The Department of Labor, through its Employee Benefits Security Administration, is charged with overseeing health, welfare and benefit plans offered by employers. This includes 401(k) plans.
401(k) plans are fairly complex offerings, and are becoming more so. Participant assets need to be tracked by source, tax characteristics, and vesting schedule, eligible employees need to be communicated with, a variety of required notices and filings need to be tracked, and the plan's investment choices need to be selected to ensure participant choice, and to comply with regulatory guidelines. Finally, plan trustees are charged with assuring that the plan is run exclusively for the benefit of participants and their beneficiaries, and that the plan is managed with a prudent, documented, process.
40 years ago, when 401(k) plans were in their infancy, asset managers such as mutual fund shops identified opportunity, and began making their funds available to plan sponsors. Over the years, there has been much time, money, and energy expended to identify an "optimal" line up of actively managed funds.
The challenge with relying solely on actively managed funds for a 401(k) fund line up is the question of fees and performance. Whether actively managed funds can consistently outperform passive, index offerings depends on which decade or ten year rolling time period is being measured. We could quote any number of white papers and studies at this point. Suffice it to say that, net of fees, very few actively managed funds can outperform their relative index, over long periods of time.
An even more fundamental question is, even if we can identify those actively managed funds which outperform over a given measuring period, will most plan participants make the time to educate themselves about the offerings, so they can make intelligent investment choices? Evaluating participant decisions tells us that most participants want to make as simple a choice as possible, as many participants feel unprepared, even with education, to make good investment choices.
This has given rise to the development of easy to use pre-mixed portfolios. These portfolios typically come in two flavors. One is age-based, and the other is risk-based. Age-based portfolios tend to be the easiest for participants. They can simply check a box indicating they want to use the age-based portfolio, and their money will be invested in a predetermined mix of stock and bond funds, based on their age. These portfolios are built around age bands that run from very young (18-22), to those near or past retirement (age 66 or 70 plus).
The risk-based portfolios require the answering of a few questions and then, the participant funds will be invested in a predetermined mix of stock and bond funds, in portfolios that range from conservative to aggressive.
Given most participant's desire to keep things simple, we have found an ideal approach to plan investment design is to populate the age and risk-based portfolios with very low cost index funds. There is value in having a line up of seven to ten actively managed funds, as there will always be a handful of employees who enjoy selecting their own investment options. We have found that fewer than 10% of the employee population will choose to select their own funds, and that this population tends to be the older, more experienced employees.
With this approach, plan fiduciaries are able to keep investment costs at the low end of the investment spectrum. While plan costs will vary, depending on average account balance, number of employer locations, and plan services selected, we see few reasons that a plan with $10 million or more in assets should have total operating expenses of greater than 1%.
Peter Lynch managed Fidelity Magellan during the 1980's, chalking up average annual gains of 28.5% for the entire decade. He's written a few books, and given numerous speeches, and has developed his "cocktail party" theory of where we are in the market cycle.
According to Lynch, the first stage of an upward market, after the market has been down for a while, occurs when he introduces himself as an equity mutual fund manager at the party, and the other attendees nod politely and wander away. During stage two, new acquaintances linger a bit longer, perhaps long enough to tell him how risky the stock market is, before they move on to talk to the dentist.
During stage three, with the market up 30% from stage one, a crowd of interested parties ignores the dentist, and circles around him all evening. Any number of individuals tries to inquire, quietly of course, about what stocks they should buy. During stage four, as the market nears its top, the crowds remain around him, though this time they are telling him what stocks to buy. Lynch said that when he looks up the dentist's stock tips in the paper, and wishes he had taken the dentist's advice, it's a sure sign the market has reached a top, and is due for a tumble.
Quote of the week:
"The glory of the workman, still more of a master workman, that he does his work well, ought to be his most precious possession; like the honor of a soldier, dearer to him than life."