OPINION: CHOICE INCREASES CONFUSION

Survey today’s defined-contribution market and you will see remarkable, and disturbing, parallels to the state of pension investing in the early 1970s. At that time, pension investing was concentrated in the hands of a few major trust banks and insurance companies, often for administrative convenience or other non-investment reasons. These large institutions managed all asset classes, or investment choices, usually in balanced funds.

Coincidentally, at the time there was also a “new paradigm.” Stocks were only going up, and a few stocks, dubbed the “nifty 50,” were referred to as “one-decision investments.” Performance was not measured against indexes or other objective benchmarks because we didn’t know how to then. Issues like objective manager selection, diversification and risk control didn’t matter too much because everyone expected that their stocks would only go up.

The oil embargo and the bear market of 1973-1974 changed all that. One good result of this unpleasant experience was that it opened the eyes of many in the pension industry to the importance of investment discipline: diversifying asset classes, diversifying managers within asset classes and measuring investment returns against benchmarks. Today, the pension industry is a highly competitive industry, full of new entrants and new ideas for making the risk-return trade-off more effective for plan sponsors.

But today’s defined-contribution marketplace raises some cause for concern. Few of the hard-won lessons of defined-benefit investing are being applied for the benefit of 401(k) participants. Specifically: Ten fund providers now manage 50% of the defined-contribution market. Administrative convenience is drowning investment wisdom.

One-stop shopping assumes that a manager’s expertise with one asset class carries over to all the others. But the banks and insurance companies taught us the perils of that in 1973-1974.

Single managers or single mutual funds are being used to cover an entire asset class,
when we know that prudence demands diversification by style. And a phenomenally forgiving 15-year stock market – that has once again proclaimed it is part of a “new paradigm” – is the background to all these risks.

Admittedly, many defined-contribution plans have taken their current form for valid historical reasons. Many were originally established as savings plans, to supplement a traditional employer-provided pension. But today, most defined-contribution plans exist in place of traditional pensions. As such, they must be structured more like the plans whose objectives they now must fill.

Since we are asking untrained individuals to act as their own chief financial officers, it is imperative to provide them with the right kind of investment options and the education necessary to use those options. It’s our job to increase the odds that individuals can succeed in this challenging role.

Recently, a dangerous trend has begun to dramatically increase the number of investment options available to participants. On the surface, this looks like a good faith effort to promote better diversification and respond to participant demand for choice. Unfortunately, however, the greater the number of choices, the harder it is for an investor to put together a portfolio that is properly diversified by asset class, by style and by manager. It’s a bit like turning a money manager loose in a Lockheed factory and saying, “Go build a space shuttle.”

Our failure to make defined-contribution participants the beneficiaries of the knowledge we apply routinely to pension investing is deeply troubling. It’s a case where less is more: We need to provide fewer options, but make sure that all the options we provide – from conservative to aggressive – have proper diversification and risk control built in.

George F. Russell Jr. is chairman of Frank Russell Co. in Tacoma, Wash. This commentary is adapted from a speech delivered at a January conference sponsored by InvestmentNews sister publication Pensions & Inves
tments and was first published there.