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3-Step Guide for Employers to Select and Monitor 401(k) Index Funds Blog Feature
Eric Droblyen

By: Eric Droblyen on November 1st, 2017

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3-Step Guide for Employers to Select and Monitor 401(k) Index Funds

index funds | Investments | Financial Advice

Index funds not only offer 401(k) participants superior returns to comparable actively-managed funds net of fees, they are a clear and simple way for 401(k) sponsors to meet their investment-related fiduciary responsibilities.  Sponsors need only select three or more prudent investments that allow plan participants to sufficiently diversify their accounts.  Index funds are indisputably “prudent” by meeting their investment objective for market-correlated returns at reasonable fees.

All of the nation’s largest index fund providers – including Vanguard, Blackrock and Schwab – offer excellent choices.  Returns match benchmarks and fees are low across the board.  These index funds are in sharp contrast to comparable actively managed funds, whose returns and fees can differ dramatically.

As an employer, you can’t just randomly choose index funds for your 401(k) to meet prudent standards.  You need a process for selecting and monitoring a basket of funds to meet investment-related fiduciary responsibilities for requiring diversification and ongoing monitoring.  This process can be completed in 3 steps.


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Step 1 - Establish a basic investment policy

It’s a fiduciary best practice to have an investment policy for your 401(k) plan. While I strongly recommend a formal written Investment Policy Statement (IPS) for 401(k) plans with actively-managed funds – because a process for selecting, monitoring and replacing active managers can be technically-complex – I think a formal IPS can be overkill for 401(k) plans with an index fund line-up. Instead, these plans can have a simple investment policy (written or not) with just 3 basic objectives:

  1. Diversification – Investments must provide participants with different, internally diversified alternatives with materially different risk and return characteristics.
  2. Market returns – Investments must offer returns that closely correlate to a target benchmark over time.
  3. Efficiency – Investments must possess low expenses that reduce drag on returns.

Step 2 - Select funds that meet your policy

To meet the objectives of your index fund investment policy, you want to select funds for your 401(k) plan that meet the following requirements:

Diversification

ERISA 404(c) states you must offer a diversified range of investment alternatives with differing potential for investment risk and return. Only three investment alternatives are required to meet the requirements, and it is satisfied by offering funds that cover equity (stocks), fixed income (bonds), and capital preservation asset classes.

Your 401(k) plan can meet its diversification objective by selecting at least 3 funds that satisfy the basic diversification requirements of ERISA 404(c).

Market Returns

Index funds attempt to track the performance of a particular stock or bond index, such as the S&P 500 Index.  To measure whether an index fund’s returns closely correlate to their target benchmark, you want to evaluate the fund’s Beta and R-Squared results – which can typically be found on the fund company’s website.

Your 401(k) plan can meet its market returns objective by only using index funds with a beta between 0.90-1.10 and R-squared between 0.90-1.00, based on trailing 36-month returns vs. the benchmark.

Efficiency

You have a fiduciary responsibility to keep your 401(k) plan’s investment fees reasonable because the cumulative effect of excessive fees can dramatically reduce the retirement savings of plan participants.

Your 401(k) plan can meet its efficiency objective by only using index funds ranked in the lowest quintile (20th percentile) of its peer group.

Step 3 – Ongoing monitoring

Once you’ve selected funds for your 401(k) plan, you have a responsibility to monitor these funds periodically to ensure they continue to meet the objectives of your investment policy. You should complete this monitoring at least annually.

Below is a sample monitoring report for an index fund lineup that meets diversification, market returns and efficiency investment objectives:  

Name

Symbol

Benchmark

Fund Return

Benchmark

Beta

R2

Exp Ratio

Morningstar Rating(1)

Vanguard Federal Money Market Fund(2)

VMFXX

US Gov't Money Market Funds Average

0.24%

0.11%

N/A

N/A

0.11%

Not Rated

Vanguard Total Bond Market Index Fund

VBTLX

BloomBarc U.S. Aggregate Float Adjusted Bond Index

0.73%

0.83%

1.03

0.99

0.05%

Low

Vanguard 500 Index Fund

VFIAX

Standard & Poor's 500 Index

4.48%

4.48%

1.00

1.00

0.04%

Low

Vanguard Extended Market Index Fund

VEXAX

Standard & Poor's Completion Index

4.96%

4.96%

1.00

1.00

0.08%

Low

Vanguard Total International Stock Index Fund

VTIAX

FTSE Global All Cap ex US Index

5.95%

6.02%

0.94

0.98

0.11%

Low

Vanguard Inflation-Protected Securities Fund

VAIPX

BloomBarc U.S. Treasury Inflation Protected Index

0.79%

0.86%

1.02

0.99

0.10%

Low

Vanguard Total Stock Market Index Fund

VTSAX

CRSP U.S. Total Market Index

4.54%

4.55%

1.00

1.00

0.04%

Low

Vanguard Total International Bond Index Fund

VTABX

BloomBarc Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged)

0.69%

0.72%

0.99

1.00

0.12%

Low

Vanguard Growth Index Fund

VIGAX

CRSP U.S. Large Cap Growth Index

4.85%

4.86%

1.00

1.00

0.06%

Low

Vanguard Value Index Fund

VVIAX

CRSP U.S. Large Cap Value Index

4.16%

4.14%

1.00

1.00

0.06%

Low

Vanguard Target Retirement Income Fund

VTINX

Target Retirement Income Composite Index

1.96%

2.04%

0.98

0.99

0.13%

Low

Vanguard Target Retirement 2015 Fund

VTXVX

Target Retirement 2015 Composite Index

2.61%

2.65%

0.98

0.99

0.14%

Low

Vanguard Target Retirement 2020 Fund

VTWNX

Target Retirement 2020 Composite Index

3.14%

3.20%

0.98

1.00

0.14%

Low

Vanguard Target Retirement 2025 Fund

VTTVX

Target Retirement 2025 Composite Index

3.52%

3.58%

0.97

1.00

0.14%

Low

Vanguard Target Retirement 2030 Fund

VTHRX

Target Retirement 2030 Composite Index

3.88%

3.91%

0.97

1.00

0.15%

Low

Vanguard Target Retirement 2035 Fund

VTTHX

Target Retirement 2035 Composite Index

4.18%

4.24%

0.98

1.00

0.15%

Low

Vanguard Target Retirement 2040 Fund

VFORX

Target Retirement 2040 Composite Index

4.51%

4.57%

0.98

1.00

0.16%

Low

Vanguard Target Retirement 2045 Fund

VTIVX

Target Retirement 2045 Composite Index

4.66%

4.71%

0.98

1.00

0.16%

Low

Vanguard Target Retirement 2050 Fund

VFIFX

Target Retirement 2050 Composite Index

4.66%

4.71%

0.97

1.00

0.16%

Low

Vanguard Target Retirement 2055 Fund

VFFVX

Target Retirement 2055 Composite Index

4.69%

4.71%

0.97

1.00

0.16%

Low

Vanguard Target Retirement 2060 Fund

VTTSX

Target Retirement 2060 Composite Index

4.65%

4.71%

0.98

1.00

0.16%

Low

(1)Capital preservation alternative. Not an index fund.

(2)This is a proprietary Morningstar data point. A "Low" rating means fund's expense ratio ranks in the lowest quintile (20th percentile).

Index funds are a 401(k) win-win!

Index funds make it easy for 401(k) participants to earn diversified market returns cheaply. Their attributes also make it easy for 401(k) sponsors to meet their investment-related fiduciary responsibilities. In short, they can be a win-win for both parties.


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About Eric Droblyen

Eric Droblyen began his career as an ERISA compliance specialist with Charles Schwab in the mid-1990s. His keen grasp on 401k plan administration and compliance matters has made Eric a sought after speaker. He has delivered presentations at a number of events, including the American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. As President and CEO of Employee Fiduciary, Eric is responsible for all aspects of the company’s operations and service delivery.

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