You call that 401(k) di­ver­si­fi­ca­tion? Take a closer look

Employee Benefit News - - Contents - By Richard Stolz

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.

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