10 best practices for 401(k) investment menu selection

How does your investment fund line-up compare to the marketplace? Do you have too many investment options or too few? Are you taking advantage of all the safe harbor options available to you? In this low return, low interest rate environment there is a new set of best practices to use for 401(k) plan menu construction that includes:

1. 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?

2. A professionally managed option. Studies have shown that between two-thirds and three-quarters of plan participants would prefer to have someone else manage their 401(k) plan accounts. Make sure your plan offers at least one type of professionally managed investment option (e.g., risk-based portfolios, model portfolios, balanced funds or target-date funds). The most commonly offered professionally managed option, by far, is target-date funds.

3. Diversity. Offer a wide variety of fund choices based on investment objective and risk profile so that those participants who wish to invest on their own may achieve an appropriately diversified allocation. Use the "style box" approach and don't forget about commodities, real estate and international fund options.


4. A stable value or guaranteed fund option. With money market funds paying close to nothing and variable NAVs, redemption fees and gates on the horizon, it is currently not appropriate to offer a money market fund in a 401(k) plan. Offer either a stable value or guaranteed rate option instead.

5. At least three conservative choices. Post-crash most participants have become more conservative. Many say they will never again have equity allocations as high as they once did. Offer at least three conservative fund choices. Typically these would include a stable value or guaranteed fund option, intermediate-term bond fund (actively managed or index), high-yield bond fund and/or international bond fund.

6. Index options. A number of your participants believe that index investing is the only way to invest. Offer a sufficient number of index fund options to allow participants to index invest in U.S. bonds, U.S. stocks and international equities.

7. Keep it simple. Participants are easily confused and discouraged by too many choices. Target 12 to 15 core fund options plus a set of target-date funds for a total of around 25 funds. Keep in mind that, according to Vanguard, the average number of investment funds used by participants has remained consistent over time at three.

8. A QDIA. Designate a qualified default investment alternative. For most 401(k) 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.

9. Use the cheapest share class. Many mutual funds offer a number of different share classes which have different costs. Make sure that you select the share class for each fund offered that is the lowest cost.

10. Elect to comply with section 404(c). By complying with ERISA section 404(c), plan sponsors can shield themselves from lawsuits originating from plan participants with regard to the fund line-up.

In addition, plan sponsors may want to consider the following:

· CITs. If you are a plan sponsor with a larger plan (with at least $50 million invested in target-date funds), consider offering collective investment trust target-date funds. Using CITs can reduce participant costs by as much as 50 basis points in comparison to the lowest cost target-date options.

· Passively managed TDFs. There are a number of target-date fund series that use index funds as their underlying investments. If your 401(k) plan is smaller and you can't use CITs as your target-date option, consider using one of these target-date series.

· Cultural factors. Some plan sponsors prefer to see at least one ESG (i.e., environmental, social and governance) investment option, while others believe in offering less volatile fund choices. Knowing what your employees will appreciate is important in creating a menu they value.

How does your investment fund menu compare?

For reprint and licensing requests for this article, click here.