Advisers, pay attention to home-country bias in 401(k) menus

Eliminate over-allocations to the U.S. market by encouraging plan sponsors to add international options to menus and explaining diversification benefits to participants.
JUN 02, 2015
401(k) plan participants who invest on their own, and without professional asset allocation services provided by products such as target-date funds or managed accounts, tend to allocate more heavily to domestic than international equity funds. This over-concentration of U.S. over non-U.S. stocks, referred to as a home-country bias, presents an opportunity for advisers to improve 401(k) investment menus and work with participants to help them understand the benefits of a globally diversified portfolio. Data on the Vanguard Group's retirement plan business suggests that the domestic-equities bias exists in both large and small defined contribution plans. Nearly all plans administered under Vanguard's Retirement Plan Access (RPA) program, which have up to $20 million in assets, have both a domestic and international equity fund; however, while 34% of participants invest in a domestic equity fund when it is offered on the lineup, that's true for only 20% with respect to international funds. The situation is the same for all of Vanguard's plans outside of the RPA program, in which 24% of participants invest in an international equity fund while 41% invest in a domestic fund. An analysis of Northern Trust's book of defined contribution business reveals a similar result — DC participants invest 82% of their equity allocations to U.S. stocks, which Northern Trust says equates to a 33% over-allocation to U.S. stocks. Chris Karam, the chief investment officer at Sheridan Road Financial, attributes this home-country over-weighting in participant portfolios in part to an interplay of behavioral finance and menu design. Investment selection can sometimes be influenced by the disparity in the ratio of domestic to international funds. For example, a typical 401(k) menu may have 10 equity funds, of which only one may be international, he said. “For a participant who isn't as knowledgeable, they're going to imply that the company sponsoring the plan thinks a nine-to-one ratio is a good ratio,” Mr. Karam said. According to the Plan Sponsor Council of America, the average number of actively managed domestic equity funds in 401(k) plans is 6.1, whereas the average for actively managed international/global equity funds is 1.9. The average number of indexed domestic equity funds is 1.9, compared to 0.4 for indexed international/global equity funds. Advisers should aim to streamline their clients' investment menus by eliminating any overlap between existing funds, which could provide a more balanced ratio of domestic to international funds, Mr. Karam said. Having anywhere from seven to 10 investment options, outside of a suite of target-date funds or other multi-asset funds, typically allows room for enough diversification, Mr. Karam said. A domestic-to-international allocation ratio of approximately 70:30 is typically appropriate for participants, he added. Jared Manville, managing consultant at Marsh & McLennan Agency, said some of the home-country bias derives from participants' tendency to chase performance, which has been skewed toward a stronger U.S. market. “Investors are going to put their money wherever is making the money at that point in time,” Mr. Manville said. This provides an opportunity for advisers to provide education to participants and plan sponsors about the benefits of investing overseas, he said. “The first thing is an education and overall awareness that this is not a portfolio or investment we're looking to cash out tomorrow,” Mr. Manville said. “Not all markets are created equal at the same time.” However, home-country bias becomes less of an issue as target-date-fund investors flood the market, because these multi-asset funds theoretically have an appropriate mix of domestic and international exposure, said Jean Young, senior research analyst in the Vanguard Center for Retirement Research. Also, to a certain extent investing domestically inherently provides for some international exposure, because most large corporations such as Coca-Cola and Apple have international operations, Ms. Young said. That's true, Mr. Karam said, adding it's important to note that correlations between U.S. and non-U.S. equities are falling, however, and the different return patterns in both markets provide diversification benefits for participants.

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