Pursuing better returns for participants through diversification

A diversified investment lineup is essential to a DC (defined contribution) plan. The next step is helping participants select and maintain a diversified portfolio. Herein lies the challenge.

The basics of diversification are fairly simple. For DC plan sponsors, creating a diverse menu of investment choices is just the first step. Next DC plan sponsors must motivate their participants to select and maintain a diversified portfolio appropriate for their timeline and risk tolerance. This sequence may become even more difficult amid market volatility.

Here are nine ways to improve your plan’s diversification:

1. Offer a diversified lineup

Primary asset classes vs. alternative investments

The traditional elements of diversification involve the primary asset classes: stock, bonds and cash. Alternative investments, such as real estate or commodities, can enhance diversification because they generally present with low correlations to the primary asset types. Before exploring these alternatives, consider the various sub-asset classes of stocks and bonds; some of them have distinct characteristics that aid in diversification.

Choosing stocks that vary in capitalization and domicile

To complement a core US large cap fund, add small cap, mid cap and international stock funds. Although their overall performance is similar, stocks of different capitalizations and domicile tend to rise and fall at different times. The performance of developed market and emerging market stocks also varies relative to one another. This low correlation is the core of diversification.

Growth and value styles diverge

Another key dynamic to be cognizant of is the results of growth and value styles diverge. Over periods of time, the performance of growth and value-style investing can vary widely. For example, although all stocks have taken a hit over the past year or so, value stocks have fared much better than growth stocks. However, over the previous five years or so growth outperformed. By offering exposure to both value and growth stocks, plan participants can help reduce the impact of market volatility.

Include a variety of bond funds

Likewise, not all bond funds respond in the same way to market conditions. The degree of exposure to credit risk and interest rate risk will determine how a bond fund responds to market forces such as deteriorating credit conditions or rising or falling interest rates. A high-yield bond fund and an emerging markets bond fund can complement funds that focus on US investment grade bonds or government bonds, leading to greater diversification within fixed income.

Cautiously consider alternative assets

Alternative assets, such as real estate, commodities, infrastructure, hedge funds and private equity, may be appropriate to include in some DC plans depending on the sophistication level of its participants. While alternative assets tend to have lower correlation to mainstream investments, allowing for effective diversifications, they can also be more volatile and difficult to understand and use. If alternative assets are included as a choice, plan participants should be made aware that these choices should comprise a small portion of their diversified portfolio.

Cash: shelter from the storm but at what cost?

Cash is an important diversifier. Although it has substantially underperformed other assets over long time periods, it can provide a buffer against heavy market volatility. However, plan sponsors should discourage younger participants from allocating heavily to low-yielding assets such as money market funds. Imagine the long-term loss of spending power participants might experience if they were heavily allocated to an asset yielding 1% when the rate of inflation was 8%.

2. Caution: don’t overwhelm participants

A tricky aspect of creating a diversified lineup is to know when to stop. Obviously participants need variety and choices, but too many choices can be overwhelming and even drive participants to take the easy way out and do nothing.

What is the ideal number of investment choices for a DC plan to provide to its participants? There is general consensus that roughly 12 to 20 fund choices can provide enough variety to enable diversification among a good number of somewhat divergent assets without becoming unwieldy.

The Schroders 2022 US Retirement Survey found that 76% of respondents who don’t have a written retirement plan find the idea of planning one daunting. For plan sponsors, the message is clear: whenever possible, keep it simple.

3. Include active as well as passive fund options

Active and passive investing approaches have each had periods when they have outperformed one another. Although there’s an ongoing debate as to which is better – active or passive investing – it needn’t be an either/or choice for your participants. By including both actively managed and index funds in a plan lineup, you permit participants to make their own choices. For greatest diversification, they can lower their overall risk exposure further by owning both passive and active funds.

4. Develop and share realistic expectations

While long-term results consistently show the benefits of broad diversification and asset allocation to risk-adjusted returns, anything can happen over shorter periods of time. When market volatility is extreme, investor sentiment can lead almost all assets to perform similarly. Rather than give up on efforts to achieve diversification based on this reality, educate participants on the limits of diversification over the short term and the benefits of diversification over the long term.

5. Discourage market timing

Help participants hold on to their diversified portfolio, particularly when volatility spikes. Make efforts to calm nervous plan participants. Encourage them to adopt a long-term perspective through market storms – it will help them maintain their critical diversification in any market environment.

It may be tempting for individuals to try to time the market, but history has consistently demonstrated that it is next to impossible to do so successfully. By the time that a market crash has occurred, investments have already lost value. By the time the market has recovered, and investors have noticed, they have lost the best buying opportunity. As a result, attempts to time the market typically lead to selling low and buying high. This is particularly true for investors who trade frequently. Generally, the more an investor trades, the worse they perform.

6. Educate, educate, educate

Putting in place a plan that includes diversified options is only as valuable as your participants’ ability to capitalize on the plan’s choices. The key is to help prevent plan participants from preventable losses arising from classic mistakes, such as inertia, being overly conservative, being overly concentrated, obsessing about account balances, paying too much attention to short-term market swings and paying too little attention to simply choosing and maintaining a diversified portfolio that is appropriate for their timeline and risk tolerance.

Best practices in educating DC plan participants

• Keep the language easy for anyone to understand. Use simple, clear, concise and direct language and avoid jargon.
• Use a variety of media. As we learned during the early stages of the Covid-19 pandemic, virtual learning can be effective and even preferable in many cases because it can be more convenient for participants. One-on-one in-person sessions can be highly effective too, along with a variety of communication methods, including mail, email, text messaging, and online blogs.
• Tailor the media usage to participant demographics. Younger participants generally respond more to virtual meetings, text messages, podcasts and online blogs. In contrast, older participants tend to prefer one-on-one in-person sessions as well as mail and email, according to PlanSponsor.¹
• Have an ongoing education program. Rather than wait until market volatility causes a spike in anxiety, keep the lines of communication open and use every opportunity to build on messages that encourage thoughtful, consistent actions such as increasing contribution rates, staying the course and building long-term financial security.

7. Use an effective Qualified Default Investment Alternative

A thorough program of participant education and ongoing communication is important but even more effective is establishing a good default investment. The US Department of Labor established Qualified Default Investment Alternatives (QDIA) in the landmark Pension Protection Act of 2006, and they are highly effective in getting participants into an appropriate (typically age-appropriate) and effective mix of diversified funds.

The QDIA can be a target-date fund (TDF) (either off the shelf or customized), a balanced fund that unlike a TDF does not taper exposure to risk over time or a professionally managed account. A recent trend is a hybrid setup in which participants begin in a TDF and migrate to a managed account once they get closer to retirement.

8. Provide access to professional guidance

Professionally managed accounts are a relatively new and growing development in DC plans. The potential value is significant in that they can provide individualized guidance that can be particularly important as one approaches retirement. And the need for guidance is great. The Schroders 2022 US Retirement Survey found that only 22% of 60-67-year-olds who are still working feel they have enough money saved to retire.

Of course, not every 60-something is in the same situation or has the same level of sophistication or risk tolerance. One person might seek to retire in a year or two while another plans to continue working for a decade or longer. A crucial one-on-one session with an advisor can address an individual’s specific questions and concerns.

9. Take advantage of an experienced partner

The process of creating and maintaining a diversified mix of investments can be challenging and complex. Working with an experienced investment partner can alleviate the burden.

In summary, effective DC plan diversification begins with selecting a broad array of divergent investment options but also involves ongoing efforts to guide participants throughout their careers and beyond so that they increase their prospects of financial security.

Schroders has decades of successful global diversified market experience that includes deep familiarity with both domestic and international equity funds as well as alternatives and multi-asset investments.

Schroders is well versed in multi-asset and alternative global strategies, from country-specific or ESG-focused to stylistic tilts within equities and the full range of fixed income offerings.

¹ https://www.plansponsor.com/plan-sponsors-eliminate-jargon-communications/