Selecting competent service providers is the most important - and most confusing - fiduciary duty of a 401(k) sponsor. Why? Services offered by 401(k) providers can vary dramatically in breadth, depth and price. This variability makes it difficult for 401(k) sponsors to match appropriate services to plan needs. Many small business 401(k) plans pay for superfluous services participants do not use. These excess services are often expensive, dragging down participant investment returns and creating potential personal fiduciary liability for the 401(k) sponsor.
If you sponsor a 401(k) plan, I recommend following a two-step process to ensure your plan does not pay fees for services your participants will not use: 1) understand the services that compose a 401(k) plan and 2) determine which of these services require professional assistance to deliver. Once this process is complete, you’ll be ready to shop for professional service providers.
Every 401(k) plan requires multiple services. These services fall into two categories, plan administration or investment management.
a. Plan administration services include:
b. Investment management services include:
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.
Why are index funds growing in popularity? While it may seem counter-intuitive, a growing body of academic research has shown that index funds outperform most of their actively-managed counterparts over decades of 401(k) investing, particularly after all fund expenses are considered.
If you prefer index funds, a financial advisor may not be required because it’s not difficult to pick funds that deliver “market returns.” Click here to view an example of an all index fund lineup.
If you prefer actively-managed funds, use of a financial advisor is highly recommended. It takes a lot of skill to consistently pick actively-managed funds that outperform their index fund counterparts. Using actively-managed funds also requires much more sophisticated monitoring to ensure investments outperform their index benchmark and peer group averages. Fiduciary liability can result if high-priced actively managed funds underperform their lower-priced index fund counterparts.
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 success.
Generally-speaking, there are two ways 401(k) plans deliver participant investment advice today:
If you prefer more customized investment advice, you should hire a professional financial advisor.
Once you’ve determined the professional services your 401(k) plan needs, you are ready to start shopping for service providers. While interviewing service provider prospects, confirm they deliver the services you want and their “all-in” fee for these services. After speaking to multiple prospects, compare their services.
Once you have taken these steps, your plan should be paying reasonable fees for the professional help it needs, improving participant returns while mitigating your fiduciary liability.