What Morningstar’s New Investment Study Means for Employers
ERISA tells 401(k) plan sponsor fiduciaries they must act solely in the interest of plan participants and their beneficiaries with the exclusive purpose of providing benefits to them. This includes actions employers take in the trust, as well as the administrative areas, as they manage company retirement plans.
On the trust side, there is debate over the way to provide participants with the best investment options to help them reach financial security in retirement. A new Morningstar study reverses the previously held “keep it simple” philosophy, which suggested employers choose only a few investment options for a 401(k) fund line-up to avoid overwhelming employees and discouraging plan participation. Morningstar’s “Bigger is Better” study found that a larger investment line-up – when plan defaults are included – results in greater participation and more efficient portfolios for all.
Since the average 401(k) participant often lacks the experience necessary to build and manage a diversified investment portfolio, he or she benefits from selecting a default that has been prudently selected. Morningstar found that with a larger core investment menu, participation in the default increased, moving from approximately 74 to 87 percent participation when 10 versus 30 funds were available.
Likewise, the “efficiency” of self-directed participants’ portfolios increased when there was a larger menu. (Efficiency is the ability to optimally balance risk and investment return.) This greater efficiency could be due to any number of factors – these participants might have been sophisticated investors, worked with a professional investment advisor, or simply employed what Morningstar calls “naïve diversification,” spreading their portfolio among a larger number of funds because they were available. No matter the reason, the Morningstar study found that the number of funds held by self-directed participants would be expected to increase by an average of three as the core menu grew from 10 to 30 funds; the result was an estimated average increase of 11 basis points in alpha (defined by Investopedia as the ability to “beat” the market).
Plan sponsor fiduciaries contemplating the Morningstar study may want to use this as an opportunity to review other aspects of their policy for selecting and monitoring the defaults and individual funds they include in the company retirement plan. (Guidance from the Department of Labor under ERISA supports each 401(k) plan’s establishing a written statement of investment policy.)
In reviewing policy related to plan defaults, employers will want to look at what the Department of Labor considers a “qualified” default for those operating under ERISA 404(c)5. Even if not taking advantage of this ERISA safe harbor, plan sponsors will want to consider offering one of its “best practices” alternatives: a target date fund, a managed account or a balanced fund. In each case, the selection needs to be assessed against the make-up of the plan’s participants. Target date fund series can have widely varying glide paths (the allocation between equities and bonds as the series reaches retirement) and management styles (strategic versus static, for example). Managed accounts, on the other hand, can be tailored to individual participant needs. Prudent fiduciaries will want to seek managed accounts without additional fees.
Regarding the individual fund line-up, a few policy best practices include well-spelled-out criteria for the selection and quarterly monitoring of funds, making sure key asset classes are represented, and offering no more than one fund from each asset class. Fiduciaries will want to review all fees associated with funds being considered, identifying the “hidden fees” subtracted from investment returns when “revenue sharing” is used vs. the quarterly fees of funds using a transparent reporting method.
Recognizing the complexity of investment policy and ERISA’s high standard that a 401(k) plan fiduciary must operate as an “expert,” many employers seek the help of their investment advisor. Under an ERISA safe harbor, they may hire a Registered Investment Advisor who is willing to serve in their place as the plan’s ERISA 3(38) Fiduciary Investment Manager. This highest level of service removes from the employer fiduciary the responsibility, as well as potential personal liability, for plan investment selections and monitoring. Only certain advisors – most frequently Registered Investment Advisors – qualify, with brokers not being among those who may serve.
Incorporating new findings, such as those revealed by the Morningstar “Bigger is Better” study, in plan investment policies, and exercising expertise in investment management, can help employers meet ERISA’s mandate to act solely in the interest of 401(k) plan participants and their beneficiaries with the exclusive purpose of providing benefits to them.
This blog is written to help make the lives of plan sponsors easier in the process of meeting legal requirements under ERISA for their defined contribution plans. Please understand that reading this blog should not alone take the place of a one-on-one consultation regarding the needs of your specific plan and hence cannot be a guarantee against fiduciary breaches.