Many companies are saddled with what most investment pros would say are average 401(k) fund options, and this problem compounds into much lower savings for employees. Oh, this includes the owners who often have the biggest 401(k) balances.
The good thing is you don’t need to be an investment pro to understand why that is and how you can ensure your company has best-in-class investment roster. Yet, you do need some insights to know how to uncover it and improve your 401(k). Here’s the “inside baseball” view on 401(k) investment management in this 7-minute read.
How Average Funds Fail You and Your Employees
As ShareBuilder 401k, we get to review plans from companies that are considering switching. When these decision-makers take the time to understand the facts, they often do switch. Of course, service is essential, and in addition, the investment line-ups standout as lacking. Many have higher than needed fund expenses, funds with average performance that are materially worse than index funds, and moreover, are missing some key asset classes.
So, what’s the big deal? How about having $350K to $1M less in your retirement savings over a career of 401(k) investing? Oh, and the same is true for each one of your employees. That’s a huge deal.
Even a 1% difference in expenses if performance happened to be equal or vice versa is dramatic.
This is a hypothetical example. Scroll to the bottom for assumptions.
Plus, when you have higher expense funds you often have average funds that perform much worse that the best-in-class index funds. This can make it a 2%-7% difference, and what you see above can double, triple the difference, or worse.
Let’s look at an example where we evaluated a company’s plan line-up and zero in on comparing the average weighted fund expense ratio based on assets of the plan versus the expense ratio of funds in a ShareBuilder 401k plan (what we consider a high-quality fund line-up):
It's clear the fund expense ratios are higher than necessary.
Let's look at performance. Here we examine the top 5 funds holding >53% of the money in the plan versus the ShareBuilder 401k fund in the same asset class over 3-, 5- and 10-year periods of time. With the exception of Large-Cap Blend, all the other funds underperformed by at least 1% and several by 7%+ over multiple periods. That's downright poor.
Further, the plan is missing important asset classes or using ones not defined in their investment policy statement (IPS) which can be a compliance problem.
You might say that this plan is a one-off, but it's not. Of the last 25+ plans we've reviewed this quarter, this is typical. There are a few good line-ups we've ran comparisons against, but those are the exceptions.
While no one can predict future performance, we take an expert parameter-based approach that considers fund expenses, performance over multiple periods, risk, and liquidity. It’s a process that focuses on finding the highest-quality fund for the asset class versus a “good” enough fund. We define high-quality funds and the high level process to identify them at the bottom of this article for reference.
Let's go deeper into what drives the differences in 401(k) investment lineups.
The Rules, Philosophy and Policy for Determining Investments in 401(k) Plans
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that sets minimum standards for most voluntarily established retirement such as 401(k) plans in private industry to provide protection for employees in these plans. ERISA requires a prudent expert to determine the fund line-up in a 401(k) and requires the investments to offer diversification to help minimize large loss. It’s pretty awesome these rules exist or what we described above would likely be even worse.
The investment fiduciary must select and monitor ongoing the investment line-up available to employees to select to ensure they meet this standard. There are other fiduciary duties a company and/or its hired advisors take on to keep costs reasonable, ensure employees have access to all the right information, and more.
But even with these rules, average funds permeate 401(k) plans. And again, the difference between average investments and top ones can create a huge difference in how big your and your employees’ nest egg will be in retirement as shown above.
Look, investment management can be made to be complex, and it’s why most employers hire an advisor to manage. But, employers may not fully be aware of all the intricacies that drive to a subpar fund line-up through no fault of their own – for one, they have a business to run.
Here are the top things to know and/or are often missing in your 401(k) investment offering:
- Your 401(k) plan does not have investment policy statement (a best practice) and/or a supporting investment philosophy, or has a policy statement but it is vague and not followed (fyi, there is risk if it’s not followed). The investment policy statement and philosophy are critical to know and follow, so that there is a clear expectation and framework on how your plan will monitor funds and determine which funds to include, which to monitor, and which to exclude.
- The method used to monitor and select investments is weak or uses a wealth management or stock “traders” framework like Buy, Hold, and Sell in determining which funds stay and which ones go. This sounds good, but like in the example we showed above, it results in a predominance of average funds that don’t historically perform near the top. Buy, hold and sell can make sense for an individual stock framework, as a stock by its nature is not diversified and its price can be expected to be quite volatile. A company’s strategy and execution can change the value of its stock somewhat quickly. However, ETFs and mutual funds offer diversification and work to perform to meet or beat an index for an asset class, so it’s about finding the best fund in each asset class.
- If the recordkeeper is owned by a fund provider or insurance company, they will often require at least some of their funds to be offered or they will charge materially more for services. The number of index funds in your 401(kO plan may also be restricted. And yes, this is true with some of the bigger brand names out there. This creates a big conflict of interest from where we sit.
- The advisor workings on your plan may have incentive to ensure some of your plan’s top fund selections have revenue sharing or 12b-1 fees, so that they earn more.
Since we pioneered the all-index 401(k) plan using ETFs in 2005, it has been fascinating to see how index investing has grown. As of 2019, more money is held in index funds than in actively-managed funds. ETFs now significantly add more new money each year than mutual funds. Yet, in the 401(k) industry, index funds and ETFs remain the minority, while actively-managed mutual funds are vast majority. The above information we hope helped shine a light in helping you understand why that is.
The good news is there are beacons like ShareBuilder 401k that are:
- not a fund provider, (unbiased approach to selecting the fund roster)
- looking to provide you the best-in-class fund line-up using a proprietary, prudent approach,
- working to offer the most appropriate asset classes for retirement saving,
- not accepting revenue sharing from funds,
- keeping fund expenses to minimum
- using ETF index funds exclusively with the exception of a money market or cash option
- dedicated to helping all employees build a bigger nest egg for retirement.
How to Know If Your Plan Has an High-Quality Fund Line-Up
So, when you are thinking about providers, don’t get too caught up in the employer paid admin or setup costs. They are important and need to be managed, but these costs don’t hold a candle to how much you may give up in your own 401(k) savings if you don’t understand the fund management approach and fund expenses in your plan.
Dive into the investment management and fund options and ask questions:
- What solutions do they have for ensuring a great 401(k) fund roster? What are the investments or choice they enable?
- What’s the investment philosophy and policy statement, or do they leave it to you?
- Are there mostly index funds or not? How many index funds are allowed?
- Will they share the last annual fund line-up review, or they leave that to you?
- What is the average expense ratio in the line-up (are they mostly under 0.20%), or is that left to you to figure out?
- What asset classes are covered, or is that left to you to figure out?
If you ensure you have a high-quality line-up as well ass all the key services you will want to support your plan, you can feel good you are helping everyone on your team including yourself build a meaningful nest egg.
Fun Facts About ShareBuilder 401k’s Investment Approach
At ShareBuilder 401k, we have the honor of helping businesses across the United States have what we believe is the best-in-class 401(k) plan. When we pioneered the all-index fund 401(k) using ETFs, it was truly groundbreaking and on the right side of savers across America. Our philosophy around low-expenses, historic performance and diversification are unassailable. Our approach still stands out as a North Star in the industry. It’s our mission to lead Americans to saving. We know that providing a high-quality fund line-up is essential and really matters to the tune of hundreds of thousands of dollars over a career of 401(k) saving for each plan participant.
High-quality Funds: The ShareBuilder Advisors Investment Committee conducts an annual review of the Exchange-Traded Funds offered as ShareBuilder 401k fund options. This review leverages a proprietary model that evaluates multiple variables including length of time since inception, asset level, historic performance over one to ten years, expense ratio, liquidity, and how the funds compare to their respective benchmark indices. Each fund is monitored and changes are made to the fund lineup as needed to align the investment options to the Investment Committee’s investment policy.
The 1% difference example shows the effect that expenses can have on your 401(k) retirement account over a career of 40 years by comparing the costs of paying 1% versus 2% on investments and how savings may accumulate. It assumes the investments have a fixed annual 7% return before expenses with no distribution or tax considerations and does not imply future returns. The example assumes each employee has a salary of $75,000 in year one and receives a 3% merit raise each year on-going. In addition, the employee contributes 5% of her salary each year and receives a 3% of salary company matching contribution.