With a Number of Choices in Most Defined Contribution Plans, What’s the Right Allocation Mix to Maximize Returns?

By Allison Landa

The company pension your father worked his entire career to earn is quickly becoming a relic of a time gone by. Shifts in American corporate culture as well as the dynamics of the modern workplace mean that workers have the opportunity and responsibility to be the architects of their own retirement savings.

Many investors are choosing to participate in their employers' defined contribution plans, which allow workers to set aside tax-deferred income for retirement purposes, and in some cases, enable employers to provide dollar-for-dollar matches to employee contributions. An estimated 40 million Americans currently invest in 401(k) plans, while other defined contribution programs include 403(b) plans, 457 plans, employee stock ownership plans and profit-sharing plans.

This format of retirement planning acts as a platform for long-term disciplined saving, according to David Wray, president of the Profit Sharing/401(k) Council of America (PSCA).

"Defined contribution plans provide the benefit of dollar-cost averaging and long-term compounding," he says. "It enhances the value of diversification because you don't need many investment bets to do well. The plan has several choices so that you can customize your diversification and control your risk exposure."

The types of choices will vary with each plan, but investors typically choose among large, medium and small-cap funds, international funds, bond funds and some element of cash investment.

Defined benefit plans are structured quite differently. Employers, and sometimes employees, contribute funds to the plan over the employees' working lifetime. At retirement, the employee receives an annuity benefit based most often on length of service and final compensation. Importantly, employees are not called upon to make any investment decisions. According to Wray, most people with a defined benefit plan also participate in a defined contribution plan, which accounts for the weight of their investment strategy. "If I'm one of those fortunate people who have both, what I need to do is recognize that my defined benefit is a fixed investment," he says. "If it's going to provide half of my retirement benefit, then I want to be pretty aggressive in my defined contribution plan."

The Great Debate: Actively Managed Funds Versus Index Funds By Jennifer D. Duell When it comes to retirement savings, weighing the options can be overwhelming when choosing between index funds and actively managed funds. The benefits and drawbacks of these two types of funds are hotly debated within the investment community. Actively managed funds, which invest in equity or fixed-income securities based on the recommendations of a single advisor or team of advisors, have grown over the years as more companies offer mutual funds as part of their 401(k) plans. Index funds are investment funds that invest in equity or fixed-income securities to replicate indexes like the Standard & Poor's 500 or the Lehman Brothers U.S. Aggregate. These funds require no research securities selection and the securities in these funds only change when the constituents of the index change. History of Performance Many investors prefer index funds because they're viewed as more diversified, easy to understand and fairly inexpensive with respect to fees. "There's no question about it—index funds are far superior to managed funds," says Neal Frankle, president of Wealth Resources Group and author of "Why Smart People Lose a Fortune." In particular, he advocates investing in exchange traded funds (ETFs), which are index funds that are traded on stock exchanges. Moreover, many investment experts contend that index funds outperform managed funds. "If you look at it from a historical standpoint, managed funds do not offer as high a return as index funds," says Dennis P. Barba, Jr., managing partner of The Oxford Group of Raymond James & Associates, a private wealth management practice, and professor at the Weatherhead School of Management at Case Western Reserve University in Cleveland. "For example, from 1984 to 2002, the average equity investor achieved a return of 5.32 percent, while the S&P returned 16.2 percent," he says. Since very few managed funds outperform any index or benchmark, Barba recommends investing in several indexes. "I believe that an investor could pick four or five index funds that would give ample performance and not only will they be less expensive, but it will provide better after-tax performance and lower volatility," he says. While many mutual funds impose mandatory holding periods, an investor can buy or sell ETFs at any time. The cost of holding index funds is typically less than 1 percent compared to managed funds, which often charge 2 percent to 3 percent. However, some experts contend that the low cost doesn't overcome the inherent drawbacks to index funds. Jeff Coons, co-director of research at Manning & Napier Advisors, a money management firm, says, "Index funds tend to be very low cost, but the problem is that they're invested very broadly." "When you buy an index fund, you are accepting mediocrity," contends Adam Bold, CEO of The Mutual Fund Store, a fee-based investment advisory firm that manages more than $2 billion. "If you're going to take the risk of the market, you owe it to yourself to be in the best possible fund, and those funds are managed." Bankable Talent A drawback to managed funds is the 2 percent to 3 percent annual fee. That expense doesn't include transaction costs, so any buying or selling of securities will add to expenses of the fund. That's why a managed fund with a high turnover rate is more expensive than one that holds securities for longer periods. "The more the managers handle the money, the more likely you are to lose it through fees," says Boyce Watkins, professor of finance at Syracuse University. Yet, proponents of managed funds shrug off criticisms related to high fees. "It doesn't matter how much you pay to invest in a managed fund," Bold says. "What matters is how much the fund pays you. Managed fund fees are only high if they're not a value." Jennifer D. Duell is a freelance writer based in Fort Worth, Texas.

Age Does Matter

When planning their retirement portfolios, experts say investors should take their age into consideration. Young investors are best advised to be aggressive because it is still early in their career. However, those nearing retirement are better served by reducing their risk tolerance.

"If you have 30 or 40 years to save for retirement, you want a good, diversified portfolio heavy on equities," Wray says. "Someone who is 23 years old should have 90 percent of their money in a mix of equity funds. However, people who are approaching retirement should be more secure with their investment. They should have 50 percent of their money in stable value funds, which is a fixed-income type of investment, and 50 percent in a mix of equity funds."

Barclays Global Investors managing director Jim Keagy prescribes real estate for investors—particularly younger ones—seeking well-diversified options. He believes it offers appreciation potential, attractive current returns, an important hedge against inflation and low correlation with other asset classes, particularly other stocks and bonds. He pegs REITs, and indexed REIT portfolios in particular, as ideal for defined contribution plans.

Keagy also advises those with defined benefit plans, particularly smaller to mid-sized plans, to invest in REITs.

"An indexed REIT portfolio provides instant diversification to all property types and all major markets in the country," he says. "That kind of diversification is impossible for an individual investor to achieve anywhere else. There are no convenient ways for 401(k) plans to invest in direct properties. Indexed REIT portfolios provide an instant basket of high-quality properties."

How Many Options?

With so many options afoot, what is the right number from which to choose, and how many choices are just too much?

"The number of options offered depends on the company," Wray says. "There's no magic number, but I think somewhere between 10 and 20 is the right number of choices."

Employers have to look at their own employees, he says. "For some people, 10 choices are all they can handle. However, if your workforce likes choices, you would need more than that."

The law stipulates that plans offer a minimum of three choices, according to Olivia Mitchell, a professor of insurance and risk management at the Wharton School, University of Pennsylvania. When it comes to the ideal number of options available, Keagy says that 12 options seems an ideal number. In general, he believes a smaller number of well-diversified options are better than a larger number of options that may be more correlated with each other.

"Simply adding another option on the menu generally doesn't attract much attention among 401(k) participants because they can easily be overwhelmed," he says. "So we would argue for fewer options rather than more options. Each of those options should be high quality, and each of those options should provide exposure to major, well-recognized benchmarks."

Some companies are trying to simplify employees' investment decisions by presenting a tiered offering of option plans, according to Wray. "If you don't want to make a decision, they'll put you into a lifecycle fund. However, if you're comfortable making a relatively simple allocation, the company lets you choose amongst four choices," he says. "For people who want more diversification, you have maybe 12 choices, and for people who want a really highly structured customized approach, maybe you have 36 funds to choose from."

Wray says these companies are letting employees pick the amount of customization that they want to have in their portfolio.

However, Keagy says he believes the number of menu options is not as important as the help and advice available to participants—something that he says is a joint effort between the plan sponsor and the investment managers.

"If they're working together, those groups need to ensure that the participants understand all the options and how they work together," he says, adding that the top plans offer third-party advice to help participants understand important subjects such as asset allocation and portfolio diversification. "They can pick up the phone or go online and discuss their personal financial situation and the choices available to them," he says.

Manageable Solutions

According to Keagy, a defined contribution retirement plan means that the investor is serving as chief investment officer of his or her future retirement.

"It's a huge responsibility, but that's the way the program is designed," he says. "The risk, both the upside and downside, is transferred to the employee, not the employer."

Keagy points to lifecycle funds as an ideal way to handle this responsibility. Lifecycle funds represent professionally managed, diversified portfolios of stocks, bonds and international stocks that become more conservative as an employee approaches retirement. These portfolios address the asset allocation problem for investors, which Keagy says is arguably the most difficult aspect of investment management, and help put investors on the efficient frontier for optimal risk-adjusted returns.

According to Keagy, good lifecycle plans tend to have a REIT or real estate allocation. "Lifecycle funds are like miniature defined benefit plans in one simple option, which is what 401(k) participants need," he says, adding that real estate is an essential asset class for individuals, just as it has been for defined benefit plans for decades.

Wray encourages investors to educate themselves and then start a retirement plan of their own. "What I've tried to tell people is, this works," he says. "If you participate in this, you are positioning yourself to have a successful retirement."

Whether you're starting with a small, mid-sized or large investment, Wray says, retirement plans help accumulate wealth in a reliable way. "A relatively small investment can build very significant assets over time," he says. "Don't let the mountain overwhelm you. It is actually climbable."