Selecting 401k Service Providers: Determine the Professional Help You Need Before You Shop
Selecting competent service providers is the most important - and most confusing - fiduciary duty of a 401k sponsor. Why? Services offered by 401k providers can vary dramatically in breadth, depth and price. This variability makes it difficult for 401k sponsors to match appropriate services to plan needs. Many small business 401k plans pay for superfluous services participants do not use. These excess services are often expensive, dragging down participant investment returns and creating potential personal fiduciary liability for the 401k sponsor.
If you sponsor a 401k plan, I recommend following a two-step process to ensure your plan does not pay fees for services your participants will not use: 1) understand the services that compose a 401k plan and 2) determine which of these services require professional assistance to deliver. Once this process is complete, you’ll be ready to shop for professional service providers.
Step 1 – Understand 401k services
Every 401k plan requires multiple services. These services fall into two categories, plan administration or investment management.
a. Plan administration services include:
- Custody – to hold plan assets in a trust and execute trades
- Recordkeeping – to track contributions, earnings and investments on a participant-level and direct the custodian to execute trades
- Third-Party Administration (TPA) – to complete plan design and annual ERISA compliance (testing, Form 5500, plan document maintenance, participant notices)
b. Investment management services include:
- Plan-level services – to select a fund lineup for participants to choose from
- Participant-level services – to assist participants in choosing investments for their account
Step 2 – Determine the 401k services for which professional assistance is needed
- Plan administration services
Virtually every 401k plan today outsources plan administration services to a professional service provider because it’s rarely cost effective to do this work in-house - recordkeeping software is expensive, while securities trading and ERISA compliance requires years of specialized experience.
The question is not whether your plan needs a professional plan administration service provider, but how many it needs – it can sometimes take more than one provider to deliver plan administration services. While Employee Fiduciary provides all 3 plan administration services, many providers just offer 1) custody and recordkeeping (“recordkeeping only”) services, or 2) TPA services. When a provider fails to offer all 3 plan administration services, a second provider must be found to deliver the missing service(s).
- Investment management services
While a professional service provider is required nearly 100% of the time to deliver plan administration services, the same is not true for investment management services – a professional financial advisor may not be required. To make this determination for your plan, consider:
- Your plan’s investment objectives
- The type of investment advice wanted for participants
Plan investment objectives
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.
Why are index funds growing in popularity? While it may seem counter-intuitive, a growing body of academic research has shown that index funds outperform most of their actively-managed counterparts over decades of 401k investing, particularly after all fund expenses are considered.
If you prefer index funds, a financial advisor may not be required because it’s not difficult to pick funds that deliver “market returns.” An example of an all index fund lineup can be found here.
If you prefer actively-managed funds, use of a 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 benchmark and peer group averages. Fiduciary liability can result if high-priced actively managed funds underperform their lower-priced index fund counterparts.
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 deliver participant investment advice today:
- Design-based – TDFs or Target Risk Funds (TRFs) are included in a fund lineup to give participants access to professionally-managed investment portfolios. Participants invest 100% of their account in the most applicable fund.
- Advisor-based - A financial advisor is hired to either construct custom TDFs or TRFs for participants to select or give one-on-one investment advice.
If you prefer more customized investment advice, you should hire a professional financial advisor.
Once you’ve determined the professional services your 401k plan needs, you are ready to start shopping for service providers. While interviewing service provider prospects, confirm they deliver the services you want and their “all-in” fee for these services. After speaking to multiple prospects, compare their services.
Once you have taken these steps, your plan should be paying reasonable fees for the professional help it needs, improving participant returns while mitigating your fiduciary liability.
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.