DC Plans Need More Diversification Options

January 24, 2013 (PLANSPONSOR.com) – Active investors may find themselves frustrated by the small number of diversification opportunities in their employer-sponsored retirement plans.

“Diversify-it-yourself” (DIY) investors—those who take an active role in choosing the allocations in their defined contribution (DC) plans—need more diversification tools from their companies’ plans, Patrick Lulley, vice president of Defined Contribution Investment Only (DCIO) and Insurance at Van Eck Global, told PLANSPONSOR. “I think plan sponsors generally find themselves catering to the passive, or reluctant investor first,” Lulley said, but active investors also must be taken into consideration.

If the plan sponsor offers individual fund choices, the lineup should also include some funds that are less correlated to stocks and bonds, he added.

Diversification tools are particularly important after the financial crisis. “We’ve already been through one sea change over the past several decades in the retirement space, as the majority of plans have moved from defined benefit to defined contribution,” explained Lulley. “Another trend I believe to be of similar magnitude is the fact that traditional asset classes have become highly correlated since 2008, making diversification opportunities in DC plans more difficult and, in my opinion, more important.”

Lulley suggests plan sponsors and advisers first help participants establish whether they are passive or active investors. Once participants understand this, he said, sponsors and advisers can better serve them.

He recommends that passive investors have a pre-diversified portfolio, and active investors have a sufficient choice of diversifying tools. Three asset classes in particular may be of interest to help investors diversify their portfolios—real estate, emerging markets and commodities.

When offering these choices, the plan sponsor must balance offering sufficient diversification tools with providing a list that’s short enough to avoid confusing participants. While there is always a risk that participants will make bad investment decisions, not including these asset classes also puts those who want to diversify at risk, Lulley said.

Participant disclosure regulation makes it even more important for plan sponsors to offer diversifying tools for participants. Under the regulation, the fiduciary is required to “have an appreciation for what others are doing,” Lulley explained, which involves benchmarking services, costs and also examining investment lineups.  

“At first glance, a DC plan with only traditional broad-based domestic stock and bond funds and target-date funds may seem complete,” Lulley said. “However, when compared on an online plan rating service to a DC plan that includes those asset classes as well as alternative asset classes—such as commodities or real assets and emerging markets—the aforementioned plan appears to only support the inactive investor. Under the new regulations, DC plans need to support the entire investor spectrum, and diversification has become just as important as appropriate options.”
Lulley also noted that while the need exists to support DIYers, plans must continue supporting participants who are likely to take a more passive approach. “Target-date and target-risk options remain an integral part of a plan’s investment menu, and these products have begun to evolve to allow advisers and investors to get a better sense of their respective glide paths," he said.