Some employees also choose multiple lifecycle funds — for example, a 2020 fund, a 2030 fund, and a 2040 fund — in the mistaken belief that doing so is similar to choosing a mix of stock and bond funds and will thus yield better diversification. "That's a good sign there needs to be some education," says Verhaeghe. Employers can also structure their plans so that employees may choose only one lifecycle fund.

Extra Choices
For more-sophisticated investors who want to make their own fund choices, employers should offer a selection of active and passive funds that span the risk-return spectrum. With a couple of index funds, domestic and international equity funds, a fixed-income option, and a stable-value or capital-preservation fund, employers can cover the critical bases required for diversification.

Yet, while experts have long recommended paring back 401(k) offerings to just 10 or 12 fund choices — and although studies have shown that employees often find a wide array of choices so daunting that they opt to do nothing — the average number of funds offered by companies remains too high at 18, according to the Profit Sharing/401(k) Council. "It's hard to take things away, and anything you take off the investment menu is viewed as a takeaway by participants," comments Walton. "Even plan sponsors still have the perception that more is better, even though data shows that having too many options leads to poor participation."

Depending on the demographics of the employee base, employers may decide to add a few (and just a few) specialized choices to their core offerings. For example, at Method, a maker of eco-friendly cleaning products, employees were polled about what they wanted in a 401(k) when the company established its plan last year. Perhaps not surprising, "the loudest response was from people who were looking for a socially responsible choice," says CFO Andrea Freedman. The company now offers a socially responsible fund as well as index funds, which employees also requested. Method offers about 15 funds in all.

At Aruba Networks, a Silicon Valley, California-based technology firm with a fairly investment-savvy employee base, finance chief Steffan Tomlinson says staffers clamored for more choice. As a result, Aruba's plan has some 15 to 20 funds, including a series of lifecycle funds and an international bond fund.

But companies shouldn't offer too many eclectic or trendy choices, because they often fail to perform well in 401(k) plans, which can have time horizons of as long as 40 years. Pamela Hess, director of retirement research at Hewitt Associates, cites real estate investment trust (REIT) funds as a specialty sector that doesn't work well in a 401(k) plan, because people invest in them when they are hot and then forget about them. "In any niche subsector or specialty sector like REITs, you get people chasing those returns, and then they don't get out and rebalance their account," she says. In general, retirement investors who are intrigued by specialty vehicles don't do well over time, says Hess. "They tend to buy high and sell low."

Keeping in Style
After selecting a mix of 401(k) funds, employers must also track them to make sure they are what they say they are. Some investment committees, after making their initial fund selections, fail to monitor fund managers' performance and behavior afterwards. But so-called style drift, in which a fund manager moves away from a fund's stated objectives and invests in securities outside the targeted sphere, can throw off a plan's asset allocation and leave employees unwittingly overexposed to certain market sectors.

While the problem has diminished somewhat as investors' awareness of it has increased, style drift is still common, particularly in midcap funds, say experts. Small-cap fund managers are often guilty of drifting into the midcap part of the market as their funds grow and they struggle to diversify their holdings, while large-cap fund managers dabble in the stocks of a few smaller companies, looking for the next successful large-cap. For this reason, Walton says she doesn't recommend any dedicated midcap funds to clients, since the sector is often overlapped by other funds.

To guard against style drift, companies' investment committees should regularly evaluate the funds in their plans and compare their performance with a style-specific benchmark — for example, a small-cap fund should roughly track the Russell 2000 index. "If your fund is significantly outperforming or underperforming that benchmark in a given year, that's a good indication that it may not be in the style you expected," says Verhaeghe. While a fund could outperform or lag its peers for any number of reasons, "you should be asking the reason why," he says.

One approach some companies are taking to both rein in costs and avoid style drift is to offer investment options through collective trusts instead of mutual funds. Collective trusts, which are ERISA-qualified vehicles that are only available to institutional investors like 401(k) plans, have long been used by defined-benefit plans. Because they are meant for an institutional audience that is highly attuned to the issue of style drift, collective trusts tend to be more style-pure than mutual funds.

Collective trusts have not been widely used in the defined-contribution market, because employers were concerned about the lack of public information about their performance, but the growing availability of fund data on company Websites and from financial-information providers like Morningstar has eliminated that obstacle. As a result, collective trusts are now starting to cross over into defined-contribution plans as employers focus more on lower-cost options, with 41 percent of plans using them in 2006, up from 32 percent in 2003, according to research from Morningstar and Greenwich Associates.

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