A Growing Fiduciary Concern: Have “State-of-the-Art” Investment Menus Backfired?
How should retirement savers deal with the complexity of investments? Over the years, behavior finance research suggests retirement savers are overwhelmed by the plethora of investment options. Worse, with financial literacy far from where it should be, employees appear to be turning increasingly to easy-to-understand “one-portfolio” solutions like target date funds (TDFs) or target risk funds (TRFs). Despite this, there’s been a push on the part of some in the industry to add even more sophistication to employee’s investment options like alts and longevity annuities. Do these more complex investment options work for the typical retirement saver, or are they merely a result of service providers stretching their value-added proposition?
This is no hypothetical question. With workers relying more and more on their 401k to provide them the means to a comfortable retirement, anything that takes their eye off the ball of saving more can have significantly negative repercussions. “One recent study (2013 401k Participant Survey conducted by Koski Research for Schwab Retirement Plan Services, Inc.) showed that 6 out of 10 participants surveyed said that their 401k plan is their only or largest resource for retirement savings,” says Jessica Maldonado, Vice President at Searcy Financial Services, Inc. in Overland Park, Kansas. “Adding complex investment options that participants don’t understand is like asking them to play Russian Roulette with their largest pile of money. Additionally, 52% of participants surveyed said that their 401k investment information is more confusing than their healthcare benefit information. I find it interesting that we as an industry continue to give participants so many choices to make regarding their investments when clearly people are confused.”
The problem stems back over several decades when the 401k investment option menu morphed from one of three “primary color” (i.e., obviously different) investment options to one of multitudes of “shades of gray” (i.e., subtlety different) investment choices. As we’ve written of previously, (see “Avoiding Decision Paralysis: How to Create the Ideal 401k Plan Option Menu,” FiduciaryNews.com, November 17, 2011) this “paradox of choice” can have dire consequences. “Most retirement savers are not investment experts and can quickly become confused by the overwhelming amount of information and advice available regarding how to allocate your retirement savings for maximum growth,” says Paula Friedman, Managing Director at encore401k, a division of McLean Asset Management Corporation in McLean, Virginia. “In my experience as a retirement plan adviser, I typically see participants allocate equal percentages to all of the available investment options in the plan. If there are too many options available (or they aren’t sure what to choose), the other commonly employed practice is to allocate most or all of their account to the stable value fund. When asked why they chose this investment, most explain that they don’t want losses and the idea of a ‘stable value’ was appealing.”
Kevin Prendergast, Chief Investment Officer of EFG Advisors, LLC in Schaumburg, Illinois, says, “The most frequent asset allocation mistakes we encounter are ‘naïve diversification,’ owning multiple Target Date Funds, and concentrating an account in a single fund/asset class based on historical performance. Naïve diversification is when an investor knows he or she should diversify across multiple investment options, but chooses to do so by allocating evenly across all of the funds on the plan’s menu without regard for the underlying exposures (e.g. 10% to each of the 10 funds on a plan’s menu). Owning multiple Target Date Funds does not provide meaningful diversification as the funds are highly correlated with one another. Target Date Funds are comprised of the same holdings, simply allocating more of the assets to bonds the nearer the Target Date. We believe participants are better off choosing a single Target Date Fund. Choosing a fund based on historical performance often turns out to be the opposite of the right thing to do, as the fund is most likely due for a period of underperformance following a period of outperformance.”
Forget Complexity of Choice Overload, Even Traditional Investments Confuse
The confusion is not limited to “complex” investments. Even traditional asset classes confound many who have little to no education in the field of investments. “Common asset classes such as bonds can confuse the typical retirement saver,” says Ed Snyder, Co-Founder of Oaktree Financial Advisors in Carmel, Indiana. “I had a client ask me if we owned any bonds in her account and if they were like the old ‘military bonds’ they use to have. I guess she meant war bonds or maybe government bonds, I’m not sure.”
Gordon J. Bernhardt, President & CEO of Bernhardt Wealth Management, Inc. in McLean, Virginia, says, “Many retirement plans offer several choices in investments thinking that more choices may reduce risk to the employer and also giving more choices to their employees. More is not necessarily better. Most of the plans most likely try to group the investments by some sort of style, i.e., bonds, US stocks, and international stocks. Some plans will break it into more categories of small company stocks, large company stocks, value stocks, growth stocks, etc. All of these choices do make it confusing for a plan participant. But it is especially confusing when a plan has two choices such as American Funds Growth Company of America and Fidelity Growth Company. Both funds have long track records but they both fall in the same asset class-US Large Growth Stocks. They will most likely select both or select the one that has the best recent return. Either way that may not be the best decision.”
What’s in a name? Apparently a lot. “I’ve seen participant accounts that are 100% invested into the funds with ‘growth’ in their name because they think that’s what it’s going to do….grow,” says Layton Cox, Director of Retirement Plan Consulting at Pathways Financial Partners in Tucson, Arizona.
But it’s not just “growth.” Nearly every description used by investment professionals can be classified as “Jabberwocky” by retirement savers.
“Allocating across, for example, equity funds is difficult because of the disconnect between industry jargon and participant language,” says Graig Stettner, a financial advisor and partner at Strategence Capital located in Fort Wayne, Indiana. “Who wouldn’t like a growth fund? Isn’t growth what one’s after? Yet value has outperformed in the long run. But who goes to the department store and buys the value suit or pair of shoes. Next, when presented with large, medium (we don’t even call them medium; we call them ‘mid’), and small company equity funds, participants are likely to overweight the higher-returning classes, increasing their portfolio’s risk.”
Industry Solution to Financial Illiteracy: Add More Complexity
It seems odd, then, given the bewilderment surrounding traditional investments, that we see an urgent push to add newer and more sophisticated products onto the plan investment option menu. As already reported, (see “Square Peg QLACs Can’t Seem to Fit in 401k Fiduciary Round Hole,” FiduciaryNews.com, August 4, 2015) the demand for these products appears to be coming from service providers and regulators, not retirement savers. Not all service providers, however, see this as a helpful trend. It’s not surprising to hear concerns from practicing fiduciaries, in particular. “Most retirement savers have a hard time understanding the basics of asset allocation and the differences between a stock, ETF, and a mutual fund,” says Friedman. “Adding more complex investments will only increase the confusion surrounding how to invest retirement savings.”
Because the popular press talks about so many asset classes, retirement savers can mix up the underlying asset class with the product without understanding the difference between the two. “More complex asset classes can confuse investors even more,” says Snyder. “When I talk to some people about investments in real estate they think I’m talking about residential real estate, when really I’m talking about real estate mutual funds. These are mutual funds that own shares of companies in the real estate business.”
Worse, and with alternative investments in particular, retirement savers can be persuaded by headline grabbing returns, not long-term common sense. Cox says, “Investors are notorious for performance chasing. Last year REITs were a top asset class. We had multiple new participants allocate 50% or more of their portfolio to REITs at the beginning of the year. They saw that awesome return number and went from there. Adding commodities, TIPS, or High Yield just makes things more confusing for the participant. They don’t understand what these asset classes do or what their purpose in a portfolio is.”
Some advisers prefer to keep it simple and avoid complex investments altogether. “We don’t include these in plans we advise on,” says Stettner, “but there is the risk of focusing on the downside protection, without considering the lack of upside participation. Or, in raging bull markets, participants might focus on the muted returns without considering the downside mitigation of alts.”
Of late, QLACs have become the term de jour among the sophisticates. “A QLAC is a Qualified Longevity Annuity Contract,” says Rahul Ray, Principal at Burr Capital LLC in Edgewater, New Jersey. “It’s an annuity that claims to provide protection from longevity risk. While the advantages are commonly cited the downsides are rarely discussed. Perhaps the most important downside is the enormous opportunity cost of the instrument. Someone purchasing the annuity is making a huge upfront purchase (e.g., $100,000-125,000) and may not get payments for many many years, sometimes decades. And if the purchaser doesn’t survive till payment date which could be as late as age 85 then that $100,000-12,000 principal could be permanently lost. This tradeoff is not always obvious to retirement savers.”
There’s a very real case that can (and perhaps should) be made that, like the old-fashioned “Reg D” investments, the complex instruments now being placed in some 401k investment menus might require a level of financial sophistication well beyond the typical retirement saver. Dan Hernandez of Lincoln Investment Planning, Inc. in Marlton, New Jersey, says, “Alternative investments or Alts, such as precious metals or other commodities, are generally more volatile investments than equity or bond funds. QLACs, Qualified Longevity Annuity Contract, while guaranteeing a future income stream, are very restrictive contracts. Both of these are complicated and should not be entered into without the proper research.”
It’s too easy for the casual investor to focus on the good news of these investments without regard to the bad news. “Particularly in the case of annuities, which are contract driven, retirement savers quickly forget how their annuities work and fail to account for their limitations as retirement approaches,” says Prendergast.
It’s important for 401k plan sponsors – who may expose themselves to some future fiduciary liability – to understand the likely behavior patterns and consequences when adding complex options to the plan menu. “Most alternative investments are confusing, expensive, and not necessarily for every investor,” says Bernhardt. “For the unsophisticated investor, they most likely will fail to understand the benefits, if any, that non-correlated assets have in the portfolio. Without guidance, they will most likely allocate percentages evenly across multiple investment choices. With regard to a QLAC, the use of it is often emotional. If an enrollment occurs during bear markets they may make the decision to allocate more to his choice than is prudent simply because they like the guarantees. Likewise, during bull markets they may ignore the benefits of a QLAC.”
Back to Square One: Less is More
Rather than falling prey to the latest investment fad (whether hawked by government regulators or product sales reps), it may be more prudent for the 401k plan sponsor to return to the basics when it comes to designing plan option menus. “Any time we prudently limit participant choices,” says Stettner, “we avoid the paradox of choice and the tendency of excess choice to make participants coalesce around a smaller subset of funds, thereby potentially missing out on valuable portfolio segments. Given the long-term tendency of stocks to appreciate and fixed-income investments to provide stability and modest returns, participants – left to their own choices – are probably best off without the alts choice.”
In word, it’s all about keeping things “simple.” Despite the amount of media devoted to investing, professionals keenly understand retirement success is based on savings strategies, not investment strategies (see “New Study Reveals Three 401k Strategies More Important than Asset Allocation,” FiduciaryNews.com, August 14, 2012). Snyder says, “The advantage of limiting investing to more traditional asset classes is its simplicity. The more simple it is, the more likely the client is to stick with the strategy and be successful. More is not always better. Adding two or three more asset classes to an investment mix probably won’t substantially increase the return potential or reduce the risk potential in that portfolio.”
It may be that one reason why the average 401k plan sponsor might ask for non-traditional asset classes is the failure to distinguish between retirement (i.e., tax-deferred) and non-retirement (i.e., taxable) investing, as well as the difference between meeting retirement goals (generally done through retirement plans) and addressing risk exposures (generally done through insurance products). Once this is fully understood, the attraction of “keeping it simple” becomes most obvious. “Most retirement needs can be met using a simple asset structure of cash, fixed, and stocks,” says Ray. “Typically where traditional asset classes tend to fail is when it comes to areas such as taxes and insurance protection.”
Hernandez says, “Long-term equities (stocks) have typically outperformed other asset classes. A mix of stocks, bonds, and cash, would not only be adequate for most retirement investors, but they are easier to understand than ALTS and QLACs and can be easier for the average investor to research.”
Keeping it simple coaxes the retirement saver to concentrate on saving. “When clients better understand an investment,” says Prendergast, “they are more likely to adhere to the investment plan in place through thick and thin. Traditional asset classes have a rich history of data upon which retirement savers can rely, whereas alts often have limited or no track record.”
The historical numbers bear out the advantage of keeping things simple, including the use of the (perhaps outdated) age-based asset allocation formulas long employed by financial planners. “Since the 20s, stocks have returned around 10% a year, corporate bonds have returned around 6%, and treasury bills around 3.5%,” says Cox. “If investors did nothing but start at 100% stocks in their 20s, 90% stocks and 10% bonds in their 30s, 80% stocks and 20% bonds in their 40s, 70% stocks and 30% bonds in their 50s, and then 60% stocks and 40% bonds in their 60s, they would retire easily. Unfortunately, participants have access to too many options and this idea becomes too complicated to commit to.”
Why is it so hard to commit to this simple strategy? It appears the more options available to retirement savers, the more likely they will be lured by the false siren of investment performance. By shrinking the number of options on the investment menu, 401k plan sponsors could help their employees. Friedman says, “Many participants solely focus on investment performance when selecting investments for their retirement accounts. Chasing performance is an easy way to find yourself over-allocated to very risky asset classes (i.e. emerging markets, sector funds, etc.) and can quickly become a drag on overall performance over time. By limiting the available options to a short list of asset class or index funds combined with fully diversified portfolios such as target-risk or target-retirement funds, investors can avoid trying to time the market or chasing past performance.”
Just how far to shrink the plan option menu is still a matter of conjecture (see “How Many Investment Options Should 401k Plan Sponsors Offer?” FiduciaryNews.com, October 18, 2011). Bob Sloma, Principal at Sigma Advantage Investments and President of MyRetirementPlan in Grand Rapids, Michigan, says, “Many employer plans have between 20 and 30 investment options. Even with this many options, plan participants find the number of choices overwhelming. Ideally, employers should provide their employees access to independent, third-party advisors or tools to help them select the funds and respective allocation within their plans. The plans should be structured to provide the most opportunity for growth based on savers risk tolerance level and time before retirement. Having two to three funds for equity and bond asset classes and one for cash should be enough to provide the diversification required for various market conditions over the long-term.”
Still others prefer a more spartan menu. “The benefits to limiting choices to traditional asset classes is that they are easier to understand, more transparent than most non-traditional asset classes, and easier to understand the proper asset allocation,” says Bernhardt. “This is especially true if you limit the choices within each asset class. For example, if you have the Vanguard Total Market Index Fund does it make sense to have a second investment in that asset class? The answer is no.”
Whether the investment menu contains only three or as many as a dozen or more options remains a tough decision for 401k plan sponsors. What we do know, however, is sticking with the basics can help employees meet their retirement savings objectives and, at the same time, take some fiduciary liability off the shoulders to plan sponsors.
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