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On the 401(k) Menu: Do More Funds Help Participants Diversify?

By Bradford P. Doninger  8/22/2005
 

Re-reviewed January 2013. This remains an excellent, and still timely, analysis of what constitutes appropriate diversification regarding funds offered in defined contribution plans.
-- SHRM Online editors

During the mid-to-late 1990s, most HR benefit managers and investment committees weren't worried about the concept of fiduciary liability. They didnt have to bethere was little perceived liability when plan participants were realizing 15 percent and 20 percent returns each year. Then that bubble burst, and the same trustees became brutally aware of just what their responsibilities entailed. And so we entered the age of ERISA section 404(c) and diversification.

But have some plan sponsors misdirected their reaction?

Too Many Funds, Too Few Asset Classes

Among other things, 404(c) regulations require that plan participants be provided with the opportunity to choose from a broad selection of investment choices that include a core menu of mutual funds. As markets became less favorable a few years ago and asset allocation became the hot topic, committees and trustees began to look at their investment menus in a different light. In some cases, they assumed that adding investment options to an already heavy menu would leave no doubt that a "broad selection" was available to participants, thereby meeting their requirements as fiduciaries. But doing this may have ended up hurting more than helping.

A study by professors of finance at New York University and Fordham University, The Adequacy of Investment Choices Offered by 401(k) Plans, shows that, regardless of the number of funds offered in a 401(k) plan, 62 percent of plans fail to provide a sufficient range of asset cl asses in which to invest, causing portfolios to underperform because they aren't adequaterly diversified.

Moreover, with multiple fund offerings in a specific asset class (such as large growth stocks), one potential problem for participants is redundancy, also referred to as positive correlation. In terms of modern portfolio theory, correlation is a statistical measure of how securities move in relation to one another. Positive correlation means two securities have historically reacted to market conditions in the same manner and with similar styles, and are therefore likely to behave similarly in the future.

"Styles" here refers to whether a stock (or stock mutual fund) is categorized as "growth" (its price reflects the expectation of strong future appreciation), "value" (viewed as inexpensive in relation to its underlying value due to lower growth expectations) or "blend" (falling somewhere in between). The well-known "style box" classification, popularized by fund analysts at Chicago-based Morningstar Inc., uses six style boxes with the vertical axis denoting size (large capitalization, mid cap or small cap) and the horizontal axis denoting value, blend or growth.

Large-cap Value

Large-cap Blend

Large-cap Growth

Mid-cap Value

Mid-cap Blend

Mid-cap Growth

Small-cap Value

Small-cap Blend

Small-cap Growth

Since each asset class only has a finite number of stocks available to include in a fund portfolio, the chances of two mutual funds in the same class investing in the same securities are considerable. Such duplication would increase the correlation between those two funds, thereby decreasing actual diversification and exposing an investor to additional risk.

But some industry experts, and benefits professionals who manage retirement plans, perceive the bigger issue to be the relationship between the total number of investment options that plans offer and the number actually used by participants. According to a survey by the Chicago-based Plan Sponsor Council of America (PSCA), while the average defined contribution plan now offers approximately 17 fund options, participants are allocating their assets to only three or four of those funds, one of which is almost always a money market option.

And then there are those who postulate that a high number of investment options actually hurt overall plan participation rates. A group of researchers from Columbia University put forth a hypothesis based on extensive research stating that, as the number of investment options offered in a plan increases, the chances that an eligible employee will participate in that plan slightly decreases. According to their theory, more choice means more research for the employee to conduct and more information to understand, which often leads to confusion and eventually a lack of interest. This general principle has been found to be true in other consumer decision-making behavior studies as well.

The Elusive 'Optimal' Number

So what is the optimal number of stock funds to offer? Unfortunately, there is no one specific answer; it will depend on the plan sponsors own situation. On one end, part of 404(c) requires three core fund options at a minimum. On the other end, research shows that more than 15 fund options may be hurting the plan rather than helping.

Some advisers recommend one stock fund from each style box, along with bond and money market funds. But the happy medium will depend on a number of variables including, but not limited to, employee investment knowledge, time horizon, education and communication methods, and capabilities of the service provider.

If benefits professionals find themselves among those that clearly offer too many funds, their first step should be to consider simplifying the companys investment menu. Offering one sound fund option in each of the major asset classes should be enough to meet 404(c) regulations (provided the sponsor continues to monitor those funds and meet all other stated requirements) and give participants the chance to diversify.

In addition, fiduciaries may want to work with an independent investment consultant to determine which funds are best for the plan, and to document their decision and monitoring processes. Steps like these will not only help participants with investment diversification decisions, but also could encourage greater participation and plan appreciation.

Bradford P. Doninger is an institutional investment consultant at Portfolio Evaluations Inc. in Morristown, N.J. His client responsibilities include developing and reviewing investment policies and strategies, quantitative analysis of investment portfolios, asset allocation analysis and the continued monitoring of investment performance. He has spoken at several industry conferences on matters of fiduciary responsibility and the investment selection process.

Related SHRM Articles:

Pointers for Designing an 'Ideal' 401(k) Plan, SHRM Online Benefits Discipline, November 2010

Tiers Recommended for 401(k) Investment Menus, SHRM Online Benefits Discipline, October 2010 

401(k) Participation Up, but Asset Allocation Challenges Remain, SHRM Online Benefits Discipline, August 2005

Exchange-Traded Funds: Less Expense for Your 401(k) Plan, SHRM Online Benefits Discipline, June 2005

Related External Resources:

Having Too Many 401(k) Options Might Be Hurting You, Business Insider, February 2013

Constructing a DC Plan Investment Lineup, The Vanguard Group, September 2012

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