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How Employers Choose Funds to Offer in Their 401(k) Plans
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By Clifton Linton
Senior Writer, mPower |
With more than 8,100 mutual funds available in the
market, you may wonder how your 401(k) plan narrowed those offerings to a handful or two.
The process of selecting 401(k) plan investments is not
haphazard. Employers are required by law to use reasonable methods to cull this wide field
in order to present your plan's choices. And some plan providers offer an additional level
of vetting.
The result is that in many cases the funds offered by your
plan have gone through at least one level of screening, if not two. Consequently, most
funds offered in 401(k) plans are of high quality. "I would say if a fund isn't
consistently in the top quartile (in performance), it would have trouble competing,"
said Ron Petrie, manager and chartered financial analyst (CFA) with Victory Capital
Management.
Still, some workers may feel that their plan could do
better. Often, these are savvy investors who would like more choice, or employees of small
companies that faced constraints on what they could afford to offer in their plans.
Here's a look at some of the techniques employers and
401(k)-plan providers use to pick funds.
Fiduciary Responsibility
According to federal law, employers (known as "plan
sponsors") are responsible for picking the 401(k) plan funds. This decision must be
made in the best interests of the plan and its participants. "The plan sponsor must
be a prudent fiduciary," said David Wray, president of the Profit Sharing/401(k)
Council of America, a trade group representing 401(k) plans.
Part of that responsibility is using defined policies and
methods for choosing funds. Many employers codify these methods by adopting an investment
policy statement spelling out the criteria they use to add or remove funds in a plan. As a
sign that 401(k) plan management is improving at the employer level, in 2000, 60 percent
of plans had an investment policy statement, up from 50 percent in 1999, Deloitte &
Touche reported in its 2000 401(k) Plan Benchmarking Survey.
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| "I would say if a fund isn't
consistently in the top quartile (in performance), it would have trouble competing." |
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| — Ron Petrie, manager and
chartered financial analyst (CFA) with Victory Capital Management. |
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The first step for an employer is to choose a "plan
provider" or providers — the firm or firms that provide services to administer
and maintain a 401(k) plan. These include investment management, recordkeeping and trustee
services, among others. Some providers aggregate these services from a variety of
independent vendors while others provide all of them from their own resources.
The employer then decides which of the funds offered by the
provider to include in its 401(k)-plan offering. Several factors influence this choice.
First are the participants, said Ted Benna, creator of the first 401(k) plan and president
of the 401(k) Association consulting firm. In most 401(k) plans there is typically a core
group of participants (often about 10 percent) who actively manage their investments and
constantly research the latest and greatest funds available. This group of participants
tends to be vocal about any displeasure with a fund.
This group "has the clout" to shape not only
their fund's offerings but also the entire 401(k) plan market, Benna said. That's why an
increasing number of plan providers offer funds outside of their own proprietary ones, he
said.
Another factor is the amount of assets in the plan.
Typically, the more assets in a plan, the more funds a provider is willing to offer, and
the more likely it is that a provider will offer funds outside of its own fund family.
A third factor is the cost of the funds. Sometimes,
employers pass on a well-known fund with high administrative fees in favor of a
lesser-known but similar fund with lower expenses.
At this point, plan providers put together a proposal to
the employer which may consist of an off-the-shelf design, if the employer wants to keep
costs low or the assets in the plan are small, or a more customized plan if the employer
doesn't mind paying higher costs or the plan assets are larger. In either case, the
employer and plan provider negotiate and the result is a unique plan that should be
designed to meet the needs of the majority of employees.
Provider Screening
The plan provider sometimes conducts the first level of
screening. Historically, plan providers, which were often mutual fund companies, only
offered their own funds. But as plan assets have grown in size and participants have grown
more demanding, these providers have begun offering outside funds. New, non-mutual-fund
companies have begun offering plans, too.
According to anecdotal evidence from plan providers and
PSCA, a growing number of providers have begun screening outside funds in order to ensure
that all their offerings are of high quality. Some are screening their own funds, too.
"I know that some of our competitors have developed
their own structured due diligence process. I think they should. This is the type of
thorough ... oversight that needs to go into running these programs," said Michael
Finnegan, CFA, vice president of The Principal Group, a 401(k) plan provider based in Des
Moines, Iowa.
One Firm's Example
In 2000, The Principal Group began using the screening
process outlined below, which is fairly typical of providers that screen.
First, the company determines what type of fund(s) it
needs. It then does a first screen, using fund manager databases produced by companies
such as Wilshire Associates Inc. or Frank Russell Co. It looks for the track record of the
fund manager and fund management company; the size of assets under management; the fund's
performance compared to its peer group and relevant benchmarks; and the investment
methodology used (fundamental analysis or technical analysis).
This screen typically produces a list of 20 to 25 firms and
funds that meet The Principal's standards, Finnegan said.
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| "I know that some of our
competitors have developed their own structured due diligence process. I think they
should. This is the type of thorough ... oversight that needs to go into running (401(k))
programs." |
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| — Michael Finnegan, CFA, vice
president of The Principal Group, a 401(k) plan provider based in Des Moines, Iowa. |
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The next step is to send those firms a questionnaire asking
for more details in five areas: the fund's organization (including the stability of the
management team and manager compensation methods), the investment process (how cash in the
fund is managed and what risk controls are in place), available resources (such as what
trading and client service capabilities exist), performance and fees.
"All of these factors come into play, but the first
three factors ... probably get 60 percent to 70 percent of the weight," Finnegan
said.
The Principal Group also screens its own funds, he said.
Plan Sponsor Screening
The most critical level of screening is actually performed
by the employer, also known as the plan sponsor, because it has fiduciary responsibility
for the plan. Some employers hire outside consultants to assist with this process.
The first task for the plan is to figure out what asset
classes it wants to offer, said Trisha Brambley, president of Resources for Retirement
Plans Inc., a 401(k) plan consulting firm.
Once it makes that decision, the employer looks at the
provider's offerings, sorts the available funds by asset class and chooses from each
class. The entire process could require whittling down a 100-fund offering to 10, she
said.
When selecting funds, employers typically look at some of
the same factors plan providers consider. Employers may look at Morningstar or Lipper
rankings (rather than Wilshire or Russell reports), expense ratios, risk statistics and
past performance. Other factors might include whether a specific fund stays with its
stated objective, how long the management has been in place and what the fund's investment
objective is. Additionally, the employer needs to check that the investments held by the
funds don't overlap, because that would reduce diversification for employees.
While these processes can help narrow a field, they can't
guarantee a winner fund every time.
"After all (the review) you can still pick a
dog," Brambley said.
If this happens and the plan decides to change the fund, it
should begin the review process again. The important point is that the plan consistently
uses the same procedures to find and maintain the funds. If you wonder if your plan has
these procedures in place, you should ask your employer, Brambley said.
The employer has to keep in mind that a 401(k) plan is a
long-term retirement savings plan, and choose funds appropriate for long-term saving.
"You don't want the plan chasing funds," or changing them frequently, PSCA's
Wray said.
This outlook tends to slow the introduction of new funds
and often causes more active investors to grow impatient with their 401(k) plan's
offerings. But, employers need to "balance" these complaints and suggestions
against the risk associated with rapid plan changes, said Edward Stavetski, director of
equity research with Pitcarin Trust Co. of Jenkintown, Pa.
Other Factors
One factor determining whether a provider offers outside
funds is whether the fund company is willing to pay the provider to offer its funds. This
is a common practice in the industry, Brambley said. Funds unwilling to pay providers
often aren't offered. Sometimes these fees increase the costs to plan participants and
sometimes they are absorbed by one of the parties offering the plan.
Sometimes, a plan provider may be unwilling to offer funds
beyond its own ones, or the employer's negotiating power may be limited because it is too
small to qualify for added funds. This can be a source of frustration for some
investment-savvy employees. Keep in mind, however, that the trend among employers is to
offer better plans and better oversight of plan investments. Remember, too, that the
401(k) has an edge over other tax-deferred savings plans you could use on your own, with
its higher contribution limits and chance of an employer-matching contribution.
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The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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