Best Practices for Developing 401(k) Investment Lineups

Introduction

Best practices surrounding the development of defined contribution investment lineups has evolved considerably over the last three decades. This evolution has shifted from the widely accepted practice of a more funds is better approach to one that recognizes the value of simplicity in helping participants prepare for retirement.

The central tenant underlying our philosophy of helping plan sponsors construct investment lineups is to help participants prepare for retirement by giving them the necessary investment tools (i.e. funds) to meet their long-term needs.

While we recognize that even the best and most carefully crafted investment lineup cannot save a participant from low and inconsistent savings, we strongly believe that one of plan sponsor’s most important duties is to provide participants with a high quality investment lineup.

In this paper, we will specifically focus on the fundamental tenets that shape our philosophy on how investment lineups should be constructed to provide participants with a simple, yet effective, array of investment options.

A Focus on Participants (And Their Behavior)

Albert Einstein, once said “everything should be made as simple as possible, but not simpler” and while the sage advice was likely not referencing the construction of defined contribution investment lineups, we believe it holds true.

In the 1990s, as mutual fund proliferation peaked, the prevailing wisdom among plan sponsors and consultants was that more funds was in fact better for participants. Extensive choice became the de facto benchmark for success. What the trend of the ‘90s missed, however, was that too much choice can oftentimes lead to paralysis by analysis among participants.

Researchers have identified a negative correlation between the number of funds available in a plan and the efficiency of the plan.[i] In short, more choice actually leads to worse outcomes as participants find themselves unable to make a decision and/or make a poor one.

Our approach to lineup construction is rooted in the idea that less is more and that a select list of high quality investment options thoughtfully selected will give participants the best opportunity to meet their long-term retirement needs.

Costs Matter (A Lot)

There are few factors that can reliably predict the future success of any investment in advance. However, research by Vanguard[ii], Morningstar[iii], American Funds, and other institutions has increasingly demonstrated that one of the best predictors of future investment success is simply how inexpensive your investments are.

We believe that when it comes to investing you don’t necessarily get what you pay for. Instead, higher costs tend to erode investment gains and over the long-term can severely lessen the amount that stays in investors pockets.

For example, a $100,000 portfolio over a 30-year time horizon that grows on average 6% per year, with an expense ratio of 0.25% versus 0.90%, would see a nearly $100,000 difference in the ending value of their portfolio.

Markets Are Efficient

The Efficient Market Hypothesis (EMH)[iv] states that all information is instantly reflected into market prices, making it extremely difficult—if not impossible—to beat the market. While we subscribe to the EMH and its ability to efficiently price markets, we recognize that price distortions can occur based on underlying investor sentiment, which creates potential opportunities for active management to outpace indices and/or decrease risk in certain situations.

This hypothesis underpins our preference towards more passively managed funds, while also recognizing that in certain situations actively managed funds can be appropriate for participants looking to mitigate risk and retain the opportunity to outperform the market in certain, less efficient asset classes.

Assets Classes Are Unique

Each asset class (i.e. large domestic stocks, bonds) has its own unique risk and return characteristic and will perform differently throughout various market cycles. It is these unique characteristics that allow participants to develop a diversified portfolio capable of minimizing volatility through market downturns, while still providing the necessary growth to meet their long-term retirement goals.

It is critical to provide participants with a variety of high quality investment options that serve as the building blocks for developing a diversified portfolio capable of withstanding the inevitable ups and downs of the market, while also balancing the fact that too much choice unavoidably leads to poor participant decisions.

Conclusion

Intentionally crafting a lean, yet broad array of investment options for participants is one of a plan sponsor’s most critical responsibilities and we believe the tenants outlined in this paper help to establish the critical building blocks for doing so effectively.

[i] Save More Tomorrow

[ii] https://personal.vanguard.com/us/insights/investingtruths/investing-truth-about-cost

[iii] http://news.morningstar.com/articlenet/article.aspx?id=752485

[iv] http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

CATEGORIES: 401k & Retirement
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