The role of the core menu in defined contribution (DC) plans has changed considerably over the last decade as default investments, target-date funds in particular, continue to capture participant attention and assets. This evolution requires plan sponsors and consultants to revisit key assumptions about optimal core menu design, especially as plan sponsors increasingly seek to retain retiree assets, which, in turn, necessitates that plans offer attractive solutions for older participants.
This paper uses data from 11,643 401(k) plans to better understand where asset class coverage gaps exist across core menus and quantifies the portfolio implications associated with the gaps. Two key potential improvements are noted.
First, core menus could potentially benefit from a “rebalance” to better accommodate the participants who are most likely to use them. Younger participants are much more likely to use default investments (e.g., target-date funds) while older participants, who tend to invest more conservatively, are much more likely to use the core menu. This is in direct contrast with common core menu design, where there are typically significantly more equity funds than fixed income funds (roughly three to one). The relatively high proportion of equity funds makes it not only difficult to build efficient conservative portfolios, but it may also lead to excess risk taking among participants (i.e., if the participant follows a naïve allocation strategy or chases returns).
Second, core menus are not currently designed to be “retirement ready.” Efficient retirement portfolios look different than efficient accumulation portfolios given the more focused objective of generating an income stream, and unfortunately the key building blocks for efficient retirement portfolios are generally missing from DC core menus. The portfolio efficiency costs of these gaps can be staggering, exceeding roughly 100 bps on alpha-equivalent basis. The most notable gaps in asset class coverage include inflation-linked bonds, high yield bonds, commodities, and real estate, although adding other asset classes, such as long-term bonds, may be worth considering.
While some plan sponsors may hesitate to expand core menus given past research on the topic (e.g., research noting negative relationship between core menu size and plan participation1) it’s important to realize that a lot of existing research may be less applicable today, given the fact it took place before the broad adoption of automatic enrollment and prepackaged asset allocation solutions, such as target-date funds. Core menus don’t necessarily need to be bigger, though, they just need to be smarter: it is possible to consolidate a few of the riskier (equity) options to make room for retirement-focused strategies.
Creating a truly optimal DC core menu requires a certain degree of art and science that will vary by plan. This research suggests, though, that most core menus today need to be revisited before they can truly be considered optimal for those most likely to use them.
