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When a small business sponsors a 401(k) plan, they must make several investment-related fiduciary decisions. These decisions are rarely straight-forward due to a glut of 401(k) investment fund options and no shortage of non-fiduciary financial advisors delivering conflicted investment advice based on the amount of fund commissions.

This ambiguity is a big problem for 401(k) fiduciaries when you consider that most 401(k) fees lawsuits today relate to overpriced plan investments. To reduce their investment-related liability, 401(k) fiduciaries need simple guidance they can trust.

My recommendation for 401(k) fiduciaries? Either choose an all index fund lineup for your 401(k) plan - like the Federal Thrift Savings Plan (TSP) – or delegate your investment fiduciary responsibilities to a professional 3(38) Investment Manager.

Index Funds – market returns and lower fiduciary liability

Investment in equity index funds – and other passively-managed investments designed to track a market index – is exploding. According to a Morningstar study, these investments took in a record $504.8 billion in 2016. That’s in contrast to actively-managed funds, which are designed to outperform an index. These funds experienced outflows of $340.1 billion in 2016.

Why are investors flocking to index funds? The answer is simple – when compared to their actively-managed counterparts, index funds that track the broad stock market indices are more likely to offer superior returns, net of fees charged. According to the latest SPIVA U.S. Scorecard, over a 10-year investment horizon, 85.36% of large-cap managers, 91.27% of mid-cap managers, and 90.75% of small-cap managers failed to outperform their respective index benchmark.

If you are a small business 401(k) fiduciary, this trend is great news. While it can be difficult to insulate yourself from investment-related liability using actively-managed funds, this job can be dead simple using index funds. I’ll explain.

Minimizing investment-related 401(k) fiduciary liability

Most excessive 401(k) fee lawsuits today relate to overpriced investment funds. To reduce their investment-related liability, 401(k) fiduciaries must do two things when choosing a fund lineup for their plan:

  • Choose only “prudent” funds. Basically, a prudent fund is one that meets its investment objectives for a reasonable fee.
  • Choose at least 3 funds that allow plan participants to sufficiently diversify their account – and minimize their risk of large participant investment losses. In other words, meet ERISA section 404(c) diversification requirements.

Unfortunately, most 401(k) fiduciaries don’t know how to choose a prudent fund lineup from the tens of thousands of funds available. This issue is exacerbated by the fact most financial advisors are not subject to a fiduciary standard today - which means they can recommend funds based on commissions, not prudence.

401(k) index funds make prudent fund selection simple

The beauty of index funds from a 401(k) fiduciary perspective is that most are inherently more prudent than comparable actively-managed funds, making prudent fund selection dead simple.

This is true for the following reasons:

  • Lower fees. Most index funds are cheaper than comparable actively-managed funds due to their passive investing approach
  • Reliable returns. Most index funds deliver highly-correlated benchmark returns. This is contrast to actively-managed funds, whose returns can differ dramatically from their benchmark.

Paying more for uncertain returns is a risky bet for 401(k) fiduciaries. When 401(k) fiduciaries lose this bet – which the Morningstar study shows is likely – they increase their liability.

Picking the best 401(k) index funds

Generally speaking, comparable index funds from any of the largest providers – including Vanguard, Blackrock, Schwab, and Fidelity – offer similar (if not identical) returns and fees. In other words, it’s tough to pick a bad one.

That said, 401(k) fiduciaries should be able to confirm an index fund’s market-correlation and low fees. This is not hard.

Market correlation

To confirm an index fund’s market correlation, a fiduciary just needs to look up the fund’s Beta and R-Squared statistics – which can be found in fund fact sheets.

  • Beta is a measure of sensitivity to the correlated moves of a benchmark, a fund or asset. A beta of 1 indicates that the fund's price will move with the market.
    • A beta of less than 1 means that the fund will be less volatile than the market. A beta of greater than 1 indicates that the fund’s price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.
  • R-squared measures the percentage of a fund’s movements that can be explained by movements in the benchmark index.
    • R-squared values range from 0 to 1. An R-squared of 1 means that all movements of the fund are completely explained by movements in the index. Index funds should have a high R-squared vs. their benchmark.
    • A higher R-squared will indicate a more useful beta figure. If the R-squared is lower, then the beta is less relevant to the fund's performance.

Index funds with highly correlated returns have a 0.95-1.05 beta and 0.95-1.00 R-squared, based on trailing 36-month returns vs. the benchmark.

Low fees

A simple way to confirm an index fund’s low fee status is compare its expense ratio against its peer group. You want your fund to rank in the lowest quintile (20th percentile).

An example of an index fund lineup that delivers highly-correlated market returns with low fees can be found here.

Better returns and lower fiduciary liability. Sign me up!

In growing numbers, investors are flocking to passively-managed index funds. This success is hardly surprising when you consider these funds often outperform their higher-priced, actively-managed counterparts. This trend is great news for 401(k) fiduciaries because index funds can lower their investment-related liability.

That said, don’t take my word for it. Hire a fiduciary-grade financial advisor and see what funds they recommend for your 401(k) plan. My bet? You’ll end up with lots – if not all - index funds.

The ERISA 3(38) Investment Manager – the top choice for 401(k) advice

In recent years, several high-profile lawsuits have alleged that employers violated their fiduciary duty to prudently select and monitor their 401(k) plan fund lineup – resulting in excessive 401(k) fees due to overpriced funds. These lawsuits have targeted larger plans, but the fiduciary standards cited in these cases apply equally to both large and small business 401(k) plans.

In an attempt to reduce their investment-related liability, many 401(k) fiduciaries hire a professional financial advisor to make fund recommendations. Ironically, this advice can often make overpriced fund selection more likely because most financial advisors aren’t subject to a fiduciary standard of care today. That means they can recommend funds based on commissions, not prudence – the standard by which 401(k) fiduciaries must select funds.

Because of this issue many 401(k) fiduciaries don’t know where to turn for conflict-free advice that can keep them safe from 401(k) litigation. My recommendation if you’re a 401(k) fiduciary? Only hire financial advisors that agree to serve your plan in an “Investment Manager” capacity, as defined by section 3(38) of ERISA. 3(38) Investment Managers are subject to the same fiduciary standards as you, which means they are obligated to select funds that are in the best interest of your plan, not themselves.

Meeting the “Prudent Expert” Standard

401(k) fiduciaries are held to an extremely high standard— the “prudent expert” standard. Under this standard, a plan fiduciary must act: “. . . with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use . . .” ERISA’s standard of prudence for fiduciaries is not that of a prudent layperson, but rather that of a prudent investment professional. A lack of familiarity with investments is no excuse. If fiduciaries are unsure what to do, they are expected to retain professional advisors to make recommendations.

Types of Professional Advisors

When plan fiduciaries decide to hire a third-party professional advisor to assist with investment decisions, they generally have 3 types to choose from: 1) consultants, 2) investment advisors, and 3) investment managers. Each type assumes a different level of fiduciary liability.

  1. Consultant – Assumes no fiduciary liability for investment recommendations. Examples of a consultant include stock brokers and insurance agents. Hiring a consultant can help mitigate risk because it demonstrates plan sponsors have taken that extra step to contribute to a deliberative process. However, because consultants do not have discretionary authority and are not plan fiduciaries, the plan sponsor retains full fiduciary responsibility.
  2. ERISA 3(21) Investment Advisor – Assumes co-fiduciary liability. Has a fiduciary responsibility to deliver prudent investment advice consistent with ERISA’s fiduciary standards. While an investment advisor is liable for the investment advice they provide, the plan sponsor retains the ultimate decision-making power over plan assets. That said, the plan sponsor is not relieved of fiduciary liability for selecting and monitoring the plan’s investment options.
  3. ERISA 3(38) Investment Manager – Assumes sole fiduciary liability for investment selection and monitoring. Hiring an investment manager offers the plan sponsor the greatest protection from claims related to poor investment selection and monitoring decisions. The plan sponsor’s liability is limited to selecting and monitoring the investment manager.

Delegating fiduciary responsibilities to an ERISA 3(38) Investment Manager

The fiduciary protection provided to a plan sponsor who utilizes an investment manager is not absolute. The plan sponsor is still responsible for prudently selecting and monitoring the investment manager. Accordingly, the sponsor must select an investment manager prudently, taking into account the manager’s qualifications and all other relevant factors.

Investment managers require a specialized understanding of retirement plan rules to meet their fiduciary obligations under ERISA. An investment manager’s ERISA qualifications are even more important than investment experience or past performance. Fiduciaries don’t get sued for investment performance, they get sued for imprudent investment selection.

Not all investment managers offer the same services. Some offer plan-level services while others offer participant-level services. Plan-level services include Investment Policy Statement (IPS) preparation and ERISA 404(c) assistance while participant-level services include portfolio management and investment education.

Can You Let Go?

Once appointed, the investment manager becomes the sole decision maker for investment selection and monitoring. In other words, the plan sponsor generally has no say in matters concerning plan investments. Input from the plan sponsor may negate the fiduciary protection sought by the sponsor.

This can be a hard thing for some plan sponsors to do. That said, the trade-off could be well worth it – reduced fiduciary liability while giving employees access to professional investment advice.

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