You call that 401(k) diversification? Take a closer look
Franklin Templeton’s Drew Carrington sounds off on why plan sponsor reluctance to try something new is problematic for employees.
What constitutes a truly diversified portfolio might be in the eye of the beholder. But most 401(k) plan offerings beheld by Drew Carrington, a senior vice president of Franklin Templeton Investments and head of the investment management company’s DC plans division, don’t meet the test. He believes that occasional plan sponsor reluctance to try something new, as well as an incomplete appreciation of the diversity of plan participant financial needs, could be problematic.
Employee Benefit News recently explored these topics with Carrington; edited excerpts of that conversation follow.
Employee Benefit News: Are many DC plans insufficiently diversified, in your view?
Carrington: Yes, most DC plans today continue to be under-invested outside the U.S. While there is access to non-U.S. investments in most plans on the equity side, there’s much less on the fixed income side. Both matter. And if you think about the typical DC plan today, it’s largely U.S. equity beta and U.S. fixed income duration. It’s important to have exposures to those two risk factors and return generators, but there are a lot of others.
EBN: What accounts for this lack of diversification?
Carrington: In the large plan space, you might see a target date fund series, eight to 10 equity options, two fixed income options, and a capital preservation solution. And that’s it. EBN: Isn’t there a problem with overloading participants with investment choices and causing them to freeze? Carrington: If there are 10 equity options and two fixed income options, you’re
signaling to participants that’s kind of how your own portfolio ought to be weighted, skewed too heavily toward equities. Also, you’re limiting participants’ ability, as they get closer to retirement and want to get more conservative, to have much diversification on the fixed income side. EBN: What do you think accounts for this pattern?
Carrington: When we talk about global fixed income investing, there is sort of a generalized assumption out there that DC plan participants don’t understand investing. That assumption may be appropriate for young participants who haven’t accumulated significant balances, but it is significantly less true for participants closer to retirement who may really understand investing and want less volatility in their portfolio. As you get closer to retirement and the time horizon gets shorter, the sequence of returns really matters. EBN: Many plan sponsors seem to be confident that target date funds, used as a QDIA, take care of that problem automatically, right?
Carrington: People sometimes think of 401(k) investors as monolithic, all equally suited to target date funds.
But research shows that even participants who were defaulted into a target date fund, by the time their balance gets to $100,000, about 80% of those participants have added something else to their target date fund position. So they’ve intervened, in effect, and said, “I’m going to drive.” EBN: What’s the lesson there?
Carrington: That we can’t make simple assumptions about what kind of portfolio design is best for people just based on their age. That’s why you’re seeing developments like dynamic QDIAs, where you’re in the target date fund until your balance gets to a certain point, or you get to a certain age, and you’re switched over to a managed account or solutions that are more personalized. EBN: Can you expand a bit on the added diversification potential of using non-U.S. bonds?
Carrington: There are multiple variables in play when you incorporate non-U.S. fixed income. Different countries and economic blocks often are on different economic cycles. That has implications for not only interest rates relative to the U.S., but also the direction of interest rates, the rate of change of interest rates, the shape of the yield curve in those other markets, the implications of changes in currency exchange rates, and credit spreads. All of those become additional potential diversifying variables. EBN: What other diversifiers do you think are important that might be underutilized in DC portfolios?
Carrington: Inflation protection solutions. The usual suspects would be things like Treasury inflation-protected securities, real estate related investments, commodities or commodity type companies or sectors, as well as direct investments and commodities.