When your business offers a 401(k), one of your biggest decisions will be determining what the best investment options are for your employees. You may have an investment policy statement that provides guidance in this regard. If so, it should provide policies and considerations that help you select your 401(k) fund line-up. It may even provide criteria for removing funds from your plan.
Whether you are considering an off-the-shelf design to keep costs low, or you prefer a more customized plan (that may cost more), you will need to understand the risks and potential benefits associated with the different approaches to investment offerings. After all, unless you are working with an investment fiduciary, it’s up to you to try to pick the best 401(k) funds for your team!
Here are 14 things to consider when considering which investment options are the best 401(k) funds for your plan
- Passive funds are cheaper. In almost every case, traditional index funds are the least expensive in an asset class for your 401(k). These passive funds can offer low fees because their job is to mimic a pre-defined index. As a result, there are typically fewer fund managers and analysts to pay as contrasted with an actively managed fund, and could be a better choice for your 401(k).
- Index no longer equals lowest fee. This does not conflict with the bullet point above. Funds which replicate major indexes like the S&P 500 or the Russell 1000 are typically very inexpensive. However, new indexes are created all the time, some of them in niche areas, or representing thinly traded markets. These kinds of passive investments can be even more expensive than actively managed funds. Buyer beware when it comes to esoteric index products – think very carefully if you are considering offering a thinly traded fund in your 401(k) lineup.
- Index funds can provide precisely the diversification called for by your 401(k) investment policy statement. Since the components of a fund’s index are readily available, what you see is what you get. By understanding the industry, geographic, or market cap weightings of each fund, you can offer the degree (and kind) of diversification you want. Active managers, by their nature, are not nearly as predictable.
- Make sure to offer enough bond funds. Many participants will want at least some allocation to fixed income. But a single bond fund may not be suitable for all investors. Be sure to at least include bond funds with different maturity structures. For example, you may want to include short-term, intermediate, and long-term bond funds in your retirement plan lineup to give your participants flexibility in building their asset allocation. If you are looking to create an excellent lineup of investments for your employees, don’t forget about bonds!
- Actively managed funds need additional vetting. If you choose to include actively managed funds, get ready to put on your analyst hat. There is an entire industry devoted to selecting active managers, so make sure you have the time to take it on yourself. If you are ultimately responsible for the investments in your plan, you will need to understand what makes a particular actively managed fund desirable. This may include a review of quantitative factors like performance relative to peers and an appropriate benchmark, historic volatility, and performance in down markets. You may also need to examine qualitative measures such as manager tenure, the experience of the management team, and the investment process. And make sure you can justify the higher fees that typically come with active management. If you think that actively managed investments might be better and want to include them in your investment lineup, you should make sure you document your selection criteria and stick with it! (Read our discussion on active vs. passive fund management in 401(k)s.)
- Active funds may not be as active as you think. Another consideration if you do want actively managed funds in your retirement plan’s lineup – make sure you get what you pay for. Beware of “closet indexers” that charge high active management fees but deliver a portfolio that looks suspiciously like their benchmark. Why not just own the benchmark instead? A metric called “active share” can help sniff out active managers who are not so active.
- Target-date funds can be a good option for automatic enrollment. Be sure to offer enough funds to provide a variety of target dates for retirement. The right target date funds can be good default investment options for employees who do not want to select their own investments.
- Target date funds can help novice investors get in and stay in the market. These set-it-and-forget strategies take care of rebalancing and shifting asset allocations for participants not interested in managing their own portfolios.
- Target date fund expenses should be scrutinized. Not all target date funds are created equal. Before including a target date fund in the line-up, compare its expenses to those of its peers. You will also need to understand how the fund works and how its “glide path” compares to other target date funds.
- Target date funds can be active or passive. You’ll need to decide which way to go.
- A “brokerage window” offers more flexibility but with higher costs. This feature can dramatically expand the investment options available to plan participants. Depending on the arrangement, employees can access hundreds or thousands of mutual funds, and even buy individual stocks.
- Beware of retail share classes when offering a brokerage window. Offering a brokerage window often means that participants will be forced to buy retail share classes which are more expensive than the institutional share classes that may otherwise be available. If you are able to implement a more limited, but lower cost fund platform, the greater flexibility of a brokerage window can come at a great cost.
- A brokerage window presents the temptation to follow fads and overtrade. How investment-savvy are your employees? Are they experienced enough to be let loose in the wild west of individual stocks and thousands of mutual funds?
- Not many employees use the brokerage window when it is available. At Vanguard, 7% of plans included a brokerage window, but only 1 out of every 100 participants actually used it. (ForUsAll’s standard 401(k) does offer a self-directed brokerage window, although not very many plan participants use it.)