Rethinking how 401(k)s Invest

By Retirement Bankrate.com

One of the big differences between defined benefit plans, or old-fashioned pension plans, and defined contribution plans, such as 401(k)s and other contributory retirement plans, is the way the money is invested.

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Defined benefit plans are tightly managed by pension professionals with long-term growth and safety in mind. Defined contribution plans have traditionally focused on maximizing returns, according to Robert Capone, executive vice president, BNY Mellon Retirement Group. He also points out that they are managed by committee, with plan administrators offering fund choices, employers picking a range of options and employees choosing among them. Capone, who authored a report that examines the investments typically included in this process, concludes that as a result, defined contribution plans ignore options that could improve return and reduce risk.

"In order to really improve rates of return with lower risk and with true diversification, you have to think out of the box," Capone says, and that can be difficult within such a stratified system.

Capone found that most defined contribution plans invest more than 50% of their assets in U.S. equities, while the average defined benefit plan allocates less than 35% to U.S. equities and they have a broader mix overall of investment types. Capone experimented with modifying the typical DC plan allocation to make it more like a defined benefit allocation by moving 20% of the money to emerging markets, real estate and hedge funds.

He applied this revised allocation strategy to 20 years of defined contribution history and determined that compared to the typical return of a 401(k) during that time period, this investment plan would have produced 0.5 percentage point greater returns and it would have performed better during periods of time when the economy cooled.

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Capone concludes the report by writing, "For us, the math is clear: Incorporating these nontraditional strategies reduced risk, provided a hedge against inflation and managed volatility while improving diversification and performance through noncorrelated assets."

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Capone says popular retirement planning target date funds easily could, but don't, offer this mix of investment options, and he doubts that they will anytime soon, largely because people view emerging markets, real estate and hedge funds as too risky. "I think it is going to take a lot of education to get people to buy into the fact that we need to change the investment paradigm," he says.