A Matter of Choice: In Search of the Optimal Investment Lineup
Provided by: Fidelity Investments
As America shifts from a reliance on defined benefit to defined contribution plans, the burden to save for retirement is being transferred to workers. The tools and vehicles are there. A vast choice of retirement products offers favorable tax treatment, convenience, broad asset allocation, dollar cost averaging, and potential long-term compounding.
Despite the opportunity, however, many individuals are their own worst enemy. They make critical mistakes. Some fail to join their employer sponsored retirement plan, passing up a tremendous benefit. Others join, but contribute too little, or they invest far too conservatively for a long-term goal. These participants are wrongly focused on short-term volatility or the loss of their investment principal, rather than the more serious long-term risk that their purchasing power could erode as a result of inflation. Throughout all this, inertia blocks many from making good decisions and acting. Many propose a defined contribution investment lineup that helps enable employees to become retirement ready no matter their level of sophistication or degree of interest in investing. This three-tiered framework begins with lifecycle funds, which are quickly becoming the default option for many participants, whether they enroll on their own or through an automatic enrollment program. Recently released regulations on Qualified Default Investment Alternatives (QDIA) from the Department of Labor will only help contribute to this trend by now providing safe harbor coverage to ERISA employers who establish a lifecycle, balanced fund, or managed account as their default fund. For now, though, most participants still create their own portfolio with a core lineup of diversified investment choices. With careful selection, you can provide broad diversification potential with about a dozen funds. This can accomplish the asset allocation task efficiently and with minimal risk of overwhelming or confusing participants . For the most sophisticated and independent individuals who seek even more choice, a third tier-a self-directed brokerage account - can allow them to go well beyond the plan's core lineup. Because the first tier (lifecycle funds) and the third tier (self-directed accounts) are fairly straightforward, the rest of this article focuses on how to put together a framework for the second tier core lineup of choices. Overall, this tier should reflect three key themes: simplicity, balance and breadth. It should have a limited number of investment options that provide broad global coverage and include non-correlated asset classes.
Fixed Income: On the conservative end of the risk spectrum, this asset class typically includes a money market or stable value fund. For the core of fixed income, some plans are content with a single broadly appealing bond fund. This could be a plain vanilla investment-grade bond fund. However, many investment professionals believe a core-plus bond fund can provide better potential returns without increasing risk appreciably because of its increased diversification. It would typically have 80% or so invested in investment-grade bonds as its anchor. The remaining 20% of assets would be in "plus" sectors, such as high yield bonds, emerging-markets debt or floating rate debt. If plan sponsors seek further diversification in fixed income, they could include a pure high yield bond fund and/or a government bond fund.
Domestic Equity: Begin with five basic building blocks - a large-cap index fund and active funds covering the large-cap core, large value, large growth and small-cap active segments. A large-cap index fund can provide broad sector-neutral market coverage at a low cost. Adding to this index fund, an active large cap fund would take sector, style and capitalization positions. This could introduce a different stream of returns. By adding style specific large value and large growth funds, participants would be able to diversify further and possibly tilt their portfolios towards one style or another. A well-diversified actively managed small-cap fund would broaden overall market coverage further. Together, these five funds would provide broad domestic equity coverage. If participants seek to diversify further, the lineup might also include small-or small/mid-cap-value and growth funds, which would marginally extend their portfolio's scope.
International Equity: Some plans offer a single broadly diversified non-U.S. stock fund. But many sponsors are exploring the vast world of additional international fund choices. These include value- and growth-oriented funds and a dedicated emerging markets fund. Some participants could gain from broader international exposure. While more than half of the world's investment opportunities are outside the United States, many retirement plan participants here have less than 10% of their portfolio allocated internationally. In addition to a broad actively managed fund, many plans would benefit from a pure emerging markets stock fund for access to the world's fastest growing economies, including China, India and Brazil. Emerging markets stocks historically have low correlation levels with those in more developed markets, which add to their diversification potential. Similarly, an international small-cap fund can add to a portfolio's return potential and its diversification over a full market cycle.
Inflation Hedges: More and more plan sponsors are interested in so-called alternative asset classes. These include commodities, real estate and Treasury Inflation-Protected Securities (TIPS). These alternative assets add further diversification and can act as inflation hedges. For maximum diversification, some investment professionals have suggested a single multi-asset class real return fund that would include as wide a variety of instruments as possible.
Creating an Optimal Framework: Many investment professionals believe the combined building blocks outlined above can provide the framework for a DC plan's optimal investment lineup. Together these building blocks can provide broad market coverage and sufficient choice without providing an overwhelming number of options. The presence of three tiers will help provide a suitable option for employees at every level of investment knowledge and interest. The world of DC investing is rapidly changing. Now is an excellent time to re-evaluate your plan's investment lineup to ensure you are providing the best opportunities for your participants.
Notes
Neither diversification nor asset allocation ensures a profit or guarantees against loss.
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