Session 10 – CAP Investment Selection and Monitoring
What Forrest Gump can teach us about investing.
By Greg Hurst, Principal, Morneau Sobeco
Investment options in CAPs are like a box of chocolates. But if you pick the wrong one, the consequences could be worse than just a bad taste. The behaviour of individuals faced with choosing a chocolate can be instructive.
During this DC Summit session, we circulated two boxes of chocolates, one with three clearly identified choices and one with 30 unidentified varieties. Three results were apparent from the experiment.
1. Participants found it easier to choose a chocolate from the small selection than the large one.
2. No participant asked to see the “map” describing the chocolates in the large assortment, even though it was available and would have been provided.
3. Participants who chose from the small selection were more likely to be satisfied with their choice than those who “guessed” from the large assortment.
A number of other studies have focused more closely on the subject of how many funds are appropriate for a CAP. For example, a U.S. study on fund offerings by Elton, Gruber & Blake concluded that adequate diversification in investment options would be achieved by offering eight basic market indexes. The same study found that approximately 85% of the 401(k)s surveyed offer less than 13 investment choices.
Furthermore, a study of member behaviour by Bernartzi, Shlomo and Thaler concluded that a significant number of members will naively diversify across all funds offered, even if such diversification is self-defeating. Some members will select multiple asset allocation or TDFs, or mix these funds with individual asset class funds, defeating the purpose of the asset allocation and TDFs.
According to the CAP Guidelines, the “diversity and demographics of the CAP members” is an important factor to consider in determining appropriate investment options. Employers should:
• design plans to avoid common member mistakes including risk tolerance mistakes, excessively conservative investing, herd behaviour (buying high and selling low), shotgun selection (over-diversification), lack of diversification and frequent trading;
• consider the diversity and demographics of membership groups;
• design plans to the lowest common denominator, or perhaps segment the group and offer different choices; and
• consider requirements for delivering information and education.
The next step is to select and monitor the funds on an ongoing basis. This can be a daunting task, and professional help can be useful. At a high level, a few strategies are worth commenting on.
TDFs – This is, in some respects, the “new frontier.” TDFs have attractive attributes but often come with many restrictions.
Risk – based asset allocation funds – These offer less of a complete solution than TDFs but are easier to analyze and have fewer restrictions.
À la carte investment funds – This approach is traditional and widely used but is very difficult for members to use effectively.
As a final note, a statement of investment policies and procedures is a very useful tool that CAP sponsors are encouraged to use to document investment selection and monitoring procedures for all CAPs—not just for registered pension plans. BC
Continued on the next page…
Session 11 – The Future of DC Investing
How today’s risk considerations will drive tomorrow’s asset allocation models.
