401(k) best practices: Investments
As president of a registered investment advisory firm that works exclusively with retirement plans, I get the opportunity to take a look at a lot of employers’ 401(k) plan investment menus. I am astounded that there still are 401(k) plans that offer 50, 75, even up to 100 investment options.
Does your 401(k) plan offer way too many investment options? Do you wonder how your investment lineup compares with the marketplace? Take a look below at the best practices regarding investments that I have collected over 30 years of working with 401(k) plans.
Keep it simple. 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. Keep in mind that, 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 participants. You should also begin to consider these factors when choosing and reviewing your 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 you 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 401(k) plan participants would prefer to have someone else manage their 401(k) plan accounts. Most participants don’t want to think about making proper allocations, rebalancing, and appropriate diversification. Make sure your plan offers 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 401(k) plan is a fiduciary breach. Money market rates are still below 1%. And, institutional money market funds now have variable NAVs, redemption fees, and gates. As a result, it’s not appropriate, in my opinion, to offer a money market fund in a 401(k) plan. Use either a stable value or guaranteed rate fund as your 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 your 401(k) plan provides 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 your 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 you could stop right there and offer just three index funds in your 401(k) plan. Or you could offer a separate index fund for nearly every asset class. Regardless of your approach, since passive investment management has beaten active recently, you need to offer a selection of index funds in your 401(k) plan.
Always use the cheapest share class. The most frequent cause of 401(k) 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 you are offering the cheapest share class your plan is eligible to use. In terms of your fiduciary duty, this is your most important fiduciary compliance item. Hold your investment adviser responsible for performing this analysis each time he/she produces a set of reports.
Keep diversification in mind. 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.
Select a QDIA. Designate a Qualified Default Investment Alternative (QDIA) for your plan. 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. You receive safe harbor protection from participant lawsuits when you invest participant contributions in a QDIA if you have not received investment direction.
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 lineup.
Investigate using 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 (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 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.
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. You should be suspect of funds that have benchmarks that are “specially constructed" for your fund. They can easily be manipulated (also known as “fine-tuned”) when they aren't yielding the results desired by your 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 401(k) 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 does your investment fund menu compare?
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC.