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Grouping investment funds into logical categories can simplify participants’ choices
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" classificationpopularized by fund analysts at Morningstar Inc.:
✓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.
✓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.)
✓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:
“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."
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
SHRM Online Benefits Discipline
SHRM Online Retirement Plans Resource Page
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