Do your 401k plan-sponsor clients offer participants way too many investment options? Do you wonder how these investment lineups compare with the marketplace?
As president of a Registered Investment Advisory (RIA) firm that works exclusively with retirement plans, I get the opportunity to take a look at a lot of 401k plan investment menus. I am astounded that there still are 401k plans that offer 50, 75, even up to 100 investment options. Take a look below at the best practices regarding investments that I have collected over 30 years of working with 401k plans.
Keep it simple
Plan sponsors should bear in mind that participants are easily confused and discouraged by too many choices. A significant amount of research shows that the optimal number of core funds choices is around 12 to 15. Add in a set of target date funds for a total of about 25 funds. According to Vanguard, the average number of investment funds used by participants has remained constant over time at three. That’s right: three!
Consider ESG factors
Data show that millennial investors like to consider ESG (environmental, social and governance) factors when making investment decisions. Morningstar now has SRI (socially responsible investing) ratings for many mutual funds. Make sure that you share these ratings with your plan sponsor clients, as they should be considered when choosing and reviewing an investment fund lineup.
Offer only one fund per asset class
More than one choice per asset class causes participants to wonder how they should invest in the asset class. For example, should they invest 50% in each fund? It also makes participants question what sort of message plan sponsors are trying to send them. Was it too hard to pick the best fund in that asset class?
Provide at least one balanced, professionally managed option
Studies have shown that between two-thirds and three-fourths of 401k plan participants would prefer to have someone else manage their 401k plan accounts. Most participants don’t want to think about making proper allocations, rebalancing and appropriate diversification. Encourage plan sponsors to offer at least one type of balanced, professionally managed investment option (e.g., risk-based portfolios, model portfolios, balanced funds or target date funds). Target date funds are by far the most commonly offered balanced, professionally managed option.
Use a stable value or guaranteed fund option
During this low-interest rate period, some observers have implied that offering a money market fund instead of a stable value fund in a 401k plan is a fiduciary breach. Money market rates are still below 1 percent. And, institutional money market funds now have variable NAVs, redemption fees and gates. As a result, it is not appropriate, in my opinion, to offer a money market fund in a 401k plan. Plan sponsors should be advised to use either a stable value or guaranteed rate fund as the safe haven option instead.
Provide more fixed income choices
Most plan sponsors used to offer an intermediate-term bond fund and a money market fund as their only fixed-income offerings. Not only has the fixed-income market become more robust, in terms of offerings, but participants have become more conservative. Many bear the scars of the 2008-’09 crash and don’t want to become over-allocated to equity funds close to their retirement.
Unfortunately, I still see too many investment menus that only include two fixed-income investment options. Make sure plan sponsors offer participants a 401k plan providing at least four. Typically these include a stable value or guaranteed fund option, intermediate-term bond fund (actively managed or index), high-yield bond fund and international bond fund.
Offer index options
A number of 401k participants believe that index investing is the only way to invest. Vanguard, through its “Total” index fund options, essentially allows an investor to index nearly the entire stock and bond market with its Total Stock, Total Bond and Total International index funds. These are three of the most popular mutual funds in the world.
So, plan sponsors could stop right there and offer just three index funds in a 401k plan. Or sponsors could offer a separate index fund for nearly every asset class. Regardless of the chosen approach, since passive investment management has beaten active recently, sponsors need to offer a selection of index funds in 401k plans.
Always use the cheapest share class
The most frequent cause of 401k plan litigation has been the use of more expensive mutual fund share classes by plan sponsors when cheaper share classes have been available. Make absolutely certain that plan sponsor clients are offering the cheapest share class a plan is eligible to use. In terms of fiduciary duty, this is the most important fiduciary compliance item. Emphasize the significance of investment advisors performing this analysis each time he/she produces a set of reports.
Keep diversification in mind
Plan sponsors should offer a wide variety of fund choices based on investment objective and risk profile so plan participants who wish to invest on their own may achieve an appropriately diversified allocation. Advise sponsors to use the “style box” approach and not to forget about commodities, real estate and international fund options.
Select a QDIA
Sponsors must designate a Qualified Default Investment Alternative (QDIA) for their plan. For most 401k plans, this will turn out to be a set of target date funds. Those participants who are unsure where to invest, or for whom investment elections aren’t immediately available, will end up investing in this option. Inform plan sponsors that he/she will receive safe harbor protection from participant lawsuits when they invest participant contributions in a QDIA if they have not received investment direction.
Elect to comply with section 404(c)
By complying with ERISA section 404(c), note that plan sponsors can shield themselves from lawsuits originating from plan participants with regard to the fund lineup.
Investigate using CITs
If a plan sponsor client has a larger plan (with at least $50 million invested in target date funds), consider advising them to offer Collective Investment Trust (CIT) target date funds. Using CITs can reduce participant costs by as much as 50 basis points in comparison with the lowest-cost actively managed target date options.
Consider passively managed TDFs
There are a number of target-date fund series that use index funds as their underlying investments. If a 401k plan is smaller and sponsors can’t use CITs as the target date option, they might consider using one of these target-date series.
A Couple of “Don’ts…”
Don’t use funds that require synthetic benchmarks
I have never understood why some plan sponsors feel they need to use uniquely constructed investment options without publicly available benchmarks. I assume they work with very persuasive investment advisors who talk them into it. These investment options are not cheaper than other alternatives. Participants should be suspect of funds that have benchmarks that are “specially constructed” for his/her fund. They can easily be manipulated (also known as “fine-tuned”) when they aren’t yielding the results desired by an investment advisor.
Don’t white label your investment funds
White labeling is the process of purposely hiding the true identity of the investments that underlie a particular investment option in a 401k plan. In an era of transparency, I have never understood why a plan sponsor would want to do that. Again, I feel that these plan sponsors work with very persuasive investment advisors who feel this is a lower-cost approach. It isn’t. In addition, it is confusing to participants and leads to lack of trust. Hiding something usually implies that there is something wrong. So why would you purposely hide the identity of investment options that perform well?
In both of the “don’ts” above, I believe plan sponsors are taking on more liability when they use unique funds without publicly available performance and benchmark data.
How do your clients’ investment fund menus compare?
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs, and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.
I am amazed as well that I still see so many funds in a plan. I met with a prospect last week who has 62 funds available in his plan. Many of them sub-advised funds for the record-keeper and 3-5 funds per category. All of that for a 16 participant, $2,000,000 plan. It all adds up to a high cost, low quality plan. A typical plan for us includes 17 funds (from 17 categories), a TDF series, and then models that we manage made up of the 17 funds in the plan, which end up being the primary investment vehicle of the participants. Keep it simple and straight-forward.