Feng Shui of Defined Contribution Menu Construction

Erik Daley, CFA
Managing Principal

In a recent meeting a client asked me to tell them what asset classes their plan should contain. While not as difficult as answering which daughter is my favorite, the question isn't as easy as it seems. Which product I might recommend depends on who and how the product will be used as well as the client's expectations.

We view investment menu construction as akin to feng shui, the Chinese philosophical system of harmonizing everyone with the surrounding environment. We work with clients to develop investment menus that create balance and harmony between investment theory, plan design, organizational philosophy and participant behavior. 

In this paper, we will address some of the issues that impact menu construction and investment product selection for defined contribution plans for the purpose of inspiring other sponsors to evaluate the harmony between their plan design and their menu construction.  

Investment Philosophies

We address in great detail our philosophy on selecting funds in our white papers, Evaluating Target Date Structure and Investment Manager Selection. But before we begin the discussion on construction, it may be useful to summarize again here:

Markets are Efficient
We know that risk and return are highly correlated. To achieve greater investment returns, investors need to be willing to accept greater investment risk (typically defined as short-term volatility). We also know that different asset classes (i.e. bonds, large cap stocks, real estate, etc.), have different risk profiles, and therefore provide different risk premiums to investors willing to accept their inherent risk. Expected investment returns are based on an investor's allocation to the various asset classes available in the marketplace. The primary determinant of a fund's investment performance is going to be its asset class exposure.

Risk and return are highly correlated
Investing is similar to every other aspect of life of which I am aware, there are no "free lunches." Over a participant's lifetime, the highest returns generally accrue to those who exposed themselves to the most compensated risk. Participants are left to decide how much risk they can tolerate at each stage of their career and what types of risks they are comfortable with.

Different asset classes have different risk profiles 
These risk profiles expose investors to different potential sources of return. Frequently, these returns are correlated (move together) but occasionally investors may be exposed to risk profiles that are negatively correlated (move in different directions) allowing participants to reduce total portfolio volatility.

Investment style drives performance
Within a peer group, managers still exhibit differences in investment style or philosophy that impacts performance. Evaluations of active managers needs to factor in these differences, otherwise investment committees will make many of the same mistakes participants make in chasing performance. Some managers provide better downside protection while giving up performance in periods of strong market growth. Other managers might generally over-/under-weight certain sectors, or exhibit biases to large or small cap stocks. These style differences frequently explain variances in short-term performance relative to peers, but are frequently confused with security selection decisions. This confusion results in firing managers based on short-term performance differentials that should be fully understood prior to hiring the investment manager.

Expenses matter
Expenses are one of the few factors that provide some predictive value for future performance. For all investors, the only measure that matters is net-of-fees performance. Higher fees create a higher hurdle for a manager to generate net-of-fee performance greater than the passive index. When excess performance is measured in basis points, even a small difference in fees can have a significant impact on performance when compounded over time.

These five fundamentals are equally true for participants. In most defined contribution plans, each participant acts as their own asset manager by allocating the funds available in the plan to assemble their own unique portfolio. As investment consultants work with clients, the tendency has been to engineer retirement plan portfolios with increasingly sophisticated, and complicated, investment menus that allow participants to design progressively more "efficient" portfolios.

Extending that logic, defined contribution plans would have dizzying arrays of emerging market equities, hedged and unhedged foreign bonds, developed microcap equities, frontier market products, international real estate, commodities of varying flavors, and a wide variety of bond products with different durations and credit qualities. Yet academic data continues to illustrate that increases in menu complication hurt participant returns and participants' retirement preparedness.   

Participant Behavior Philosophies  

Sophisticated and extensive investment menus tend to fail in defined contribution plans because participant behavior trumps investment philosophy nearly every time. Investment returns are only one of the primary four factors that impact retirement income adequacy. Those four are:

  • Level of contributions - How much to save
  • Length of the contribution and retirement period - How long to save and how long will income be needed in retirement
  • Utilization of lifetime income protection - For many, self-insuring longevity risk may be difficult
  • Investment returns - Largely out of the control of participants (with the exception of risk-averse behavior minimizing the opportunity for long term growth)

In working with defined contribution plans since the inception of our firm and analyzing the fascinating studies and statistics of investor behavior impacting retirement savings, we have observed the following participant behaviors:

An object at rest tends to stay at rest
In retirement plans, very little changes from year-to-year from participant perspective. New employees are slow to enroll, employee deferral levels don't change to reflect change in income and need, and investment portfolios tend not to change. Since the level of contributions and the period of time over which contributions are made are two of the four factors impacting retirement readiness - this issue looms large.

Some participants are "know-it-alls"
Individuals seem to have a high level of confidence in their judgment, even in regards to difficult questions, like investing, despite little information and experience. This causes many to irrationally avoid risk, chase returns and generally try to "beat the market." 

Participants like to invest in things they've heard of
Familiarity bias is a measurable phenomenon in retirement plans, whether it's employer stock, sector stocks, or overweighting funds with big blue-chip holdings. 

Participants hate losses more than they like gains
The result of regret avoidance works directly counter to the fact that risk and return are highly correlated. Fear of risk is akin to a fear of returns over long time periods.

When forecasting returns, participants look backwards
Decades worth of academic research suggest that the direction of the market tomorrow has no correlation with the direction of the market yesterday. This belief is outlined in literature and is the cornerstone of the "Random Walk" philosophy. Participants seem to disregard market efficiency and look at short- and long-term historic returns as indicative of future returns.

Negativity Bias
Consumers of information are conditioned to focus more on negative information than positive information. This evolutionary bias makes accepting the investment risk necessary to generate returns difficult. Investors can spend so much time preparing for the 100-year flood they neglect to notice the sun is shining.   

Constructing Investment Menus

Constructing an asset class strategy an investment menu is the balancing of two conflicting phenomenon; increasing asset class availability improves the theoretical efficiency of investment menus, while creating simplicity helps participants avoid falling into behavioral finance traps that will impair their retirement readiness.


In reviewing hundreds of investment menus over my career, I have come to only one conclusion: no two client situations are identical. However, some tested approaches seem to work frequently for clients, including:

Tiering Investment Menus
Generally adding investment options to client arrays can add complexity and negatively impact participation and savings rates. However, creating a series of decisions that allow participants to stop at any point in the process seems to reduce the friction. Tiering an investment menu allows participants to easily identify their approach and to select from a more limited menu dedicated to that approach. Tiers vary by client, but might include:

a) Target Date Funds
b) Index Array
c) Extended Array
d) Brokerage Window

Developing A Full Array Of Indexed Options
There continues to be growing interest among participants in index investment strategies that generally have lower cost than their actively managed equivalents. Many participants are interested in developing fully passive investment portfolios for their defined contribution plan. Having robust passive alternatives and identifying them in the investment array helps participants better implement their personal preferences.

Understand Correlations
Most frequently investment committees tend to focus on two issues: coverage and individual fund performance. Their goal is to offer an option in each style box and to evaluate the funds selected against their individual peers and benchmarks. Lost in this analysis, is that offering more funds or filling more style boxes doesn't necessarily improve the diversification of participants' portfolios. Many funds have high correlations even though they fall into different categories. The focus should be on offering diversification opportunities by building a lineup consisting of a variety of investment strategies, rather than trying to check all of the boxes. Clients should also focus on other less tangible correlations. Frequently, client menus over represent investment products that overlap their operating business. Technology firms want technology funds. Hospitals want healthcare funds. These correlations carry risks as well. Personal income growth is frequently tied to the health of the industry participants are in, as well as the firm they work for. Having stagnant income at the same time as experiencing low returns in a specific industry fund, multiplies the savings short fall. Worse yet, in periods like 2008 when layoffs were rampant, having an over-exposure to securities correlating with the declining health of a specific industry meant unemployment was rising at the same time as markets were sharply declining.

Know Your Participation Base
The sophistication of the investment alternatives you make available should correlate to the general investment knowledge of your participant base. Small-cap emerging markets may be an interesting asset class with low correlations to domestic equity markets, but making the asset class available to participants who are looking at last year's return to make allocation decisions could be a disaster.   

IBM is the largest 401k plan in the country covering 200,000 participants with more than $48 B in total assets. Their menu has four tiers, life cycle, core funds, expanded choice funds, and a mutual fund window. The expanded choice funds are limited to only twelve options. This doesn't mean it's the ideal menu, but it is interesting that despite the size and sophistication of the workforce of IBM, the menu is very manageable. 

Engineering investment menus is a critical fiduciary duty and will have a material impact on how well participants do in their preparation for retirement. However, understanding the behavioral issues related to the savings process may allow committees to better weigh the natural tradeoffs between increasing menu sophistication and size, and how participants react to those changes. 


Multnomah Group, Inc.
Phone: (888) 559-0159
Fax: (800) 997-3010

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