Plan design can only go so far in helping participants invest 401(k) funds wisely, but companies have an obligation to assist employees in preparing financially for retirement. Plan sponsors need to offer sufficient investment choices to enable participants to make sound asset allocation decisions. But how many investment choices are enough and how many more just lead to confusion?

Are your company's 401(k) plan participants making the kinds of asset allocation decisions that will yield adequate retirement funds?

If a recent study is any indication, the answer to this trillion dollar question is no. In fact, less than a third of companies included in a study conducted by pension consultants Rogers, Casey & Associates Inc. and the Institute for Management and Administration predicted that their employees would have adequate funds for retirement. As a result, investment education in general and improving asset allocation continue to head the agendas of most companies sponsoring 401(k) plans. Overall, 42 percent were working to improve asset allocation and 37 percent view improving asset allocation as one of the most important issues facing companies over the next five to 10 years.

Companies need to avoid simply offering more investment options in response to an asset allocation problem.

The challenge for companies, of course, is to provide appropriate asset allocation education to employee populations that may include 25-year-olds who are fully invested in money market funds or 60-year-olds who never met an aggressive growth fund they didn't like. However, companies have a key role and obligation, according to the U.S. Department of Labor, to help employees make appropriate investment decisions regarding their 401(k) plan assets. If companies, particularly those that are looking to terminate an existing defined benefit plan in favor of a 401(k) plan, want their 401(k) plan to be an effective retirement financing vehicle, the asset allocation question must be addressed.

How does a company know if its 401(k) plan has an asset allocation problem? Benchmarking and demographic investment information are two important ways of determining if a problem exists. To see where plan participants are investing, companies can obtain a demographic breakdown of asset allocation from their recordkeepers. Vendors also are likely to be able to provide general asset allocation models against which to measure participant allocations. Benchmarking this demographic data against companies that are demographic peers can also provide some context around participants' asset allocation mixes. Companies with better asset allocation among participants may be willing to share their methods for achieving those results.

A word of caution: Broad demographic averages alone may not tell the whole asset allocation story. A recent study of three large company plans (AT&T, IBM and New York Life Insurance Co.) conducted by the Employee Benefit Research Institute (EBRI) found that a large number of 401(k) plan participants were not investing their account funds aggressively enough to ensure a secure retirement. In fact, the study found that up to a third of employees, including many younger participants, had no plan assets invested in equities outside of company stock.

In addition, the EBRI study also found that asset allocation problems were not readily evident using broad-based measurements. For example, when the study focused on averages of broad demographic groups, it did not appear that any age group had a majority of their assets invested in non-equities. However, a closer look at specific investment behavior in each age group revealed that, in reality, a significant percentage of employees, if not a majority, in each age group held almost all non-equity investments.

Once they have gained some insight into actual participant allocations, a plan sponsor's next step is to assess the plan design to make sure investment options are adequate to the task.

Providing Choices

Mergers, acquisitions, strategic alliances and competitive pressures have forced many 401(k) plan service vendors to expand their investment offerings beyond a single family of mutual funds. As a result, companies now may have literally thousands of mutual funds to choose from in designing their 401(k) plans. Not surprisingly, the number of investment options in the average 401(k) plan rose from four in 1991 to 7.7 in 1996, according to a study of 743 companies conducted by benefits consulting firm Foster Higgins.

However, companies need to avoid simply offering more investment options in response to an asset allocation problem. “When companies have 10 more investment options, utilization of those options seems to decline,” said Robert A. Rudell, director of defined contribution services at Scudder, Stevens & Clark Inc. “The number and types of investment options necessary for a given plan really depends on the nature of the employer and the nature of the workforce.” Adds Ray Marcinowski, a senior vice president with Fidelity Investments, “Plan participants tend to choose an average of 3.5 investment options for investing their plan assets regardless of the number available.”

Therefore, in plan design, keeping investment choices simple can be critical for success, especially if the plan is newly formed or a significant portion of the employee population is new to the world of investing. “Having a multitude of investment options may only serve to confuse employees,” said Marcinowski. For companies that want or need to keep things simple, he suggests three basic investment options — a money market, a fixed income and a large company growth fund — as a starting point. Three investment choices is also the minimum necessary to comply with the U.S. Department of Labor's section 404(c) regulations. With this approach, companies can add more options, usually other classes of equity funds, as employees get used to the plan and become more investment savvy.

“The actual mix of investment options really depends on the sophistication of the plan participants,” said Adele Langie Heller, a director of Rogers, Casey, & Associates Inc., a pension consulting firm. She recommends a broader set of core investment options that cover the spectrum of investment choices — a balanced fund, a large cap domestic equity fund, a bond fund or a GIC (but not both), a money market fund, an international fund, and a small cap fund. Then, with this core investment mix in place, companies can add investment windows as the plan and its participants mature, she said.

These windows can take a couple of different forms. The first option is to maintain the previously mentioned core funds while adding a window to any number of other mutual funds from a variety of fund families. This window allows individuals with more sophistication to choose other funds focused on such things as emerging markets, specific industries, countries or geographic regions of the world. Another option is providing brokerage accounts to allow plan participants to buy and sell individual securities in their accounts. However, while these accounts offer maximum flexibility, only about 4 percent of 401(k) plans offer them. Those companies that do offer them tend to be in the professional and financial services industries with very financially sophisticated employees, said Heller.

Life Cycle Funds and Company Stock

One answer to this asset allocation question may be the so-called life cycle or lifestyle funds, which allocate investments among other mutual funds based on savings objectives and risk tolerance. In 1996, 7 percent of companies offered these funds and 16 percent of assets were invested in these funds, according to the Foster Higgins survey.

Most lifestyle funds differentiate themselves according to the risk involved, using labels like “conservative,” “moderate” and “aggressive.” However, some fund groups are taking a slightly different approach. Fidelity recently introduced its Fidelity Freedom funds, which target specific retirement dates — 2000, 2010, 2020 and 2030. For example, a participant who plans to retire in 2008 has the option to invest all of his or her plan assets in the 2010 fund. Unlike many lifestyle funds, the Fidelity offerings automatically reallocate fund assets as the chosen retirement date approaches. Meanwhile, Scudder has lifestyle-type funds with conservative, balanced and growth labels to indicate increasing levels of risk within the funds, but it also offers an International fund that features holdings in Scudder's various international and global funds.

Company stock also plays a role in asset allocation. However, growing concern that employees with significant amounts of 401(k) assets invested in company stock may limit this as an investment option. “While it is good for employees to have ownership in the company, it can be dangerous for them to have too much riding on the fate of one company,” said Heller. “People may not realize how much of their retirement is tied up in company stock, especially if the company match is in stock.” Many others share this view. Federal legislation proposed by Sen. Barbara Boxer of California, which is expected to gather significant support, would limit 401(k) plan assets invested in real estate or company stock to 10 percent of plan assets.

What's Next?

Just as companies should make sure that plan investment options are not confusing to employees, they also should make sure those options are meeting employees' asset allocation needs as plan participants become more comfortable and educated about investing. For indicators of what is next in 401(k) investment options, Heller suggests that controllers keep track of trends in defined benefit pension plan investing. “Investment activity, for example, using real estate or emerging markets to increase returns, tends to occur first in defined benefit plans and then moves to defined contribution plans within five to seven years,” she said.

Overall, however, controllers need to recognize that “plan design can only do so much in making sure employees invest appropriately,” said Marcinowski. “The real key to improving asset allocation is employee education.”

Next month: How employee education can lead to sound asset allocation and diversification strategies.