the Citigroup 3-Month T-bill Index. Commodities are represented by the S&P GSCI Index. Emerging Markets is represented by the MSCI Emerging Markets Index. High Yield Bonds is represented by the BofA Merrill Lynch U.S. High Yield Master II Index.

 

Risk/Return Characteristics
Of course, we’re just getting started. Within asset classes there are sub-classes that, while positively correlated with other members of their class, have risk and return characteristics that make their inclusion in a portfolio worthwhile and meaningful.

As plan sponsors consider building out a lineup, they should strive to make selections that add meaningfully to potential diversification. Offering participants five best-of-breed Large Cap Equity portfolios is unlikely to be as helpful as offering a lineup of equity investments with historically different risk/return characteristics. One possible alternative would be to offer two large cap portfolios, two mid-cap portfolios, and one small cap portfolio.  

To illustrate this, Chart 1 plots the risk and return characteristics for several equity and fixed-income sub-asset classes. We’ve also included several multi-asset solutions that aim to achieve a specific risk profile. Of course, as each new investment is added, plan sponsors should consider another factor: the need to properly educate participants on the characteristics of—and the differences between—the investments being offered.

 

Chart 1. The Risk-Return Spectrum
For illustrative purposes only. Not intended to depict any specific risk measurement, such as standard deviation, nor is it to depict any performance of actual investments or portfolios managed by Lord Abbett. The chart represents Lord Abbett’s assessment of the relative level of investment risk and potential investment return among the asset classes and portfolio types listed in the chart.

 

Designing the Lineup
Plan sponsors are now ready to contemplate the design of the individual investment lineup. This final step centers on how much choice to make available within the plan. While there may be a variety of approaches to answering this question, we’ve described below three different investment lineups and the kinds of investments that may be considered within each:

  • Core—This is a lineup of broad asset class vehicles that have the ability to serve as the foundation for participants’ portfolios. These investments should offer materially different risk and return characteristics, and when combined with one another, minimize risk through diversification.

  • Expanded—This is a roster of style-specific or sub-asset class portfolios that afford participants additional choice and the opportunity to pick investments with even greater variance in their risk/return characteristics.

  • Comprehensive—This is a robust lineup of investments offering participants increasing levels of diversification and the ability to incrementally shift their portfolios toward risk or safety.

We will cover the specific equity and fixed-income investment options plan sponsors may wish to consider within these categories in the next two articles in this series.

Some Final Considerations
Without getting into too much detail here, plan sponsors should also consider the investment options available to them through their retirement plan service provider. Depending on the size of the plan, and the capabilities of their platform provider, sponsors should inquire about their ability to construct their own “custom” multi-asset solutions or model portfolios.

Likewise, plan sponsors should also consider an approach called “white labeling”—that is, the unbranding and customizing of investment options—that could grant plan sponsors the flexibility to consolidate the menu of individual investments into fewer, broad-based asset class portfolios. 

Conclusion
There is no “one size fits all” approach to building an investment menu, but with consideration given to key variables, the best menu for a particular plan can be designed to promote participation, fulfill fiduciary responsibilities, and allow each participant construction of their own optimal portfolio. To cater to both the participant profiles we described earlier, plans may consider designing a menu that includes both a lineup of professionally managed multi-asset solutions and a separate collection of individual investment options. Plan sponsors should also carefully consider the role of each investment within the menu, and ultimately, the total number of options to make available within the plan.     

To summarize these key concepts, we’ve created the following investment menu matrix. While this grid is by no means inclusive of every investment option or menu variation, we hope it will provide a useful guide to plan sponsors as they work through their own process for designing their plan’s investment menu.

Investment Menu – Matrix

*“Active Allocation” indicates the mix of stocks and bonds that will vary over time.
The information in the table above is for illustrative purposes only and does not represent any specific portfolios managed by Lord Abbett. Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.   

 

Pete Swisher, “401(k) Fiduciary Governance: An Advisor’s Guide,” P321 – Liability for Breach of Fiduciary Duty (3d edition),  Lexington, Kentucky, 2012.
2 Ibid.
Plan Sponsor Council of America, “PSCA’s Annual Survey of Profit Sharing and 401(k) Plans – 56th Annual Survey,” Chicago, Illinois, 2013.
Sheen S. Iyengar, S.S., W. Jiang, and Gur Huberman, “How Much Choice Is Too Much: Determinants of Individual Contributions to 401(k) Retirement Plans,” in Olivia S. Mitchell and Stephen P. Utkus, eds., Pension Design and Structure: New Lessons from Behavioral Finance (Oxford, UK: Oxford University Press, 2004).
Sheena S Iyengar and Emir Kamenica, “Choice Overload and Simplicity Seeking,” unpublished paper (New York, NY: Columbia University, 2006).

 

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