Americans love freedom and choice! So isn't it good to have many fund choices in 401(k) plans? To answer that question, we have to address diversification.
Diversification: The Employee Retirement Income Security Act (ERISA),
the Uniform Prudent Investor Act (UPIA) and the Restatement 3rd of Trusts
(Prudent Investor Rule) all agree that the key to long term investment success is broad diversification
of risk.
Therefore as a plan overseer, one of your most important duties is to increase the probability that each participant has maximum diversification in their account. If you want to know more about why diversification is so critical, please contact us.
Too many funds choices is bad because it takes away from diversification. What's "too many"? See common mistakes, next section below.
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Common Mistakes
1) Tyranny of Choice: If your plan participants invest in more than one fund in the same asset class - they unknowingly concentrate their assets, causing less diversification, more volatility which hurts their long term returns. This problem occurs most often in the large cap space. Here's a great article on this problem, "The Tyranny of Choice."
2) Bundled Plans: Often a bundled plan of funds - one fund family - will share their "best investment ideas" among the funds. So you will find the same stock in many different funds and participants' assets become concentrated in certain individual stocks. Again, this lowers diversification, increases volatility and hurts long term returns.
3) Retail mutual funds: Often retail mutual funds have the problem of style drift or not investing as their fund name would suggest. This leads to, yes, you guessed it, less diversification, higher volatility, lower returns.
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What to Do Next
Easiest Solution: You're probably not trained as an investment advisor. Use an ERISA Section 3(21) independent advisor that insists on bringing an ERISA Section 3(38) independent advisor with them. The 3(38) advisor takes over responsibility for fund selection and monitoring. They do it for you, relieve you of significant fiduciary liability and are cost competitive. They are investment experts.
If you are delaying a move to a 3(38)-based plan, then you just need to avoid the most common mistakes listed above. Break the myth, be a "choice contrarian" and help your participants get better long term returns through greater diversification and lower volatility!
Most plans ought to be able to achieve good diversification and avoid concentration with about 10-15 funds. A few of your participants may rebel a bit at first, but you can confidently move forward knowing that you are doing what's best for everyone in the plan and fulfilling your fiduciary oversight responsibility with flying colors!
We may be able to provide a free analysis of your plan, contact us for more information.
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