Good Practices When Creating the Investment Menu
Updated: Jun 19, 2018
When a plan sponsor sets up an investment menu for its participants, it relies heavily on mutual fund companies in many cases. While there is absolutely nothing wrong with that, since plan sponsors rarely have the expertise and knowledge for selecting investments, some conflicts may arise. For example, it is no secret that mutual funds are biased towards proprietary investment products, even when more suitable alternatives are available. A recent study by the Center for Retirement Research at Boston College concluded that this can adversely affect your employees’ retirement readiness.
As a plan sponsor, you have the responsibility as a fiduciary to monitor plan service providers and make sure that they follow a prudent investment process when recommending any changes to the plan. You must be even more cautious and alert when it comes to choosing and monitoring plan investments in light of recent excessive fees lawsuits filed against plan sponsors. Understanding governing principles, rules, and trends when setting up the investment menu, or reviewing it, is essential. Having an independent third-party, like a retirement plan adviser, can certainly help.
Which practices should you be guided with when setting up the investment menu or making changes to it?
First and foremost, the investment menu for plan participants must be aligned with plan demographics and participants’ goals and behavior. Do you know what your employee tenure is? What are the savings rates? How well-educated are your participants? Do participants save outside of the 401(k) plan?
Make sure your investment menu offers “a broad range of investment alternatives.” By a “broad range” I mean diversification. Your investment menu must have at least three pooled or core funds. If your plan automatically enrolls employees into qualified default investment alternatives (QDIA) and complies with this requirement, you will be rewarded with Safe Harbor under ERISA Section 404(c). Section 404(c) protects plan sponsors and fiduciaries from losses on investments directed by plan participants.
Specify the criteria by which investment funds will be selected and included in the investment menu. Performance over what period of time and against which benchmark should you look at? What about manager tenure? Fund style? Risk/reward metrics? Costs?
Check the fees, but keep in mind that they are not the primary decision factor. Many recent lawsuits filed by plan participants against plan sponsors were related to excessive fees embedded into the investment funds. In order to protect themselves, plan sponsors are working extensively on revamping the investment menu by replacing funds that are deemed to be “expensive” with inexpensive funds. However, low fees are not necessarily a panacea from any future legal issues. What many plan sponsors don’t understand is that the investment management fees should be reasonable.
Keep it simple. I would recommend not cluttering up the investment menu with too many funds. Plan participants will only get discouraged and confused. To avoid the “paradox of choice,” offer fewer investment options but with more diversification. A good rule of thumb is to have 10-12 funds along with a set of target-date funds.
Customize the investment menu and adjust it to the needs and wants of plan participants. Consider either white labeling or creating a multi-tiered investment menu
Consider the open architecture approach. If you rely on the help of a mutual fund company, make sure that the mutual fund company suggests investment funds outside of its proprietary products. Not only will you avoid a conflict of interest, you will also improve diversification.
Managing a 401(k) plan is a dynamic and ongoing process. Just because you delegated the duty of investment selection to someone, it doesn’t mean that you are off the hook. As a fiduciary, you have to make sure that there is ongoing oversight over the plans’ investments and the people who chose the investments for you. Make sure you document all of the processes and decisions that were made along the way, as well as staying on top of recent changes in both the investment and regulatory world.