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Defaulting Some 401(k) Investors into Diversified Funds Not Expected to Harm Stable Value Industry

The retirement plan market, it appears, is big enough for more than one investment strategy.

The U.S. Department of Labor is widely expected to endorse diversified investment portfolios, including lifecycle funds, as appropriate default investments for 401(k) plans once Congress gives the go-ahead as part of the pension reform legislation it's trying to hammer out right now. Yet retirement plan providers say they don't expect the move to have any dramatic impact on the use of stable value funds, which for the past two decades have been the most popular default investment option.

The investors most likely to be defaulted into an investment option, they note, are workers whose employers automatically enroll them in their retirement savings plans unless the worker specifically opts out. In most cases, industry experts say, those are younger workers at the lower end of the pay scale with consequently small account balances. Meanwhile, older workers with larger balances typically choose their own investment options and tend to appreciate the role stable value can play in their portfolios, especially as they approach retirement.

The proposed government endorsement of diversified portfolios comes at a time when much of the retirement industry has begun to question whether a conservative, single-asset class investment is the most appropriate choice for the average worker defaulted into a retirement plan, especially an investor with a long investment horizon. Two trends have contributed to this skepticism. One is the surging popularity of automatic enrollment; various surveys indicate that anywhere from 14 percent to 24 percent of plan sponsors now use it. Many more are expected to follow suit if, as is anticipated, Congress passes pension legislation this year and explicitly endorses the concept. That means plan sponsors could find themselves making default investment decisions for far more of their employees than they have in the past.

Also factoring into the new thinking on default investments is the growing popularity of lifecycle funds-diversified stock and bond portfolios with varying risk profiles that can be easily matched to an employee's age and investment horizon. Many retirement industry experts see the funds as a defensible default investment not just for young plan participants but for participants of any age. Retirement plan providers Fidelity Investments, Merrill Lynch, and Transamerica, among others, have gone on record backing diversified portfolios as default investment options. Without them, warns Kevin Crain, director of integrated benefits in Merrill's retirement group, many 401(k) plan participants will have scant chance of meeting their retirement savings goals.

Both the Senate and the House of Representatives have passed legislation that would direct the Department of Labor (DOL) to draft new and broader guidelines on default investments. Industry observers are optimistic that differences between the two versions will be reconciled this spring. In any event, the DOL has already begun work on such guidelines, and it seems inevitable that it will endorse lifecycle funds and similarly diversified investments. Less clear is whether the new guidelines will also mention stable value and money market funds. Bob Holcomb, vice president of legislative and regulatory affairs for JPMorgan Retirement Plan Services, says the DOL has been focused on the need for default investments that afford investors opportunity for capital appreciation-as has the language in the Senate's pension bill. But he says the language in the House bill reflects concern about both capital appreciation and capital preservation. "I think we're seeing more of a push now to make capital preservation part of the menu," he says. "I think the push is to broaden the menu of funds rather than be restrictive."

Regardless of what Washington does, many employers already plan to switch their default investment option to something more diversified. A Hewitt survey conducted late last year found that 17 percent of respondents were planning to change their default investment fund this year to either a balanced or asset allocation fund instead of a stable value or money market fund. Only 4 percent were planning to makes changes in the reverse direction.

As noted, though, even if many employers embrace lifecycle funds as their default investment option-and many retirement industry experts see no reason why they should not-it shouldn't sound the death knell for stable value. Other trends are at work in the retirement plan market that will continue to favor stable value investments, says Catherine Collinson, senior vice president for strategic planning at Transamerica Retirement Services. One important development is the massive wave of 76 million baby boomers now starting to reach retirement age. "These people typically are going to have larger account balances and unique needs which call for a more active approach to management, and allocation of their account balances outside of any default investment option," she says.

Meanwhile, Merrill's Crain notes that lifecycle funds aren't the only diversified investment option available to plan sponsors. Managed accounts are another; with them, the plan provider or third-party advisor uses a highly formalized investment methodology to construct custom, diversified portfolios for plan participants using the investment options already available in their plan. Often, that lineup includes stable value funds. "This has been a pretty quick trend," observes Crain. "We have about 25 percent of our plan sponsors who are adopting automatic enrollment-up from close to 0 percent two or three years ago-using our managed accounts program as their default investment vehicle. Our strong feeling is that this is the perfect solution because it offers a completely customized, personalized, target-maturity fund to participants that considers their individual characteristics."

Finally, although stable value funds are not represented in the lifecycle funds being marketed by mutual fund companies, there is no reason that plan sponsors could not create their own lifecycle offerings that do. In fact, Hewitt encourages it. "We've encouraged plan sponsors to use their own existing fund lineup to create these premixed portfolios," says Lucas. "One key reason is they typically have a stable value fund they can use for the fixed income component, which will generate a superior yield, in all probability, to what a money market fund would." Such an approach is especially practical, she says, for large employers that use privately managed commingled funds or separate accounts as their investment options. Those funds offer economies of scale, in terms of pricing, that are generally not available with mutual funds. "Plan sponsors have already spent a lot of time and effort vetting their existing funds," Lucas adds. "Their existing fund lineup is something they've selected because they believe they are the best investment funds that will fit their plan."

In short, stable value may no longer be the only kid on the block when it comes to choosing default investment options for 401(k) plans, but it looks to remain a vital part of the 401(k) investment lineup.

Read Next: EBRI/ICI Report on 401(k) Plans