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401(k) Investment Basics for Employers

Employers must make certain investment-related decisions on behalf of their 401(k) plan participants. Because this decision-making can result in very different participant returns, employers have a fiduciary responsibility to make “prudent” investment decisions. Otherwise, they can be personally liable for restoring unreasonable participant losses.

Fortunately, prudent 401(k) investment decision-making does not need to be difficult or time-consuming. All 401(k) plans require just two basic investment decisions:

  • Picking a fund lineup and
  • Choosing a form of professional investment advice for participants.

Making these important decisions can be straightfoward when employers understand their options.

ERISA responsibilities related to 401(k) investment decision-making

Believe it or not, ERISA imposes few investment-related 401(k) fiduciary responsibilities on employers. They boil down to picking – and maintaining - enough “prudent” investments to allow plan participants to diversify their account “so as to minimize the risk of large losses.” Prudent 401(k) investments are simply funds that meet their investment objective for reasonable fees.

Picking a fund lineup

There are literally thousands of 401(k) investment funds available. All of these options can make investment selection overwhelming for many employers. 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 – employers 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 - including the employer - 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.
    • 401(k) fiduciaries 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 401(k) 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. In general, index funds cost less than "comparable" actively-managed funds - basically, active funds with a similar market benchmark.

    If a 401(k) 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 comparable index funds - most don't over time, net of fees. Using actively-managed funds also requires much more sophisticated monitoring to ensure investments outperform their index benchmarks.

    We like to consider index funds a baseline for 401(k) 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. Click here to view an example of a low-cost index fund lineup. 

Choosing a form of professional investment advice

Participant investment advice is important. An Aon Hewitt study found that median investment returns for 401(k) 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 succeed.

Generally-speaking, there are two ways 401(k) 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 401(k) participation via more personalized advice.

Don’t be confused - know your options!

We meet a lot of employers confused about the investment decisions they need to make for their 401(k) plan. We get it. There is a dizzying array of 401(k) investments and services available. However, this process doesn’t need to be overwhelming. The key for employers is breaking this process into its two basic decisions and knowing the options for making these decisions.