In a commentary, Building Blocks of a Well-Balanced Portfolio, investment management firm Vanguard recommends that 401(k) and other defined contribution plans be structured around easy-to-understand tiers of investments, including a tier of low-cost index funds that span all major asset classes.
"Since research has shown that participants can be easily overwhelmed by excessive choice, tiering—the grouping of investment options into logical sets—can help simplify participant decision-making," according to Vanguard's commentary.
Here's an example, drawing on both the Vanguard report and the well-known "style box" classification popularized by fund analysts at Morningstar Inc.:
• Tier 1: Automatic asset allocation investment options, such as a series of target-date funds, for participants who lack the experience, time or inclination to construct portfolios on their own.
• Tier 2: For those seeking to build a balanced portfolio consisting exclusively of low-cost index funds, the “index core” of a plan’s investment menu could include a relatively small set of funds tracking U.S. stocks, international stocks and domestic bonds. For instance:
✓An S&P 500 (large U.S. companies) stock index fund.
✓An extended market index fund that tracks the remainder of the U.S. stock market (mid-sized and small companies).
✓An international stock index fund.
✓A total bond index fund.
(As with actively managed stock funds, below, a more comprehensive index fund strategy would be to include funds that separately track large, mid-size and small-company stocks, and that further distinguish between "value," "blend" and "growth" style funds.)
• Tier 3: Actively managed funds for participants seeking to incorporate active manager risk into their portfolios. Funds can be grouped as actively managed stock, mixed or bond funds.
✓Stock funds can be categorized as large, mid or small company (or "capitalization") funds, and then as either "value," "blend" or "growth" style funds. Below is a sample style box for stock funds:
✓Bond funds can be categorized as government or corporate holdings, and by whether they hold bonds with short, medium, or long-term maturity dates. Increasingly, plan sponsors also are adding bond funds that focus on Treasury Inflation-Protected Securities (TIPS).
Benefits of a Tiered Approach
Vanguard points to a number of benefits that a tiered menu approach offers plan sponsors and participants, including:
• Low-cost options. Offering more indexed options means reduced investment management expenses for a plan. For participants, the less they pay in investment costs, the more they keep in savings that can grow and compound over time. For sponsors, offering a full array of index options helps them as plan fiduciaries to respond to regulatory and marketplace concern over plan fees (see
the box "Indexing Keeps It Simple," below).
• Higher levels of diversification. With the broad index tier options, participants are able to construct portfolios that are highly diversified across all major asset classes.
• Simplicity and better understanding of choice. Grouping the options into logical categories or tiers should help simplify participants’ choices. Tiering also offers an explicit opportunity to educate participants on the differences between index and actively managed funds, the advantages of indexing and the importance of minimizing costs.
• Ease of fiduciary oversight. Because index funds seek to track specific benchmarks, it is easier for plan sponsors to evaluate performance and the investment manager’s performance. While index funds, like all investments, are subject to market risk, there is little risk that an index fund’s portfolio manager may fail to execute the fund’s investment strategy effectively. Actively managed funds, by contrast, must be more closely monitored given their unique exposures and risks.
• Flexibility. Plan sponsors can tailor the tiers to match the investment experience level and needs of their own participant populations. Participants benefit because they have a range of appropriate options.
“An index core at the heart of a 401(k) plan with additional tiers featuring other types of funds is a win-win for plan sponsors and their participants," said Gregory Barton, head of Vanguard’s Institutional Investor Group. "A plan designed in this fashion can meet sponsors’ fiduciary goals and participants’ needs for a user-friendly retirement savings tool. It’s another example of how the 401(k) plan is adapting to meet employer and investor expectations.”
"The key," he added, "is to keep the overall number of funds at a reasonable number to facilitate participant understanding—and enable them to build soundly balanced portfolios."
Related SHRM Articles:
Indexing Keeps It Simple
Index funds attempt to match the performance of an underlying market benchmark that tracks the performance of a designated asset class. As a result, investment advisory fees and the risk of manager underperformance relative to the benchmark are low. Portfolio turnover is minimized, so portfolio transaction costs, which are passed along to participants in the form of reduced net performance, are kept to a minimum as well.
On the 401(k) Menu—Do More Funds Help Participants Diversify?, SHRM Online Benefits, November 2010
DOL Issues Final Rule on 401(k) Fee Disclosure to Participants, SHRM Online Benefits, October 2010
Plan Sponsors Tipping into TIPS to Provide Inflation Protection, SHRM Online Benefits, January 2010
Related External Report:
Constructing a DC Plan Investment Lineup, The Vanguard Group, September 2012
Stephen Miller is an online editor/manager for SHRM.
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SHRM Online Retirement Plans Resource Page