There are a lot of moving parts to your company’s retirement plan. From getting employees enrolled to making distributions in a timely manner, to keeping up with ERISA regulations, there is much to do in the world of defined contribution plan administration. But the real reason for running a 401(k) or 403(b) is to provide an investment vehicle so you and your employees can grow a retirement nest egg through tax-deferred investing and the investment options you select for your fund lineup are the plan’s backbone.
Hopefully you have an advisor who is performing most of your plan’s administrative and compliance tasks for you, and taking on fiduciary responsibilities as well. But as the plan sponsor, you may still be involved in choosing, or at least reviewing, your 401(k)’s investment lineup. In fact, if you hired a 3(16) fiduciary to help you with the plan’s investments, you not only are involved in the investment decisions, you are ultimately responsible for them.
Given the thousands of investment options available today, it can be difficult to know where to start when it comes to selecting funds for your company’s plan. No wonder so many so many plan sponsors have relied on an investment advisor to help with the fund selection process. But for years, this process led to 401(k) plans filled with high-fee funds. That’s less often the case today given the recent scrutiny of 401(k) fees. While this focus on fees is a win for investors, plan sponsors may still feel overwhelmed with the abundance of investment options available to them.
Whether you are actually choosing the investment lineup or signing off on a lineup chosen for you, there are 10 practices that can help ensure your investment lineup offers you and your employees the best chance for retirement success.
1. Follow your Investment Policy Statement.
You have an IPS right? A written IPS not only demonstrates a well thought out investment process to regulators, it can provide a template for selecting the fund lineup. A well written IPS will spell out how investments are to be selected and monitored, and what factors result in placing an investment on a watch list.
2. Have enough fund options.
ERISA’s section 404(c) allows plan sponsors to avoid liability for investment performance if they follow certain practices, including offering a sufficiently diversified investment menu. At least three core options must offer materially different risk and return characteristics. In practice, this generally means including equity, fixed income and money market/capital preservation options. This is hardly a tall order given today’s investment landscape. And that brings to our next best practice…
3. Limit fund options.
A prudent investment lineup should have the Goldilocks quality of being sufficiently diversified without offering too many choices. Good investment selection reflects a tug of war between diversification and complexity. It may seem like a good idea to provide an equity fund every market cap and style, but research has shown that too many choices can paralyze participants into inaction. According to FiduciaryNews.com, (“How Many Investment Options Should 401k Plan Sponsors Offer?” October 18, 2011), a study published in the Journal of Public Economics found that the more equity funds that are available, the less the equity exposure by participants!
So, how many funds do most 401(k)s offer? It depends, of course. According to the 2016 survey (2014 plan year) by BrightScope and the Investment Company Institute, 401(k) plans held an average of 22 funds (when a suite of target date funds is counted as a single fund). These plans included an average of 10 domestic equity funds, 3 international equity funds and 2.5 non-target date balanced funds.
Vanguard did their own study of investment options where they served as recordkeeper. Vanguard clients held slightly fewer funds, 17.9 on average in the 2016 plan year.
The Vanguard survey offers an amazing statistic for sponsors who worry about offering too few funds. The average Vanguard participant selected just 2.7 investment options in 2016, thanks largely to the increasing popularity of target date funds. In fact, 46% of participants held a single target fund in their 401(k) account.
If your fund menu looks more like a pizza buffet than a lean mean investing machine, it’s never too late to cut back on the number of funds offered. Research reveals that when investors are forced to switch funds due to a plan’s shift toward fewer options, investors tend to move toward lower cost funds. That’s not a bad trade.
Another drawback of offering too many investment options is the risk of skewing the offerings toward a particular style. If the menu offers a small-cap growth and small-cap value fund, but only a single large-cap equity fund, participants may take that as an endorsement of a small cap strategy. This might mean participants overweight this riskier asset class even if they describe themselves as risk-averse investors. An abundance of international offerings may persuade employees that non-US funds should be given as much weight as domestic investments. Yet many participants may not understand the currency risk associated with such investments.
5. Do tilt toward low fee funds.
401(k) costs have been in the news the last few years, often due to lawsuits claiming inattention to plan expenses. Since investment costs account for the bulk of what it costs to run a 401(k), mutual fund fees are directly in the spotlight.
These headline-making lawsuits are generally filed against large providers who have failed to leverage their size to the benefit of their participants, or they have simply allowed high fees to go unchallenged. The key to getting a handle on investment expenses is to compare performance and expenses to industry benchmarks. While a short-term performance shortfall need not place a fund on the watch list, a fund with above average expenses should be a red flag.
One way to cut back on overall plan fees is to remember #3. Limiting the number of investment options may lower recordkeeping fees or shrink fees paid to other providers given the reduced complexity.
If your 401(k) provider is a mutual fund company, pay special attention to the fee structure of their proprietary mutual funds. Further, a study published in the Journal of Finance found that fund company involvement in investment selection tends to favor that company’s funds. This bias can affect setting the fund lineup, and even skew fund evaluations, for example, by not removing proprietary funds for poor performance.
6. Be sure to include index funds.
One to way to bring down average fund costs is to include index funds. These low-cost options are designed to mimic a specific equity or bond index rather than beat the “market,” however defined. In addition, funds that track an index may be easier to explain to participants than the nuances of a particular manager’s active strategy. And we know that complexity can paralyze employees from making any investment decision. Also, broad market offerings like core index funds can help you limit the number of funds in your lineup. A core equity fund that provides exposure across market caps and investment styles could mean that the plan need not offer nine different equity style options.
Just as when evaluating any fund, buyer beware when shopping for index funds. Some fund companies offer products that are far more expensive than others, despite seeking to deliver the exact same performance. After all, matching the index is the goal. That’s another reason why it’s so important to compare fund candidates to other players and industry averages. Today’s investors seem to like the passive approach, at least judging the fund flows away from active managers and toward passive alternatives.
7. Avoid revenue sharing.
Your provider may have convinced you that revenue sharing fees are simply industry standard practice. That may once have been the case, but times have changed. Typically revenue sharing means that a portion of a mutual fund’s fee goes to pay for another service.
Understanding 401(k) costs is complicated enough without trying to track down these indirect fee payments. ERISA requires that fees must be reasonable, and revenue sharing can make that judgement difficult. At a minimum, plan sponsors should understand what they are paying and how that stacks up against industry norms. If you fund lineup includes 12(b)(1) fees or Sub-TA fees, make sure they can be identified and that they are reasonable.
8. Do seek the cheapest share class available. The same mutual fund portfolio can be priced differently depending on who the customer is. A 401(k) plan with billions in assets is more likely to be offered the cheapest share class than the plan with a dozen participants. Don’t be afraid to ask your provider exactly which share class you are getting and why. Be sure to understand the fees associated with that share class, and see how they compare with the competition.
9. Do include target date funds As indicated by the Vanguard survey data, participants are definitely embracing these do-it-for-me alternatives. That makes sense because target date funds (TDFs) adjust the asset allocation for you as you move closer to retirement. The heavy equity allocation early in a participant’s career provides the best chance for long term growth. As employees approach retirement age, the shift toward bonds dampens volatility. And less risk of a significant loss in value is generally appealing to employees who will soon be taking distributions.
10. Consider the track record – is there one? We put this practice last to emphasize that performance data alone should not determine fund selection. However, funds in your lineup should have some performance history. New products are coming to market all time. Exchange Traded Funds (ETFs) have been particularly prolific. Many new equity ETFs, for example those in the smart beta space, sound appealing, and many of their algorithms are backed up by reams of research. But a real track record can be quite different from the one simulated by the product developers. Look for a long track record, or at least be sure you understand the fund’s strategy. And be sure to document why the fund won a place in the fund lineup.
Give your employees more than just a 401(k), join the movement.