The debate over how many and what kind of investment options should be offered to working men and women in their workplace-sponsored retirement savings plans has been raging as long as employees have been expected to manage their own investments. The latest debate, no doubt ignited by the recent financial crisis, is over investment risk. And, as usual, the professionals do not agree.
Trends ranging from target-date funds to behavioral science were supposed to reduce the number of investment options in 401(k) plans, on the theory that people do better if they have professional management, automatic asset allocation and limited choices. Yet sponsors keep piling on the options — to an average of 22 last year, up from 12 in 2001, according to the consulting firm Aon Hewitt. And still employees avoid making investment decisions.
So the debate is shifting a bit, as some experts question whether plans are offering enough low-risk selections.
“Maybe it’s time to rethink the options, to reflect the changing risk profile of participants,” says Michael Rosenberg, a senior vice president at Prudential Investments.
In a new paper and a follow-up interview with Institutional Investor, Rosenberg says plans should eliminate some equity offerings and replace them with a wider choice of fixed income, including high-yield, international, floating-rate and inflation-protected securities. His paper cites a survey by the Profit Sharing/401(k) Council of America showing that 56 percent of the funds offered in an average defined contribution plan are equities, versus just 12.3 percent for bonds.
More fixed-income choices are needed, Rosenberg says, because “the risk profile of the workforce has changed.” Aging boomers are thinking about protecting assets rather than accumulating, while people of all ages “have become more conservative investors in the wake of the financial crisis.”
In particular, he recommends junk bonds for their returns, global bonds for diversification and other choices “that will perform in different interest-rate environments.” He wouldn’t specify which equity choices to eliminate, other than pruning any duplicates. Nor would he spell out an ideal ratio of equity to bond funds, saying such decisions were “plan-specific.”
However, Jean Young, a senior analyst with the Vanguard Center for Retirement Research, says that when people are offered a broader array of bond choices, they avoid them. Among the 1,700 plans for which Vanguard was the recordkeeper last year, only 6 percent of participants invested in high-yield bonds when available, 5 percent took advantage of an inflation-protected fixed-income option, and a mere 3 percent went for international bonds.
“Most participants struggle in constructing portfolios,” Young says.
And if stable value and short-term money market funds are also considered types of fixed income, adds Beth McHugh, vice president of market insights at Fidelity Investments, “there’s enough variety for now.” Still, she says the mix might be rethought in the future, as boomers move past the first years of retirement, when they are still accumulating assets for their long lifespans.
If participants want to avoid risk, another obvious route might be index funds. Moreover, fees can be significantly lower. For instance, Vanguard says the average expense ratio for the index funds of its 401(k) clients, 0.15 percent, is just about half the 0.29 percent for their actively managed funds.
Indeed, McHugh says that usage has grown in the past couple of years, as “employers are looking to add diversity and employees are asking about lower-cost options.” About 80 percent of Fidelity clients have added one or two more choices to the standard S&P 500-based index fund, which is offered to virtually all Fidelity participants. The most popular additions: international and small cap.
But there’s disagreement over this topic, too. In another recent paper, Daniel Gardner, an analyst at Russell Investments, argues that index funds don’t really protect against risk, since “investors take on the full systematic risk of the market.” Further, this approach “can deprive participants of the sponsor’s best thinking” in selecting active managers. And for sponsors who worry about being sued if they choose anything but the cheapest index funds, Gardner says, proper oversight of active managers can “mitigate litigation risk.”
Even more use of target-date funds might not settle all the debate.
These funds were supposed to simplify sponsors’ task of selecting 401(k) investment options, because participants would just put all their assets into a premixed portfolio, based on age — thus, in theory, eliminating the need for any other individual options at all.
But Prudential’s Rosenberg points out that customized versions of these funds are usually created from the options within the plan menu. In that case, “you certainly should have a better representation of fixed income” to choose from, he says.
So how many options should a sponsor offer?
“Choice is good,” Fidelity’s McHugh says, “as long as individuals are educated and feel empowered to make the decisions.”