Maybe 401(k) plans can be dragged into the world of modern portfolio theory after all.

At least that’s the hope of observers who contend the automation of 401(k)s promoted by last year’s pension law will bring about a drastic change in the way defined-contribution plan assets are invested.

As companies automatically enroll more workers in 401(k) plans’ default investments, observers say, the current system in which participants make their own investment decisions will be replaced by one in which the majority of 401(k) assets are professionally managed.

Boston College found that between 1988 and 2004, the overall returns on defined-benefit plan assets beat those of 401(k) plans by about one percentage point and attributed the 401(k) shortfall to participants’ “poor timing and investment mistakes.”

At a minimum, the new default investments will ensure that participants are diversified. The Center for Retirement Research report found that nearly 50 percent of 401(k) accounts were not diversified, with some participants having little or nothing in stocks and others investing only in them. The report concluded that using default investments that provide diversification should “significantly improve the performance of 401(k) plans.”

But compared with the investments that companies currently use as defaults, like stable-value and money market funds, the new default investments are more aggressive and more volatile. Are companies that sponsor 401(k) plans ready for the change?

The three types of investments that the Department of Labor proposed as defaults last fall are lifecycle funds, balanced funds and managed accounts. Consultants say plan sponsors’ interest seems centered on lifecycle funds, also known as target-date retirement funds, which invest in a manner appropriate for an employee planning to retire around the date specified in the fund’s title.

Lifecycle funds are “more aggressive compared with, say, money-market defaults of the past,” says Mark Ruloff, director of asset allocation for Watson Wyatt Investment Consulting, adding that money market defaults were not very good investments in the first place.

The new defaults “have better expected returns, but they also will have more volatility than the money market strategy,” he says.

He added that the lifecycle funds’ approach is basically an effort to deal with 401(k) participants’ shortcomings as savers: “The lifecycle funds are trying to compensate for [participants’] overspending and under-saving and long life by taking on more aggressive investment strategies.”

As lifecycle funds take over the task of investing participants’ savings, they are going beyond the stock and bond funds that make up the bulk of choices in 401(k) plans to add more sophisticated options, ranging from emerging-markets securities and high-yield bonds to real estate.

Donald Stone, president of Plan Sponsor Advisors, says some lifecycle funds already use “one or two or even more asset classes that you don’t see often in a core [401(k)] menu.”

He cited TIPS, high-yield bonds, emerging markets and even real estate. “Emerging markets is not anything you see on core investment menus.” And while some 401(k) plans offer real estate as an option, Stone said it is showing up more often in lifecycle funds.

Adding different types of investments, especially those whose performance tends to have a low correlation to the performance of traditional investments, “can in fact enhance returns and mitigate risks,” he says. “Real estate is a really good example of that. It tends to dampen volatility and [over time] has enhanced returns as well.”

Ruloff says that putting alternative investments on a 401(k) investment menu has different ramifications than putting them in a lifecycle fund.

If investors could stash all their retirement money in emerging-market funds, they could see volatility like last week’s 9 percent sell-off in the Chinese stock market. But using a broad range of investments within a lifecycle fund “actually provides the opportunity to have less [overall] volatility,” Ruloff says.

If companies are concerned about the level of risk or volatility of lifecycle funds, the third type of proposed default, professionally managed accounts, may seem like a safer bet, since managed account providers divide participants’ assets among investments already in the 401(k) plan.

“The nice thing with managed accounts is you know exactly what’s being used,” says Jeff Maggioncalda, president and CEO of Financial Engines, a managed account and advice provider.

The shift toward a defined-benefit style of investing in 401(k) plans includes a change in the way goals are framed. Instead of the traditional focus on the total amount a participant has saved, plan providers and the companies sponsoring plans are beginning to consider how those assets will translate into retirement income.

“It’s not so much your balance, but if you’re on track to have the income you need,” Stone says. “That’s a very DB concept.”

Filed by Susan Kelly of Financial Week, a sister publication of Workforce Management. To comment, e-mail editors@workforce.com.

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