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Are Plain-Vanilla 401k Investment Options a Fiduciary Imperative?

Are Plain-Vanilla 401k Investment Options a Fiduciary Imperative?
September 29
00:03 2015

Investment fads come and go, but they tend to stay on the 401k menu of investment options longer than their 15 minutes of fame. Who’s responsibility is it to recognize when investment fads expire? Many suggest it’s the duty of the retirement saver to mood-ring-1535833-300follow the advice of their own fiduciary adviser. After all, a fiduciary is driven by the client’s best interest, not by the potential payout offered by the product. A non-fiduciary adviser possesses no similar legal constraints. But, does the average retirement saver know this?

“Let’s face it, the investing public who use an ‘adviser’ don’t know what a fiduciary even is in this context and have no idea if their adviser is or isn’t one,” says Tom Hamilton, President of Hamilton Wealth Management in Fairport, New York. “Why? The disclosure is so concealed that it is basically useless. It’s the fine print of fine print. If you go to a Chevy dealer to buy a car, you know they will want to sell you a Chevy – no one thinks they are an ‘Auto Purchase Advisor’ who’s selecting the best for them from all available makes of vehicles. In our industry, almost everyone who uses the handle ‘advisor’ is assumed by the public to be impartial advisers, when the truth is, some are, but some are selling just Chevys.”

Rather than rely on the employee to determine the correct point of view of his personal adviser, it may be more reasonable to place that responsibility on the fiduciary duty of the plan sponsor who then can offer employees with the proper menu of the core building blocks. “Investors in the DC space should be given an opportunity to invest in all of the core building blocks of asset allocation, i.e., stocks, bonds, and cash to allow investors the opportunity to act on their risk preferences,” says Robert G. Smith III, President and Chief Investment Officer at Austin, Texas-based Sage Advisory Services Ltd., says. “Where investors are ill-prepared to construct their risk preferred portfolios, they should be offered pre-constructed investment risk or goal oriented models such as balanced, risk-based or target-date forms. Beyond that, most investors are not well prepared to address the different unique investment risks and timing decisions that may be required for more exotic, less liquid or structured forms of investment.”

While Smith expresses caution regarding letting employees loose on so-called “Alternative” investments, others, seeing how they have helped larger institutional investments, don’t see why they couldn’t be treated the same way we use sector funds. “Stocks and bonds are not sufficient to diversify client portfolios,” says Pedro M. Silva, a Financial Advisor at Provo Financial Services Inc. in Shrewsbury, Massachusetts. “Retail investors deserve the same choices that have been protecting institutional investors for years. If 401ks can have energy, health care, floating rate, commodities, they should be able to include Alternatives.”

Kevin K. Albert, Managing Director at Pantheon in New York City, says, “We believe that 401k plans should be entitled to benefit from the 75+ years of investment expertise and technology that have been developed in the context of institutional savings vehicles such as defined benefit pension plans, endowments and foundation and sovereign wealth funds all of which have similar long-term investment objectives. This would include professional asset allocation, attempting to select best of breed managers for each investment strategy and the inclusion of alternative investments such as illiquid real estate and private equity. Unlike ‘portfolio insurance,’ ‘smart beta’ and other concepts that may come and go, private equity has been one of the top performing investment strategies for defined benefit pensions for the past 30 years.”

David Swensen, famous for guiding Yale’s endowment to its impressive returns, has relied on non-standard investments to fuel that growth. Once limited to the domain of institutional players like university endowments, these Alternative investments (or “Alts”) now find themselves readily available in product form – the kind of product that can easily find itself in a 401k plan menu. Can what works for institutional investors work in a similar manner for individual investors?

Should 401k Plans be Limited to Plain-Vanilla Investment Options?

Academic theory certainly supports the idea of Alts. “401k plans should not be limited to plain vanilla investments,” says David F. Wirth of Savant Capital Management in McLean, Virginia. “There is clear academic evidence showing both reduced risk and enhanced return potential by allocating funds beyond the types of investments that have historically been found within many employer-sponsored plans. The benefits are clear provided the products have reasonable, or even better, low costs and are used correctly within a properly diversified strategy suitable for each individual’s goals and needs.”

Investment professionals, being much more aware of how Alts work within the total structure of portfolio management, tend to be very comfortable with their use. That’s not to say they don’t recognize the limits they might offer to non-professional investors. “Alternative investments should be offered in 401k plans,” says Mark Carruthers, an independent financial planner based in Congers, New York, says. “From a historic perspective, most 401k plans are indeed plain vanilla. They offer a variety of stock and bond funds and nothing more. In recent years, they’ve added Target Date Funds to allow for international exposure, perhaps emerging markets, etc. However, asset correlation continues to increase in our global economy. So, while I do believe alternative investments should be offered in retirement plans, I am a bit cautious. Investors shouldn’t use them as trading vehicles, but rather ways to lower risk & volatility. Thus, perhaps offering them via an allocation model would be best.”

Even accounted for the theory of Alts, there’s no denying there are practical constraints to their use in 401k plans. “In my opinion there should be more than plain vanilla options within 401k plans,” says Kevin Mastaler, Portfolio Manager at Maclendon Wealth Management in Delray Beach, Florida. “Markets are not plain vanilla and investors could benefit from a greater range of offerings if allocated appropriately. With plain vanilla investment options, you could be setting yourself up for more downside during the next market pullback without the use of alternatives. Unfortunately, with alternative investments there needs to be a level of understanding on the risks involved, ways to implement them in your portfolio, and the higher fees usually associated with the strategies. Therefore, I would recommend offering alternative exposure in asset allocated vehicles based on risk tolerances and objectives and not in a stand-alone strategy.”

When asked about limiting 401k plans to plain-vanilla investments, Noah Greenbaum, Director of Investments at Canal Capital Management in Richmond, Virginia, responds with an emphatic, “Absolutely yes.”  He says “there is an incredibly steep learning curve in understanding the different types of alternative investments that are out there, and for the most part, the ones that are available to most investors, are not very good. The characteristics that make alternatives good investments, typically do not translate very well to mutual funds – which is traditionally the only vehicle available to the average investor. The area where alternatives can potentially add value is within pooled plans where an experienced money manager is directing the allocation of the funds rather than the employee.”

You must keep in mind that, when it comes to the average investor, even “plain-vanilla” can appear “Neapolitan” (in keeping with our ice cream metaphor. “Employer sponsored 401k plans should have investment options that the employee can accurately decipher what type of fund it is (ex: equity, fixed income, real estate), and how the fund is invested (ex: large cap, Small cap, International/global),” says Kaleb Robuck, Associate Advisor at Miller Financial Group in Red Oak, Iowa. “Even ‘Plain-vanilla’ investment options can sometimes be hard to determine the underlying fundamentals. It is my belief that you can never have enough investment avenues amongst the different asset classes to help diversify your portfolio. This is not to be confused with having 10 different large cap funds to choose from (that is not diversification).”

Alts raise a legitimate question of whether their value offsets their complexity. “For a 401k plan where participants are selecting their own investments, the plans should be limited to straightforward, relatively easy to understand investment options,” says Celia Rafalko, Managing Principal at Rafalko Investment Advisory in Glen Allen, Virginia. “Alternative investments can be extremely difficult to understand, particularly if the investment is using borrowing (leverage) or has a complicated structure like buying some stocks and selling others (Long/Short funds). Alternative investments can be illiquid as well, so may be difficult to sell at a price close to the actual underlying value of the assets. Some alternatives also have large swings in value, making it easy to get discouraged and sell low, and excited and buy high.”

This doesn’t mean Alts don’t have their uses. Rafalko says, “In general, an alternative investment is for a small percent of a sophisticated, high net worth investor and is best left outside of a 401k account.”

Given the value-added questions pertaining to the use of Alts, the potential for increase fiduciary liability to plan sponsors cannot be ignored. David Ramirez, Chief Investment Officer at ForUsAll in San Francisco, California, says, “We believe that a 401k lineup should make it super easy for employees to get a low-cost, diversified portfolio without introducing undue fiduciary risk (or work) for employers. For most employees, a low-cost, diversified target date fund is all that’s needed. Introducing alternative investments not only makes it more complicated for employees to create diversified portfolios but can significantly increase investment fees, investment risk, and ultimately fiduciary risk.”

Illiquidity can only exasperate that fiduciary risk. “Adding and removing investments in a 401k lineup takes a good amount of time,” says Rafalko. “With current regulations, a participant must be notified 30 days in advance of an investment change. When one is dealing with alternatives, this can be a lifetime, so the plan sponsor can’t make a timely investment change, even if the advisor on the plan recommends it in a timely way. A recent study found that the average participant made an investment change once every 4 years. With alternatives, an investor needs to be watchful and willing to act when one alternative cycles out of favor and another comes in.”

In addition to the above, Alts present a series of other issues. “Alternative investments tend to be very expensive relative to ‘plain vanilla’ investment vehicles such as index mutual funds designed to track mainstream assets classes,” says Kevin J. Prendergast, Chief Investment Officer at EFG Advisors, LLC in Schaumburg, Illinois. “Moreover, when adapted and packaged in mutual fund form for retail investor consumption, alternatives tend not to perform nearly as well as the private instruments on which they are modeled, utilized by large institutions and the ultra-wealthy. Lastly, because alternatives tend to produce return streams uncorrelated with major asset classes and often lack fundamental value (i.e., market value is based on a trading algorithm/strategy or commodity), when these investments inevitably experience long period of underperformance, the average investor will not have a track record or valid premise on which to rely and remain invested. For these reasons, we do not like to include alternatives such as Long/Short, Merger Arbitrage, or Managed Futures strategies in 401k lineups.”

In the end, though, there may be no cookie-cutter solution. Brian Gregov, Vice President, Retirement Plan Solutions at AEPG(r) Wealth Strategies located in Warren, New Jersey, says, “All 401k plans are not the same and a plan’s investment line-up, whether it is plain vanilla or more comprehensive, should be designed to fit the demographics, investment knowledge, and needs of the participants.”

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s every 401k plan sponsor and service provider wants and needs to know.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. His new book Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort is available at your favorite bookstore.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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