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Streamlining 401(k) Plans to Improve Diversification

When it comes to defined contribution retirement offerings, a simpler array of choices may be the best option.

It appears that expansive 401(k) investment menus evolved ostensibly to benefit investors. As defined contribution plans became more common and mutual fund offerings broadened to meet the growing DC marketplace, the mantra for plan sponsors might have been “More is better.” Over time, however, it has become clear that extensive fund lineups can create problems for DC plan participants. For one, there’s the “paradox of choice” — the anxiety created by multiple options that paralyzes consumers and can lead 401(k) investors to opt out. Or a confused investor could simply decide to sample everything on the menu, as nearly 75 percent of 401(k) participants in a recent MFS Investment Management survey indicated they would do.

Those may be extreme scenarios. But we at Northern Trust Asset Management believe expansive fund lineups contribute to a more common — yet still harmful — issue for U.S. retirement investors: home-country bias. In 2013 DC plan participants allocated 82 percent of their entire equity allocation to U.S. stocks, according to data from the Northern Trust Defined Contribution Tracker. That’s a full 33 percentage points over the market weight of U.S. equities based on global stock market capitalizations. (The trend continued in 2014.) This overweight in U.S. equities is a less than ideal investment mix, considering that over the long term, the U.S. market has outperformed the global market (excluding U.S. equities) only about half the time. And U.S. stocks have performed in the top half of global equity markets in just four of the past 11 years.

What’s behind this home-country bias? Part of the issue is behavioral: Participants tend to invest in what they know. But DC investors are also heavily influenced by fund lineups, which often skew toward U.S. issues. In fact, the Plan Sponsor Council of America found that a typical DC plan offers nearly three times more U.S. equity funds than international ones. By offering a more balanced menu of U.S. and international equity options, along with target-date funds, plan sponsors can help participants invest across the global equity opportunity set, which would position their portfolios for greater potential long-term gains.

For more than five years, Northern Trust has surveyed plan sponsors, participants and consultants on how to help DC plans fulfill their emerging role as the default retirement savings and investment vehicle for U.S. workers. One of the recurring ideas is to streamline the investment menu to offer fewer choices but with broader diversification. For example, instead of a U.S. equity and non-U.S. equity fund, consider a global equity fund. Not only will that help those with a home-country bias, but it also provides a simpler way to access the essential building blocks of a diversified portfolio. Taking this streamlining a step farther, we believe plan sponsors could offer a core menu of funds based on objectives such as growth, income, inflation and capital preservation. Each of the options would be broadly and globally diversified. As part of such a simplification process, sponsors could offer target-date funds to their participants as a way to more easily diversify their holdings and reduce risk. One study showed that adding target-date funds, which automatically adjust risk allocations as participants approach retirement, resulted in less equity concentration and less exposure to systematic risks than their nonstreamlined counterparts.

This white-label approach is a big change from the lineups of name-brand funds with which 401(k) investors may be familiar. Plan sponsors may encounter some resistance to streamlining the number of benefit offerings in which participants can invest their hard-earned dollars. But our research shows that most participants are open to the idea. In fact, our latest Path Forward survey of plan participants suggests that the majority of them would likely accept such a menu simplification and that only 3 in 10 would oppose it.

DC plans are continually evolving. We think that plan sponsors should strongly consider whether they can help improve their participants’ investment choices by streamlining their menus. Simplifying investment decision making while reducing home-country bias can go a long way toward helping participants achieve better retirement outcomes.

Susan Czochara is a managing director of defined contribution solutions at Northern Trust in Chicago.

See Northern Trust Asset Management’s disclaimer.

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