More than 60% of 401(k) plans offer too little diversity in investment choices

PERSONAL FINANCE

April 24, 2005|By Eileen Ambrose

MORE THAN 60 percent of 401(k) participants don't invest outside their plans, which makes it all the more critical that plans have good investment choices.

A recently released survey finds that the majority don't.

A review of 680 plans by three finance professors at New York and Fordham universities concluded that 62 percent of plans don't offer adequate diversification. That can make a big difference for workers over 20 years, whose accounts could grow to only one-third the size of nest eggs invested in a broad range of asset classes, the professors found.

"They are right on target," said Rick Meigs, president of the 401(k)helpcenter.com in Oregon, a provider of plan information. "The vast majority of 401(k) plans don't do a proper job of ensuring there are a wide variety of investment choices. Ideally, they would ensure that there is at least one option in all the major asset classes."

Not everyone agrees with the professors' findings, which was based on data collected through 2001. The ProfitSharing/401(k) Council of America, which represents employers, said plans have been improving. In its study of about 1,100 plans in 2003, the council found that plans offered an average of 16 choices.

But the debate raises important questions. What is a well-diversified plan? Can you have too many choices? And what can workers do if their plan comes up short?

Diversification is important because it prevents an entire account from tanking if the bottom falls out in one or two sectors. Remember what happened several years ago when the hot technology sector suddenly turned cold.

"The whole idea is to maximize return but minimize risk," said Christopher R. Blake, a Fordham University finance professor and one of the study's authors.

Investing in lots of funds in a 401(k) doesn't guarantee diversification, though.

Some plans might offer three large-cap growth funds. "They all move the same way," said Michael Scarborough, president of the Scarborough Group in Annapolis, which manages individuals' 401(k) accounts. "Those funds are substantially the same fund. Different name, but no diversification."

For a plan to be properly diversified, it should include domestic and international stock and bond funds, many experts agree. The plan should also have stock funds focused on small companies and on large corporations.

Investors should have a choice of investment style: value, which looks for underpriced gems overlooked by Wall Street, and growth, which seeks out companies whose earnings are growing faster than average.

There should be short-, intermediate- and long-term bond funds, and some suggest a high-yield, or junk, bond fund. A money market fund or some cashlike investment should also be included, experts said.

Real estate investment trusts, which own and manage properties, are rarely an option in 401(k)s, but they should be because they tend to move in the opposite direction from bonds, Scarborough said.

Workers should also have the option of low-cost index funds, Meigs said. These funds basically try to mimic the performance of a certain benchmark, such as the S&P 500 index.

How many funds should a plan have?

Experts disagree on the ideal number. Some say 10 or 12 options are sufficient; others suggest as many as 25 or 30 funds.

But having too many choices can paralyze investors, who sometimes don't know what to select so they don't do anything, experts said.

"There are a lot of participants who simply throw up their hands in confusion when confronted with 10 or 12 options," Meigs said.

A survey of about 200 companies last year found that nearly one-third expected to simplify their plans, such as reducing the number of funds, said Lori Lucas, director of participant research for Hewitt Associates, a benefits consultant.

One solution is to offer a "no-brainer" option, such as a lifestyle fund, Meigs said. Workers can put their money in a fund based on how many years they are from retirement or how much risk they want to take. The fund's manager does the rest of the work, often gradually shifting toward more conservative investments as the worker approaches retirement.

Typically, companies assign an individual or a committee to select investments in the 401(k). Some employers also hire outside advisers to assist in fund selection. If you're unhappy with your plan's choices, here are some suggestions:

Lobby your employer. "If you don't like the options you have, for gosh sake, say something," Scarborough said. Companies will listen, plan experts say, because they want their 401(k) to be used by employees and to be more attractive than plans competitors offer.

Understand, though, that the employer is more likely to add an option that has broad appeal with your co-workers. So, a demand that your company add a fund that invests solely in, say, Albania, might not fly.

If the employer likes your suggestion, be patient, because it can take a year to add an option, Meigs said.

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