How to Pick Investments for Your 401(k)
At Betterment, we believe there’s a better way when it comes to 401(k) investments. It starts with us providing the highest level of investment fiduciary protection available.
You know how important it is to offer a 401(k) plan in today’s marketplace. Having a competitive retirement plan can help your organization attract and retain talent and be a key component to an overall financial wellness program. Your employees may be years away from retirement, but a 401(k) plan, and the educational resources that often come with it, can help them feel more confident about their futures; and especially if your organization offers a 401(k) match and/or profit-sharing contribution, balances in employee retirement accounts can really add up quickly.
Whether you are starting up a 401(k) plan for the first time or your organization already has a 401(k) plan, it’s important to keep current with market trends. This is especially critical if your company has a high percentage of positions in competitive fields, where an attractive 401(k) plan can be a deciding factor for people (either prospective hires or current employees (who may be evaluating competing job offers).
Your 401(k) Decisions
Some of those trends may revolve around plan design, including whether or not to offer a matching contribution, automatic enrollment, or whether to convert your plan to a safe harbor design that eliminates compliance testing. Each of these decisions will likely have a significant financial impact to your organization and therefore must be weighed carefully.
One of the most visible decisions you have to make is around investments. It’s not just that you might pick funds that your employees don’t like (although you might hear about that!); selecting and monitoring funds is one of the most important fiduciary responsibilities that you can have as a plan sponsor. And the consequences of not executing that responsibility can be serious and expensive.
In fact, in recent years there have been a significant number of lawsuits against plan sponsors alleging that 401(k) funds have been too expensive. Fund expenses are deducted from fund assets meaning that they directly negatively impact fund returns and reduce amounts that participants would otherwise have been able to accumulate in their retirement accounts. Said differently, fund fees are embedded in fund expense ratios, so the amount that employees pay is determined by how they are invested.
Traditional Approach to 401(k) Investment Selection
Most 401(k) plans today offer a menu of mutual funds, selected from various companies based on a number of factors including investment performance and fees. Often plan sponsors retain a financial advisor to assist in identifying appropriate funds, but typically the employer retains full fiduciary responsibility for the selection and monitoring of funds.
Having a broad array of investment options across asset classes (stock funds as well as bond funds; domestic as well as international) and investment styles (large cap as well as mid and small cap) allows employees to create a diversified portfolio; provided, of course, they feel comfortable selecting their investments. And research shows that many employees don’t feel comfortable selecting and monitoring investments; that’s why many plan investment menus also include target date funds and default employees into them.
Target date funds are presented in a series, each targeting a specific retirement date (year) which corresponds to an individual’s investment time horizon. In addition to being well-diversified, target date funds also adjust their asset allocation over time, becoming more conservative as the retirement date approaches, which reduces an investor’s risk in accordance with his or her shorter time horizon.
Mutual Funds in 401(k) Plans
Mutual funds are a popular choice for 401(k) plans because many employees are familiar with them, recognize the brand names, and might even be invested in the same funds outside their 401(k). From an employer perspective, mutual funds are a comfortable choice because of their price structure, which often enables the various service providers associated with the 401(k) plan to be compensated directly from the funds’ expense ratio, meaning they are paid for by the participants.
While using mutual funds may be a convenient way for plans to pay for necessary and legitimate fees, having all these expenses embedded in the expense ratio makes it difficult for both employers and employees to understand the true costs of the fund. While required fee disclosures are intended to facilitate understanding the complicated fee structure, there is little evidence that this has increased employer and employee awareness around hidden 401(k) fees.
If you think these expenses may be insignificant, think again. Administering a 401(k) plan involves many moving parts, carried out by a number of parties. Examples of the firms that may assist a plan sponsor with 401(k) investments and administration may include:
|Investment Company||Company that manages investment funds|
|Custodian||Holds assets in trust and processes transactions|
|Recordkeeper||Tracks each individual participant’s assets|
|Third-Party Administrator||Performs compliance testing, assists with government reporting|
|Financial Advisor||Advises plan sponsor on investment selection for the plan|
|Accounting Firm||Performs annual audit for larger plans (with 100+ participants or certain assets)|
Understanding Your Investment Fiduciary Responsibilities
Like most plan sponsors, the day-to-day responsibilities of your business leave little time for extensive investment research and analysis. Many plan sponsors engage service providers to take on the fiduciary investment duties. However, the scope of fiduciary protection provided by 401(k) providers can vary greatly.
Some providers disclaim any fiduciary responsibilities and simply make a menu of investments available, leaving the plan sponsor with the fiduciary responsibility and liability for choosing options for the 401(k) plan.
Some providers will agree to share your fiduciary investment duties. This level is referred to as ERISA 3(21) investment advice. Under this model, investment advisors or service providers agree to be subject to the fiduciary standards with respect to their investment recommendations and are subject to the DOL’s enforcement jurisdiction. But the plan sponsor retains the final discretion regarding which investments will be included in the plan and shares legal responsibility for each investment decision.
The Betterment Approach
At Betterment, we believe there’s a better way when it comes to 401(k) investments. For starters, we provide the greatest level of investment fiduciary protection available, serving as your plan’s 3(38) investment manager. This means we assume full discretionary responsibility for selecting and monitoring the plan’s investment options, relieving you of fiduciary liability for selecting plan investments.
ERISA Section 3(38) Fiduciary Responsibility
As a 3(38) investment manager, Betterment will take on the following duties, moving them from your 401(k) plan to-do list to ours:
- Develop an Investment Policy Statement. It is a plan governance best practice for 401(k) plan sponsors to adopt an investment policy statement that defines the strategic objectives for the plan’s investments and the criteria that will be used to evaluate investments.
- As the investment manager we are responsible for creating the due diligence process for selecting and monitoring investments and will select the investments for your 401(k) plan.
- We will monitor investment performance and replace any investments that do not perform well or when comparable investments with lower fees become available.
With Betterment as your ERISA 3(38) investment manager, you are not responsible for monitoring our investment decisions. You have fully delegated that fiduciary duty to us.
One of the more challenging investment fiduciary duties is the requirement to analyze 401(k) plan fees and ensure only reasonable expenses are paid from plan assets, as required by the DOL Fee Disclosures rules (ERISA 408(b)(2)). This is no simple task for a busy employer trying to run a business.
Exchange-Traded Funds (ETFs)
As noted earlier, fee structures for traditional 401(k) investments can be complex, complicating the fee analysis for both sponsors and participants. Betterment, as a 3(38) investment manager, takes on the duty to monitor investment fees and eliminates many of the concerns associated with traditional 401(k) investment models because of its exclusive use of Exchange Traded Funds.
Compared to mutual funds, ETFs have a more transparent fee structure, which means the 401(k) service providers aren’t being compensated behind the scenes. With no embedded fees, all plan vendors have to charge clear and explicit fees for their services, making it easier for plan sponsors to evaluate, compare, and understand the true costs of plan administration. And it makes it easier for employees to see where their money is going.
Investment Advice for Employees
Some 401(k) products that offer ERISA 3(38) services limit the investment management services to plan sponsor support, leaving employees on their own to decide how their savings should be allocated among the investments available. Betterment’s 3(38) investment management support extends to participants as well as plan sponsors. We recognize that professional investment support is crucial to helping your employees become more financially secure – in both the short term and long term.
Specifically, Betterment helps your employees determine:
- how much it costs to retire, given their desired lifestyle and where they may choose to live; and
- how much to defer from today’s paycheck into the 401(k) plan to meet their long-term savings goals.
By providing additional personal information such as household income, and already existing retirement savings balances, employees receive more tailored recommendations, including advice on how much they should be saving and which accounts to use.
Betterment will build a personalized investment portfolio to help each employee achieve their savings goals, and will allocate each portfolio across asset classes, giving employees diversified exposure to over 36,000 stocks and bonds from companies and governments in over 100 countries. In addition, risk is automatically managed over time, and the portfolio is regularly rebalanced to help keep the goal on track.
A Smarter Approach to 401(k) Investing
Betterment’s investment approach combines smart technology with low-cost, index-based ETFs to relieve employers from one of their most important fiduciary duties: having to select and monitor 401(k) funds. We also make it easier for employees to save for their future by creating efficient and diversified long-term portfolios on a goals-based platform.
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