FiduciaryNews

Hosting an industry conference? Ask us about including it in this ticker?
What do you think of our site upgrade?

This Is How We Rescued Retirement Savings From The 401k Frankenstein Created By An Infatuation With The ‘Style Box’

This Is How We Rescued Retirement Savings From The 401k Frankenstein Created By An Infatuation With The ‘Style Box’
May 19
00:03 2020

In the beginning, 401k plans were nothing more than profit sharing plans with three separate and unique options, generally speaking, “stocks,” “bonds,” and “cash.” Some enterprising portfolio managers created mixed asset portfolios with different risk characteristics.

Less like static balanced portfolios, these were dynamic “lifestyle” portfolios that contained an ever-changing mix of asset classes depending on the risk/return opportunities revealed by the portfolio manager’s proprietary research.

These portfolios were just that – individual plan portfolios. Individual plan portfolios presented no problem for registered investment advisers. That’s how that had been serving clients for decades. On the other hand, without the technology to accommodate unitized pricing, recordkeepers found participant accounting with individually managed plan portfolios quite burdensome.

Mutual funds, with their daily pricing, offered a way out. What started as a trickle towards the end of the 1980s became a torrent in the early 1990s. Plan sponsors, sold on the idea of greater transparency and easier employee access to their investments, moved management from individual plan portfolios to the ultimate pooled investment vehicle – the mutual fund.

In 1992, Morningstar introduced their “Style Box” format. This simple nine-box square offered an easily digestible way for investors to understand the differentiating characteristics of the mutual funds they held. “Graphics such as style boxes help people to understand the complex parts of finance and investing,” says Andrew Roderick, CEO of Credit Repair Companies in Kirkland, Washington.

Prior to Morningstar’s innovative invention, the complexities of Modern Portfolio Theory (MPT) and the drive toward asset allocation it spearheaded were left only to sophisticated investor. The typical 401k investor could understand stocks, bonds, and cash. MPT, however, drilled down into the heart of these broader asset classes. Researchers and investment professionals appreciated this. The average investor could care less.

The creators of MPT and its attendant offshoots would be awarded the Nobel Prize for their efforts in 1990. That was hot news that everyone understood. No one understood the sizzle of the Prize more than marketers. Morningstar came to their rescue.

“Morningstar’s style boxes were at the heart of why MPT was so appealing,” says Jeff Ransdell, managing director, Fuel Venture Capital in Miami, Florida. “They were extremely helpful in helping someone construct a portfolio because they created an easy-to-understand roadmap for allocation. Large-cap growth stocks, small-cap growth value investing, emerging markets … you ticked off those boxes and you were pretty much good to go, was the thinking.”

With the compelling narrative of the Nobel Prize-winning theory and the attractive display of Morningstar’s new classification system, it became almost impossible for plan sponsors to say “no.”

“MPT and the style box format had an enormous influence on the structuring of 401k plans,” says Michael Sury, Lecturer in Finance and Managing Director of the Center for Analytics at the University of Texas at Austin in Austin, Texas. “First, MPT argued that investors should be properly diversified across asset classes and securities. Second, the style boxes essentially categorized fund managers into these boxes. The combined effect was that 401k plans developed programs that fostered both broad diversification and the relative weighting of asset classes and managers based upon their style labels.”

And, almost overnight, the 401k industry changed. Gone were the handful of mixed asset individually managed portfolios. In came asset class specific mutual funds but the tens and hundreds.

“Entities offering 401k plans are required to offer a minimum of 3 different types of investments that have 3 different types of risk and exposure (e.g., cash fund, bond fund, and stock fund),” says Nolan Schexnayder, owner and senior advisor of Schexnayder Wealth Advisors in southeast Louisiana. “MPT, and the ‘style box’ format in particular, influenced 401k plans by offering providers more levels of diversification, thereby limiting their liability exposure.”

 

“…A VITAL REFERENCE TOOL

FOR YEARS TO COME.”

401(K) FIDUCIARY SOLUTIONS ADDRESSES THE FIVE KEY AREAS OF FIDUCIARY LIABILITY FACING 401K PLAN SPONSORS ON A DAILY BASIS.  IN ADDITION, 401(K) FIDUCIARY SOLUTIONS FEATURES SEVERAL CHECKLISTS 401K PLAN SPONSORS CAN USE TO HELP ENSURE THEIR PLAN IS THE BEST IT CAN BE.

WOULD YOU LIKE TO DISCOVER THE COLLECTED WISDOM OF DOZENS OF INDUSTRY EXPERTS AND THOUGHT LEADERS? CLICK HERE AND BUY YOUR COPY OF 401(K) FIDUCIARY SOLUTIONS TODAY!

 

“In 401k plans you started to ‘have to have’ certain assets that fit a style box,” says Dan Cupkovic, Director of Investments at ARGI Financial Group in Louisville, Kentucky. “Whether that be Large Caps, Small Caps, or EAFE it began to be more a more necessary to have most if not all of the global asset classes for retirement plans.”

The proliferation of investment options promised participants a plug-and-play plan. In the process, it created a 401k Frankenstein monster of a mess. It would take researchers a decade or more to fully define the detrimental impact of the choice paradox. In the interim, plan sponsors just kept piling on. They thought it was the prudent thing to do.

“With the wide adoption of MPT,” says Debashis Chowdhury, President of Canterbury Consulting Inc. in Newport Beach, California, “it is fair to say that most advisors of DC plan assets as well as the underlying investors themselves believed that it was important to fill all boxes to large extent so as not be overly concentrated in any specific asset class or style.”

Not only did the infatuation with style boxes lead to plan designs which arguably hurt investors, it has ended up encouraging a form of behavior among portfolio managers that can harm investment performance.

“An unintended side effect of the style boxes was to create ‘closet-indexers’ as many managers tried to maximize their information ratio (defined as alpha divided by tracking error),” says Sury. As a result, some fund managers would sacrifice alpha in order to reduce tracking error, thereby essentially hugging their benchmark.”

Today, there’s less concern with offering plan participant do-it-yourself asset allocation portfolio building blocks and more emphasis on ready-made professionally managed funds. Some of these come in the form of custom portfolios managed at the participant level, but more often they remain at the fund level.

“It took years for 401k plans to offer managed portfolios,” says Guy Baker, Ph.D, founder of Wealth Teams Alliance in Irvine, California. “But even so, most plans do not provide this opportunity. They leave the management to the participant unless they are in a Target Date Fund, which may be built using the style boxes.”

After all these years, 401k plans have returned to the original concept of mixed asset lifestyle portfolios.

Frankenstein has been unplugged.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary Solutions Hey! What’s My Number? How to Improve the Odds You Will Retire in ComfortFrom Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

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.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

0 Comments

No Comments Yet!

There are no comments at the moment, do you want to add one?

Write a comment

Only registered users can comment. Login

FiduciaryNews.com is sponsored by…

Vote in our Poll

Disclaimer

The materials at this web site are maintained for the sole purpose of providing general information about fiduciary law, tax accounting and investments and do not under any circumstances constitute legal, accounting or investment advice. You should not act or refrain from acting based on these materials without first obtaining the advice of an appropriate professional. Please carefully read the terms and conditions for using this site. This website contains links to third-party websites. We are not responsible for, and make no representations or endorsements with respect to, third-party websites, or with respect to any information, products or services that may be provided by or through such websites.