While the extent of reform needed often varies by plan size, simplifying the core investment menu of defined contribution (DC) retirement plans is critical to helping participants succeed.
The Pension Protection Act of 2006 popularized the use of asset-allocation solutions as a qualified default investment alternative (QDIAs)—a plan’s default investment—but some 80% of DC assets reside outside this option. At the same time, 63% of DC plan participants are still making their own investment decisions.
DC plans rely on the plan sponsor to provide the menu options that can help participants reach their investment objectives. However, according to data from the Plan Sponsor Council of America and Aon Hewitt, out of an average of 19 choices, participants typically invest all their money in just three to four funds. For this reason, fewer and easier-to-understand menu choices can encourage more appropriate selections and help put investors on the path to better outcomes.
As plan sponsors work to streamline and enhance DC plans, it is vital that menus include a limited set of building blocks geared toward helping the average participant—not just the savviest. The menu should ideally include funds with broad mandates that provide complementary risk-return profiles, meaningful diversification and strong risk-adjusted results.
A new framework
A streamlined DC menu should include a strong QDIA, which is increasingly a target-date fund, and a preservation fund such as a stable value or money market fund. Between those options sits the core menu. How do you adjust that core to improve participant outcomes? Consider the following steps to build a better DC core menu:
- U.S. equity:Streamline to three or four funds that have style and market cap flexibility.
- International equity:Broaden to include one pure international and one global fund.
- Fixed income:Anchor the menu with two funds that diversify exposure to major asset classes.
DC menus on average have nine U.S. equity funds, making this asset class primed for streamlining. Too many equity options can confuse participants and potentially prevent them from broadening their exposure to international and emerging markets.
Even with the consolidation of specific asset classes, diversification is still an important goal. Offering one fund per style box does not provide enough diversification or benefit participants. Funds with broader mandates can provide a wide range of exposures to styles and market capitalizations and provide improved results by giving skilled investment managers greater style and market cap flexibility to seek better investments.
International mandates are an integral part of a balanced DC investment menu. Plan sponsors should consider providing non-U.S. equity exposure by offering two different types of strategies—global options and stand-alone options. A global option can mitigate participants’ “home bias” and allow them to feel comfortable with a fund that has international companies by featuring familiar names like Coca-Cola.
Further, stand-alone options offer a single, actively managed strategy that has flexibility to invest in both emerging and developed markets. Participants shouldn’t have to determine exposure to emerging markets and having a flexible fund option helps broaden a participant’s investment approach and potential for investment growth.
Fixed income doesn’t need to chase returns and should allow a portfolio to diversify exposure to non-correlated assets and absorb volatility in the market. Plan sponsors should anchor the fixed-income menu with both a true core bond fund and core plus fund. A true core bond fund provides balanced exposure to the three major U.S. fixed-income asset classes—treasuries, mortgages and investment-grade credit—and the core plus fund can provide higher total return potential through investments that have greater credit exposure.
With the inclusion of both true core and core plus, a fixed-income menu can support the four critical roles of fixed income, which are equity diversification, capital preservation, income and inflation protection.
Many current DC investment menus are spread too far across asset classes and styles and can lead to participant confusion, disengagement and, in some cases, poor investment decisions. While there may not be a perfect number and mix of funds for every plan, plan sponsors can simplify plan menus with fewer, broader choices and relabel those choices to correspond to retirement and investment objectives.
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