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

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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: Does the legacy of John Templeton, the global investing pioneer, live on in Franklin Templeton investment philosophy today?

Drew Carrington: We’ve always been known for investing outside of our home market, whether on the equity side in traditional large cap equities or emerging markets, or on the fixed income side where we have quite a global footprint. We believe diversifying away from home market investments is really important for defined contribution plan participants and sponsors.

EBN: 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 just 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 towards equities. Also, you’re limiting participants’ ability, as they get closer to retirement and they 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: There seems to be a lot of different opinions among target date fund sponsors on glide paths …

Carrington: Yes, and the variation among them is vary wide the closer to the retirement target date. Ours is a low-risk strategy, and there are others that still carry very significant equity allocations at that stage. Our baseline assumption isn’t that we always know what’s best for participants. Maybe they know some stuff that we don’t know.

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: So how do you construct a well-diversified international bond portfolio?

Carrington: I can’t say with 100% certainty what the exactly correct allocation to non-U.S. fixed income is for a defined contribution plan participant. But what I can say with certainty is the correct answer is not zero, which is what they have available to them today.

EBN: That sounds reasonable. So why do international fixed income allocations in DC plans tend to be so small?

Carrington: There is always resistance to change. And also concerns about litigation — if I make a change and offer something that is new and different, am I more than likely to get sued?

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.

EBN: Are you seeing much interest in that area?

Carrington: Some. It’s true that we’ve gone a long time without witnessing any meaningful increase in CPI, but we don’t think this is a permanent state of affairs. Also, there’s two ways of thinking about inflation. The usual way is the erosion of purchasing power with the same amount of dollars — prices going up. The other is going through a financial crisis like we did ten years ago and having your portfolio decline by 40 or 50%. Now you have fewer dollars to buy stuff. Whether that stuff got more expensive or not, you have fewer dollars.

EBN: What other concerns do you have about the way typical 401(k) plans and retirement savings efforts in general are being run?

Carrington: One of the biggest challenges we face as an industry is helping people make the transition from accumulation to the drawdown phase. And that retirement readiness question is often not only a function of the money that’s in that 401(k) plan, but is a broader household related question. Retirement is a “we” question, not an “I” question. Households think about retirement at the household level.

EBN: How can plan sponsors act on that?

Carrington: We talk about a concept called “retirement tier” offerings. The do-it-for-me participant is tier one, and the do-it-with-me is tier two. And we think about a retirement tier, and the tools and coaching that we can offer people, like a social security optimizer to help people put the pieces of the puzzle together, as well as investment choices that are targeted to people approaching retirement. Plan sponsors need to be proactive, reach out to those people and offer them the kinds of things that are relevant for their life circumstance.

EBN: That requires knowing a bit about those circumstances.

Carrington: Yes. But I think that’s happening, as sponsors recognize that there’s more than just age that determines people’s retirement planning needs. And other information is available to employers within their HR systems that they can pull up to help with that, like their job tenure, whether they’re married, how long they’ve been saving, whether they have increased their savings level. Those factors can be used in deciding the way we deliver investment solutions to participants, as opposed to just age.

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401(k) Retirement planning Retirement income Retirement benefits Retirement readiness