By David Blanchett and Dan Bruns
How would you feel if you had to build a portfolio using only four or five funds? Probably not very happy. Sure, it’s possible for an investor to build diversified, high-quality portfolios using a few building blocks, especially if those blocks are themselves diversified and high quality, but advisors tend to build well-diversified portfolios using lots of funds.
In the early days of defined-contribution plans, sponsors often provided a multitude of investment options to participants, many of whom were do-it-yourselfers. Back then, core menus of 50-plus options weren’t uncommon. Of course, this was in the days before qualified default investment alternatives, or QDIAs. The industry quickly learned that offering too many options led to “choice overload,” scaring away some workers from participating in the plan at all.
The industry came to the rescue—albeit years late—by moving to “light” core menus that reduced investment options to as few as four or five. Reducing choice overload, proponents say, benefits participants by lowering the odds of making bad timing decisions, and it reduces the number of funds that the plan sponsor, advisor, or consultant has to monitor.
We don’t buy it. Light core menus may have made sense before QDIAs, which were created after the Pension Protection Act of 2006. But today, participants who don’t want to build portfolios themselves don’t have to—and most don’t. About 75% of participants end up in a plan default, based on research we have coming out soon.
This fundamentally changes the role of the core menu for participants who opt out of the default. Our research shows that those who do— those actually using the core menu—are probably the best equipped to do so. They tend to be older, with higher incomes, higher contribution rates, and higher account balances. We’re not saying they’re the next Warren Buffett, but these investors are the type who are likely to make better investing decisions—and they are also more likely to be using a financial planner, who could be managing their 401(k) alongside their other assets, such as taxable savings and real estate investments.
Larger Menus, Smaller Overlap We think core menus should be wide, not deep—that is, menus should offer exposure to a wider array of investments but not multiple options for the same asset class (with the potential exception of an active and passive option). The idea is to offer a range of investments that will better help participants achieve their retirement goals. We think it's important to give participants access to funds with unique risk characteristics so they can supplement allocations in their other accounts (such as an IRA) as well as give a financial advisor (who is not associated with the plan) the ability to design a portfolio inside the plan. These funds can also be used by in-plan advice providers, such as managed accounts, to build better portfolios.
Larger menus can also enable retirees to keep their savings in the plan during retirement. We’re not saying everyone should stay in their defined-contribution plan, but often there are advantages to staying put in a high-quality plan (such as access to low-cost advice, institutional pricing, and unique fund offerings). If advisors can’t build diversified portfolios using the core menu, however, they would presumably be more likely to recommend a rollover.
It’s worth mentioning that there’s been a trend lately among very large plan sponsors to create custom (or “white label”) portfolios. This practice allows the plan sponsor to bundle many investment options together behind the scenes. It results in a very streamlined menu (four or five portfolios) but still offers diversification—it’s just hidden to the end investor. This process takes a lot of time, energy, and expense, so it’s not something we see going mainstream, especially for your average 401(k) plan.
Quality Over Numbers Where does all this leave us? A plan sponsor's important investment decisions start with the plan default, because the default will get the lion's share of participants and plan dollars. But after that, it's important to try to understand who's using the core menu and to develop it with those participants in mind.
At Morningstar Investment Management, we generally offer plan sponsors 10 to 20 investment options in a core menu, with an average of about 15. This is fewer than you might see in some plans, but a lot more than recommended by some plan sponsors, advisors, and consultants.
The key to a great core menu is not the number of options; it’s the quality. Offering unique market exposures can be better than having, say, multiple equity funds with active U.S. large-cap mandates. Again, consider going wide, not deep.
This information is provided for informational purposes only. Morningstar Investment Management LLC is a registered investment adviser, subsidiary of Morningstar, Inc., and shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. Opinions expressed are as of the current date and are subject to change without notice.
This article originally appeared in the Summer 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.