At least once a year plan sponsors and/or other plan fiduciaries should take a critical look at their investment fund lineups. Eight items that are normally considered in a review include:
1. Investment tracks. An investment track is a group of investment funds that appeal to a particular type of investor. It's become common for 401(k) plan menus to feature the following investment tracks: core funds, index, specialty and target date.
For example, there are investors who believe index investing is the way to go. They believe that active managers don't beat the market frequently enough to justify their higher cost. Therefore, index funds will be the only investment funds in a plan that will interest this group of investors. Highlighting these funds in your employee education materials for the index investor group will help them identify their index fund track. Talking directly to each of these investor types during employee education sessions will help them understand which funds are in the tracks that appeal to them.
2. Traditional asset classes. Most retirement plan lineups have a hole or two in their menus. Typically, at least one fund per style (value, blend and growth) is offered in each of the following capitalization sizes: large cap, mid cap and small cap. Doing a little quick math yields a total of nine funds to cover all of these categories. Your core funds investors will be looking for these funds to properly diversify their account balances.
3. Commodities funds. Most of the clients that I work with offer investment menus that feature at least two commodities funds. These typically include a general commodities fund and a real estate fund. Offering these fund options broadens the spectrum of asset classes represented in your menu and can decrease overall portfolio risk for investors in your plan (if used properly). However, investors should keep in mind that commodity funds may be more volatile than traditional investments and that commodity funds often use leverage to magnify returns (and therefore potential losses). Investors should also be aware that the values of real estate funds can be affected by interest rates, property tax rates and changes in supply and demand.
4. International equity options. There are three ways of looking at international equity funds at the moment: developed/emerging markets, growth/value and world/foreign.
Investors who prefer to view the world through a developed/emerging markets lens typically see developed international markets as Europe, Japan and Hong Kong, while emerging market countries normally include the BRIC nations (Brazil, Russia, India and China).
International growth/value investors believe that it's possible to identify international companies by investment style, either growth or value.
World/foreign investors believe in funds that include companies in the United States (a world approach) and funds that don't (the foreign approach). Employees should be aware that international investing is subject to additional risks, including currency fluctuation, political risk and lack of liquidity. These risks may be even greater in emerging markets funds.
5. Fixed-income options. Most investment fund menus I work with feature fixed-income options from the following categories: Money market/stable value, intermediate bond, high-yield bond and internationalbond. In addition, given how some investors feel about inflation, it's not uncommon to see an inflation-protected bond option or TIPS investment option as well. While these two types of fixed-income funds try to offer investors protection against rising inflation, they are subject to interest rate, credit and reinvestment risks.
6. Index funds. Many retirement plans now feature up to three index fund options. Included in this group are large-cap, mid-cap and small-cap options. These tend to be very cost-efficient equity options for your participants.
7. Target-date funds. Target-date funds have become one of the most popular fund options in many retirement plans, gathering the most assets and the most participants. I believe that every 401(k) plan will soon offer a set of target-date funds. An advisor can help you select and monitor an appropriate target-date fund family based on risk tolerance since these funds are subject to the risks attendant to the underlying funds in which they invest.
8. Communication materials. How effectively you are communicating your lineup to plan participants directly impacts participation rate, employee satisfaction and overall understanding of the plan. It's a good idea to check both the written materials that are shared with new enrollees and your website presentation. It will be helpful for most participants if you clearly outline the investment tracks that are available.
If you were to offer only one fund in each of the categories listed above, you could easily end up with a lineup that includes up to 20 investment funds, not including target-date funds. For many larger plans, this is an appropriate number of investment funds to offer. In fact, a 2009 survey by Watson Wyatt (now Towers Watson) indicated that 69% of plan sponsors offered their employees up to 19 investment options. However, sponsors of smaller plans may want to consider offering fewer investment options.
There are good reasons for you to take a look at your investment menu annually. The Department of Labor requires you to offer an investment menu that is appropriate and provides the opportunity for diversification. Remember when looking at your investment menu to consider both fund performance and overall quality and appropriateness.
Contributing Editor Robert C. Lawton is an independent consultant based in Hales Corners, Wis. He has over 25 years of experience working with retirement plan sponsors and is a Chartered Retirement Plan Specialist and Accredited Investment Fiduciary. Lawton holds Series 7, 31 and 66 licenses and may be reached at firstname.lastname@example.org.
At a glance
Eight considerations when reviewing your investment fund lineup include:
2. Traditional asset classes.
3. Commodities funds.
4. International equity options.
5. Fixed-income options.
6. Index funds.
7. Target-date funds.
8. Communication materials.
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