As president of a Registered Investment Advisory (RIA) firm that works exclusively with retirement plans, I am often asked for my thoughts on a firm’s 401k investment menu. I am astounded that there still are 401k plans that offer 50, 75, even up to 100 investment options.
Does your plan’s 401k investment menu provide way too many investment options? Do you wonder how your 401k investment menu compares with the marketplace? Take a look below at the best practices regarding investments that I have collected over 30 years of working with 401k plans.
401k Investment Menu Best Practices
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 in a 401k investment menu 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 401k investment menu.
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 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. Make sure your 401k investment menu 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 401k 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 is not appropriate, in my opinion, to offer a money market fund in a 401k investment menu. 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 401k 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 401k 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 401k plan.
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 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 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. 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 401k 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 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 does your investment fund menu 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 email@example.com.
Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or firstname.lastname@example.org or visit the firm’s website at: http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges, and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.