401(k) Investment Advice – Pros and Cons of the 3 Basic Forms

To meet retirement goals as affordably as possible, 401(k) participants must do three basic things – save early and often, keep account fees to a minimum, and invest appropriately. To invest appropriately, participants must construct - and maintain – an investment portfolio that includes a diversified mix of investments based on their time horizon (time to retirement) and risk tolerance. An appropriate portfolio balances the participant’s growth potential with risk of losses. Striking this balance is important. Otherwise, a participant could miss out on returns by investing too conservatively when young or sustain unrecoverable losses by investing too aggressively when older.

Given the stakes, it’s not surprising that many 401(k) participants want professional help investing their account. This makes even more sense when you consider the complex strategies that must applied to construct an appropriate investment portfolio. Fortunately, 401(k) plans have more professional advice options than ever. There are three basic forms – fund-based, advisor-based, and algorithm-based.

If you’re a small business 401(k) plan sponsor, you want to understand the pros and cons of the three forms to pick the best form (or combination) for your plan participants.

Constructing 401(k) investment portfolios

To construct an appropriate 401(k) investment portfolio, three investing strategies must be properly applied - asset allocation, diversification, and rebalancing.

• Asset allocation involves the allocation of an investment portfolio among different asset categories, such as stocks, bonds, and cash based on time horizon and risk tolerance. In general, young participants should invest heavily in stocks – which have higher growth potential, but are more volatile. Older participants should invest more conservatively.
• Diversification involves picking investments with uncorrelated returns for an asset allocation. This way, if one investment is declining, others are more likely to be growing, or at least not declining as much – minimizing the risk of large losses.
• Rebalancing involves periodically buying or selling assets in a portfolio to maintain a desired level of asset allocation.

Applying these strategies properly is too much to expect from most 401(k) participants. Fortunately, professional advice is easier than ever for 401(k) plans of any size to offer today.

Fund-based advice

Fund-based investment advice is delivered by a mutual fund – usually a Target-Date Fund (TDF). There is no easier way for 401(k) participants to access professional advice. To do so, they just need to invest 100% of their account in the TDF that best matches their estimated retirement date.

Pros:

• The easiest way for 401(k) participants to access professional investment advice.
• Set it and forget it. TDFs offer automatic rebalancing. Further, their asset allocation will gradually shift to fewer stocks and more bonds (i.e., become more conservative) the closer the participant gets to retirement.
• Low cost. The investment expense of a Vanguard Target Date Index Fund (TDIF) can be less than 15 bps (0.15% of assets) annually.
• TDFs can qualify as a Qualified Default Investment Alternative (QDIA) when participant disclosure requirements are met.

Cons

• Advice can’t be personalized to meet individual investment goals.
• TDFs comprised of actively-managed investments can get expensive.
• Insurance companies can add variable annuity wrap fee to otherwise low-cost TDFs
• TDFs offer no participant engagement or coaching.

Advisor-based advice

Advisor-based advice is delivered by a professional financial advisor. This advice generally takes two forms 1) a lineup of custom portfolios for 401(k) participants to choose from or 2) one-on-one advice. This advice can be delivered in-person and highly-customized to meet individual investment goals – factors that can help motivate 401(k) participants to keep their retirement savings on track. Many 401(k) financial advisors also offer value-added, non-investment related services, including:

• Coordinating the activities of other plan service providers
• Helping the plan sponsor to meet 401(k) fiduciary responsibilities
• Keeping the 401(k) plan design up to date given changing company goals

Pros

• Advice can be personalized to meet individual investment goals.
• In-person advice can be helpful in motivating 401(k) participants to keep their retirement savings on track. Like a personal fitness trainer.
• Non-investment services can make 401(k) plan sponsorship less stressful for business owners.

Cons

• Usually the most expensive form of professional advice. 401(k) participants should receive commensurate value in return.
• Non-investment services may be better delivered by a Third-Party Administrator (TPA).

Algorithm-based advice

Algorithm-based (“robo”) advice is delivered by a computer algorithm - a set of rules that construct investment portfolios based on investor responses to risk tolerance and time horizon questions. Over the years, I have read a lot of articles comparing robo and human advice. I don’t think this comparison is fair in the 401(k) space – because plan participants don’t need two common robo features - tax-loss harvesting (not applicable as 401(k) accounts are tax-deferred) and the ability to solve for unrelated investment goals. I think it’s fairer to compare 401(k) robo advice to TDIFs since both construct portfolios using low cost index funds. The big difference between the two? Cost. TDIFs can cost 40-60 bps (0.40%-0.60% of assets) less annually.

Pros

• Advice can be personalized to meet individual investment goals.

Cons

• Comparable to TDIFs, but more expensive. Questionable value in return.
• Has a computer application ever motivated you to do anything? Me neither. A human advisor can do a better job at motivating 401(k) participants to keep their retirement savings on track.

Remember, cost matters!

When small business 401(k) plan sponsors weigh their professional advice options, they should do so within the context of cost. After all, they have a fiduciary responsibility to plan participants to only pay reasonable fees for necessary services from plan assets.

All three of the above advice options can achieve the same goal – get 401(k) plan participants invested appropriately. However, their cost can differ dramatically. To meet fiduciary standards, you only want to pay more for advice that offers commensurate value for plan participants (e.g., greater net-of-fee returns) in return.