Downloadable verion (pdf) of this article

Before the typical participant in a 401(k) plan even picks up the enrollment form, he knows what he’ll be ordering: stocks, and lots of them. Stock-laden mutual funds are the meat and potatoes of the 401(k) industry. They are, to borrow a phrase, what’s for dinner. Bond funds, on the other hand, are the broccoli that typically gets pushed to the side.

There are a few different drivers for this situation, but one of the most powerful comes from the menu itself. In a typical 401(k) plan, there are stock (equity) funds that fit the following categories: large cap value, large cap blend, large cap growth, mid cap value, mid cap growth, small cap value, small cap growth, international equity and, more recently, emerging markets. In many cases, there are also index options that overlap many of these same categories.

By comparison, the average 401(k) plan offers the following options in the bond (fixed income) universe: core and indexed core (according to Deloitte’s Annual 401(k) Benchmarking Survey: 2009 Edition).

Target date funds, which are on their way to becoming the most popular investment category, are by design diversified stock funds with the bond and cash position only becoming significant factors once the target date is reached. To put it another way, the typical 2050, 2040, 2030, and even 2020 fund has anywhere from 75% - 95% invested in equities. It is this emphasis on equities that has led many to question the labeling and approach of target date funds, particularly in light of their performance in 2008.

The 401(k) industry reflects the mutual fund industry at large.  Discounting the multiple share classes available for each fund, there are 4,659 equity funds currently offered compared to 1,853 bond funds. 401(k) participants have many, many choices when it comes to stock funds but few to support a diversified approach to fixed income.

A trend that very much disturbs the 401(k) industry and investment managers has arisen: investors are fleeing equities in favor of fixed income. According to the ICI: bond funds attracted $559 billion in new assets in the 30-month period ending June, 2010. On the other hand, domestic equity funds lost $209 billion to withdrawals over this same period and international stock funds lost over $24 billion.

Another aspect of the stock vs. bond debate is the simple truth that equity funds cost more and are more profitable than fixed income funds. Firms that depend on equity funds to drive their bottom lines are suffering from reduced profitability. At the same time, these same firms are waiving some or all of their management fees on their money market assets, which no longer produce enough interest to cover their fees. Before the relatively recent decline in short term rates, money market funds were a predictable source of reoccurring income for fund managers (the dinner roll that rounded out the meal and the profits of the fund family). This particular menu looks bleak for fund managers who like the meat and potatoes approach.

Returning to our 401(k) menu, it is logical to assume that as investors want less in the way of equity funds they will likely push for more choices in the bond universe. I don’t realistically expect that green vegetables will soon outnumber the meat and potatoes, but the current disparity is not likely to stand as long as bond funds continue to outperform.

Investors, as a group, have a long history of ordering the wrong thing at the wrong time. In the more recent past, mass migrations to funds heavy in technology stocks ended in tragedy in April 2000, as did large appetites for real estate in 2008. The dangers involving a new, significant investment in bonds at this time are real (dangerous broccoli?). Interest rates are as low as they can theoretically go, and our nation’s debt is sky high. The movements of the yield curve are as much art as science, but anyone expecting that bonds will continue to produce near double-digit returns for years to come is likely going to be disappointed.

It is theoretically possible to populate a menu with as many bond choices as stock options (the choices include high yield, multi sector, short term government, short term corporate, intermediate term government, intermediate term corporate, long bond, GNMA, mortgage backed, TIPS, emerging market debt and so on). Unfortunately, there is already evidence on the books that increasing choices actually reduces participation (imagine a restaurant with a 20-page menu). There is further proof that most participants fail to grasp the basic investment concepts (a FINRA study concluded that while 71% of those queried understood that bonds were essentially loans only half knew what a junk bond was and only 40% understood the inverse relationship between bond prices and interest rates).

Even as the fund companies wrestle with declining revenues, the committees that oversee the 401(k) menus are likely going to struggle with more requests for green veggies, and lots of them. In light of the challenges most participants face in understanding the basic differences in asset categories, and with the potential for a bursting bond market bubble on the horizon, any additions to the investment menu should come with a healthy side of education. Too much of anything is likely a bad thing at the end of the day. It can be argued that we’ve already seen that mistake with stock funds. Plan sponsors and their committees should take care to avoid the same issue with bond funds.

Marshall J. Cobb, CRSP, is president and founder of Cobb Retirement Solutions, LLC., an independent, fee-only firm offering qualified plan analysis and oversight exclusively to corporations and organizations. Cobb’s first-hand knowledge as a veteran representative of retirement plan vendors beginning in 1990 gives him a unique perspective as he advises his clients. Cobb runs his office -- based in Houston, Texas -- with employees and clients across the country

.