Investment Primer for 401(k) Plan Fiduciaries: Understanding the Merits Of Portfolio Diversification in the Context of Participant Disclosure

As Section 401(k) plan fiduciaries take steps to comply with new Labor Department participant disclosure regulations, they need to understand and explain to participants the purpose and merits of the plan's investment options, as well as why participants pay more for some options than for others.
Retirement plan investment advisers often recommend that participants diversify their retirement plan investments across appropriate asset classes to reduce their investment risk. To permit such diversification, plan sponsors need to understand the array of investment options their plans offer to ensure that participants have the appropriate investment tools to construct a diversified asset mix.
Participants may question the cost differences in the tools. Some asset classes are inherently more expensive than others, according to investment advisers. Plan sponsors need to explain to their participants that it is often necessary for them to use these more expensive investment tools to construct a diversified retirement plan portfolio.
Investment advisers told BNA in recent interviews that individual account plan participants are likely to benefit in the long term by spreading their assets among several distinct asset classes that behave differently in response to certain economic events and thus are said to have a low correlation.
Stephen Dopp, senior investment analyst at the plan consulting firm Cafaro Greenleaf, in Red Bank, N.J., told BNA that correlation is the degree to which differing asset classes behave relative to each other. For example, he said the value of gold is likely to rise when inflation increases and is thus said to have a high correlation to inflation. Fixed income or bond investments, however, are negatively correlated to interest rates and thus will decline in value as interest rates rise, which would occur in periods of inflation, Dopp said.

Joe Goldberg, principal and director of retirement plan services for the Buckingham Family of Financial Services, St. Louis, said studies have shown that 94 percent of a portfolio's investment return can be explained by examining the portfolio's asset allocation rather than merely its individual investments. According to Goldberg, by diversifying among asset classes that are not perfectly correlated, investors can confidently place their money in asset classes that would be too risky to use if not part of a larger integrated portfolio. By combining these risky asset classes in a diversified portfolio, participants can construct an investment strategy that has a reduced overall risk while maintaining a greater expected investment return, he said.
Goldberg said that, to fully take advantage of portfolio asset allocation, plans should offer passively managed funds, such as index funds, since these funds provide the most pure exposure to their targeted asset class. Actively managed mutual funds, however, pose a risk that their managers may stray from the fund's investment objective or underperform the asset class, he said.
To construct a diversified portfolio, Goldberg said equity asset class exposure should include domestic, international, and international emerging market asset classes, including large and small company classes as well as value and growth company classes.