What are the best funds for your 403(b) plan?

If your non-profit offers a 403(b) retirement plan, one of your greatest responsibilities is choosing the right investment options. Your employees are relying on you to make good fund choices for the 403(b) – but how do you do that?

How an investment policy statement can help you choose good funds for your 403(b)

If you have an investment policy statement it may provide you with guidance in this regard. Typically, an investment policy statement will explain the process for selecting and monitoring plan investments. It may even instruct on how to hire and monitor investment managers, when to remove funds from the line-up, or when replacing a manager may be necessary.

Whether you have a low-cost off-the-shelf plan, or have taken a more expensive customized approach, you should understand the risks and potential benefits associated with your investment line-up. After all, unless you are working with a 403(b) advisor who is taking on the investment fiduciary responsibilities, the plan sponsor is responsible for the investments offered in the 403(b) plan.

10 things to consider trying to choose the “best” 403(b) investment options

1. Passive funds are cheaper. Generally, index funds are the least expensive option in any asset class. These passive funds can offer low fees because their job is to “look like” a pre-defined index. As a result, there are typically fewer fund managers and analysts required to manage the fund compared to an actively managed fund. Several studies have shown that low-cost index funds typically outperform actively managed funds as well. Read our take on active vs. passive funds in retirement accounts to help figure out if passive funds are a good fund choice for your 403(b).

2. Not all index funds offer the lowest fee. Certainly funds that replicate major indexes like the S&P 500 or the Russell 1000 are typically very inexpensive. However, new indexes are created all the time, and some are in niche areas. These types of funds can be more expensive than traditional index offerings. They can even be more expensive than actively managed funds. When it comes to new-fangled index products, buyer beware.

3. Index funds can provide precise diversification. Your investment policy statement may call for certain asset classes to be available to employees. Since the components of a passive 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 that your plan documents require. Active managers, by their nature, are not nearly as predictable.

4. Make sure to offer enough bond funds. Many participants will want at least some allocation to fixed income. But they may need different maturity structures to accomplish their objectives. So a single bond fund may not be suitable for all investors. You may want to include short term, intermediate, and long term bond funds in your retirement plan to ensure participants have flexibility in building their asset allocation. Because different investors may have different bond duration needs, there is not likely to be a single, best fund for your 403(b) in this particular asset category.

5. Actively managed funds need additional vetting. If you choose to include actively managed funds, get ready to do your homework. There is an entire industry devoted to selecting active managers, so make sure you have the time to take on this endeavor. If you are ultimately responsible for the investments in your plan, you will need to understand what makes a particular actively managed fund desirable. You may want to examine quantitative factors like performance vs. peers and vs. an appropriate benchmark. You may also want to check out volatility and performance in down markets. But qualitative factors can be important as well. These include such factors as manager tenure, the management team’s combined experience, and the team’s investment process. Be sure you can justify the higher fees that typically come with actively managed funds. If you do go the active route, be sure to document your selection criteria.

6. Active funds may not be as active as you think. If you decide to include actively managed funds in your retirement plan’s line-up beware of “closet indexers.” Some managers charge high active management fees but deliver a portfolio that looks suspiciously like the benchmark. Might as well just own the benchmark! A metric called “active share” can help you spot active managers who are not so active.

7. Target date funds can be a good option for automatic enrollment.The right target date funds can be good default investment options for employees who do not want to select their own investments. They are also appropriate for employees who have no interest in shifting their allocation over time.

8. Target date funds can help new investors get invested and stay invested. These set-it-and-forget strategies do the rebalancing and asset allocation shifts for your employees.

9. Target date fund expenses should be reviewed closely. Not all target date funds are the same. Before including a target date fund in the line-up, be sure to compare its expenses to those of its peers. Make sure to understand the fund’s “glide path” and how that compares to other target date funds. A target date fund may charge a fee in addition to the fees associated with each individual fund. Be sure to understand all expenses associated with the target date funds in your plan before you decide which are the best ones for your non-profit employees.

10. Target date funds can be active or passive, or even some combination. You’ll need to decide which way to go.