Evolving the 401(k) fund menu

Have you ever asked a factory worker what an Equity Income Fund is? I have. 401(k) plans were initially constructed to be employer-sponsored supplemental saving programs. Let's start there. Most web tools, participant websites, industry articles and commentaries consistently refer to participants as investors, and thus begins the paradigm flaw. Unscientifically, once plan participants hear themselves referred to as investors, half will walk away immediately, a few will mention something about being broke all of the time, and a few will talk about their friend who gets a 25% to 30% average annual rate of return investing in cheese doodles. Very few would be considered educated investors.

But one thing that many people have been taught since they were young is the benefit of saving. Saving is conceptually more appealing and morally more satisfying than investing. Most importantly, saving is simple and easy to understand. One goal of participant education initiatives should always be to emphasize the importance of saving and not the allure of investing.

With that concept in mind, the fund menu should be built on simplicity and not convolution; easy to understand entry points for plan participants. This, of course, is much easier said than done.

The biggest obstacle is all of the moving parts. Fund availability, fund requirements, revenue targets, platform flexibility, sponsor reluctance all make the transition to reduce the amount of options in the fund menu a formidable task. As we all know, much as a guinea pig isn't a pig nor from Guinea, “open architecture” is neither open nor architecture. It basically tells me as an investment analyst one thing: It uses mutual funds.

I wish that there were an easy explanation with how to attack these obstacles, but under the current system there is not. “Required revenue” should not be an if/then statement (“if you use our target dates, or if x is mapped into our stable value”); it should be a profitability measure. As a consultant, I get it, you need to make money just like everyone else. I'll take it a step further and say that a plan sponsor gets it. I have sat through enough finals presentations to see that it is hardly ever the cheapest provider winning the business; it is the provider with the best value proposition. Certainly fees are a consideration but I rarely see a plan sponsor choose a provider over a couple of basis points unless it is to break a tie.

The other obstacle that we consistently run into in our “less is more” initiative is the fact that when dealing with investment committees, you as the consultant are typically dealing with the highly compensated executives and thus potentially more sophisticated investors who enjoy the benefits of a robust selection of fund options. Remember, you ARE (hopefully) a fiduciary and so your actions must be consistent with what's in the best interest of plan participants and not the executives. It is a difficult dynamic to navigate but hopefully you have gained the trust of your client and they understand your intentions. If the highly compensated executives want access to individual oil stocks then let them do that in their IRAs.

Target-date funds have come under increased scrutiny in the past couple of years, and rightfully so. What began as an innocent endeavor to simplify things for plan participants spiraled into an arms race for gathering assets and has become a catalyst for bitter arguments: Transparency, glidepath construction, “to vs. through.” We all have differing opinions on the most prudent way to construct these new hybrid investments. The purpose of this paper is not to inject an opinion on what is the best method, but suffice it to say that while conceptually target-date funds offer a single entry point for diversification and automatic features, investment companies need to lock themselves in a room and figure out the mess or the Department of Labor will attempt to do it for them.

If choosing target-date funds, consider using 10-year increments as opposed to five. Remember, less is more. This even applies to a single concept in the fund menu. We want to reduce the amount of boxes to check, not increase them.

My preference for target-date funds is rooted in my oath as a fiduciary. This is not an absolute by any standard. Understanding the culture of a company or the demographics of the participants is paramount, so this commentary is simply a generalization. One thing that target-date strategies do not consider is risk tolerance of a participant. One thing that target-risk strategies don't account for is time horizon. Research has consistently shown that the most important factor when developing an asset allocation is time horizon and thus my affinity toward the target-date concept; but there are smarter people than me that would argue otherwise and the target-date universe is still very much flawed.

The important thing to remember is that when evolving your fund menu, a large portion of assets are going to be driven to whichever option that you choose as the qualified default investment alternative, so make sure you do your due diligence and document the process.

Because many startup plans don't have consultants and are often in group annuity products or sold under the enduring promise of open architecture, there are too many investment options from inception. Having 3,000 investment options on a plan level is a box checker and a sales tactic, but probably sows the seeds for the mess of complexity. How often do you look at a fund menu and there are eight U.S. equity options, and they are all large growth.

Condensing the menu starts at the sponsor level. If the decision-maker drinks the proverbial Kool-Aid, then that trust will permeate through the rank and file. (The opposite also rings true). Come in with a plan and not just a concept. Have a proposed mapping strategy, develop a three-year timeline, and address participant communication and education. Do the leg work prior to engaging the discussion and be prepared for objections. Most plan executives want to be heard. They want to inject their preferences and corporate culture into the investment option discussion, and rightfully so. This might be the most important step in the process of evolving the fund menu.

Creating a timeline is often an important step as well. Moving from 40 investment options to five can be culture shock for the participants and a PR nightmare for plan sponsors. Instead of replacing underperforming funds, remove them. Consolidate the midcap growth and large-cap growth into one single entry multicap growth option. Slowly begin to shape the investment lineup into fewer and fewer choices, so there is no shock value to plan participants. Remember, this is an evolution and not an exercise. Even if the plan sponsor wants to transition overnight to a five-option investment menu, tread lightly. Employee dissatisfaction will eventually reach the decision-maker, and that frustration will trickle down to the consultant.

The question then becomes, “Where is the end of the evolution?” Choosing a platform that allows you as the consultant to customize the participant experience is important. If we can get out of the mind-set of registered products and think participant behavior, why not introduce the participants to the investment options using simple, easy to understand entry points. If they choose to look under the hood, then so be it. Your job as a fiduciary is more important to the participant who knows nothing than the participant who does, and hopefully your value as a trusted consultant will be magnified by what people don't see.

This could be one mutual fund, a combination of several mutual funds, a collective trust etc., but asking a participant to choose to put money into stock is much simpler than asking a participant to put money into the Blackrock Equity Income fund or the Franklin Rising Dividends fund. What do they do when they don't understand? Nothing. Cash. Fixed. Things that they understand they trust. They might have a preconceived notion about stock, but at least they have a notion. They have some level of understanding. Let's face it, a novice investor would take a look at 30 different stock funds and do what? They would choose the one that has performed the best over the last published period of time. They do not consider things like risk-adjusted return or systematic factors or market capture.

By introducing the single entry point for stock, this allows participants to focus on the more important aspect of their retirement plan: saving!

There is no tried and true solution to creating an optimal entry point to differing asset classes.

These are, of course, just examples of what I see out in the marketplace. They probably are on the extreme end of the bell curve and reflect more of what I envision as the culmination of the evolutionary process.

Our first duty as a fiduciary is to establish a prudent process while our first duty as a consultant is to maximize participant outcomes. Using the behavioral finance data that our strategic business partners continue to publish only further reinforces the need for consolidation in order to maximize the participant experience. We need to take a step back and look at fund menu design from the perspective of the plan participant and not the plan sponsor. Most often, the whole menu is not equal to the sum of its parts and the average plan participant grossly underperforms the benchmark. This is a failure by the retirement community, despite good intentions. This solution helps to maximize the participant experience, simplifies decision-making and helps to maximize outcomes while adhering to our obligation as plan fiduciaries.

Stephen Dopp is the senior investment analyst at Cafaro Greenleaf, Red Bank, N.J.