Picking 401k Investments and Related Services Is Easy When Fiduciaries Know Their Options
When a small business sponsors a 401k plan, several investment-related decisions must be made by fiduciaries. Dramatically different fees and expenses can result from this decision-making, so fiduciaries should know their options in order to make “prudent” decisions on behalf of plan participants – an obligation under ERISA. Otherwise, personal liability can result.
Fortunately, prudent 401k investment decision-making does not need to be difficult or time-consuming. All 401k plans require just two basic investment decisions:
- Pick a fund lineup and
- Choose the nature of participant investment advice to offer.
These important decisions can be simple to make when plan fiduciaries know their options.
ERISA responsibilities related to 401k investment decision-making
Plan fiduciaries have 2 primary ERISA responsibilities when making 401k investment decisions - a) pick funds that allows participants to sufficiently diversify their accounts (and minimize the risk of large investment losses) and b) ensure participants only pay reasonable fees and expenses for investments or investment-related services.
Pick a fund lineup
There are literally thousands of 401k investment funds available. All of these options can make investment selection overwhelming for many plan fiduciaries. It doesn’t need to be. ERISA has very basic diversification requirements and fund selection can be easy when simple benchmarks are used to qualify funds.
- 404(c) diversification requirements – plan fiduciaries want to pick a fund lineup that meets ERISA section 404(c) diversification requirements. Why? Because when all 404(c) requirements are met, plan fiduciaries are relieved of liability resulting from participant investment losses.
- To qualify for 404(c) relief, a fund lineup must include at least 3 core options with materially different risk and return characteristics. Generally, a lineup that includes equity (stock), fixed income (bond), and capital preservation (money market or stable value) funds satisfies this requirement.
- A 401k fiduciary can pick additional funds, but they are not obligated to do so to meet ERISA diversification requirements.
- Index funds as a benchmark for fund selection. For decades, actively-managed mutual funds were the most popular type of investment used by 401k plans. Actively-managed mutual funds employ portfolio managers to attempt to select stocks that beat market benchmarks like the Standard & Poor’s 500.
Recently, however, passively-managed index funds have grown increasingly popular. In contrast to actively-managed funds, Index funds try to track (not beat) the performance of a particular market benchmark—or "index"—as closely as possible. Generally speaking, index funds are less expensive than actively-managed funds.
If a 401k fiduciary prefers actively-managed funds, hiring a professional financial advisor is highly recommended. It takes a lot of skill to consistently pick actively-managed funds that outperform their index fund counterparts. Using actively-managed funds also requires much more sophisticated monitoring to ensure investments outperform their index benchmarks.
I like to consider index funds a baseline for 401k investments – participants should never earn less than index fund returns. Further, fiduciary liability can result if high-priced actively managed funds underperform their lower-priced index fund counterparts. An example of a low-cost index fund lineup can be found here.
Choose the nature of participant investment advice
Participant investment advice is important. An Aon Hewitt study found that median investment returns for 401k participants using Target Date Funds (TDFs), managed accounts and personal investment advice were 3.32% greater than returns earned by participants that picked an investment portfolio themselves. In short, professional advice is proven to help participant investing success.
Generally-speaking, there are two ways 401k plans provide investment advice to participants today:
- Fund-based – a TDF family is added to a fund lineup to give participants access to professionally-managed investment portfolios. Participants can then invest 100% of their account in the TDF that best matches their estimated retirement date.
- Advisor-based - A professional financial advisor is hired to either 1) construct custom TDFs or TRFs or 2) give one-on-one investment advice.
Both approaches have merit. While the fund-based model is generally less expensive, the advisor-based model can help increase 401k participation via more personalized advice.
Don’t be confused - know your options!
I meet a lot of plan fiduciaries confused about the investment decisions they need to make for their 401k plan. I get it. There is a dizzying array of 401k investments and services available. However, this process doesn’t need to be overwhelming. The key for fiduciaries is breaking this process into its two basic decisions and knowing the options for making these decisions.
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.