Many of us are familiar with the intimidating feeling involved with clicking on the investment tab of our 401(k) only to find a laundry list of options. As a plan sponsor, you are tasked with offering employees the Goldilocks of investment menus…not too many options, not too few. Just enough.
When determining where that line falls, it is helpful to understand the categories of funds that are available and what expectations the appropriate regulatory bodies have for your plan.
Domestic Equities – refers to investments into stocks held within the United States. Typically, this is broken down further into Large Cap, Mid Cap, and Small Cap investments.
International Equities – refers to investments in companies held outside of the United States. Again, this area can be broken down further into International, Global, Established Markets, Emerging Markets or Regional Investments.
Fixed Income – refers to bonds and preferred stock holdings. These investments vary in returns and volatility based on the quality and duration of the investments held. On average, fixed income securities are designed to limit volatility.
Cash or Cash Alternative – all 401(k) plans should offer at least one investment option available for those investors not interested in having their retirement funds in the equity or fixed income markets. This choice typically takes the form of a money market or stable value fund. These typically have low returns but with minimal downside risk.
Target Date Investments – designed as an all-in-one option for plan participants. Target Date Investments operate as blended portfolios which invest according to a plan participant’s targeted retirement age. The blended portfolios adjust asset allocation as the employee approaches the designated age. These funds are the most popular investments made available within 401(k) plans and receive favorable treatment in the eyes of the Department of Labor.
Alternative Investments – investments into areas like real estate, commodities, utilities, or other less traditional investments can be offered within a 401(k) plan. Plan sponsors should be conscious of the complexities involved with such assets and weigh whether their plan participants are qualified to understand risks/rewards involved.
Minimum Investments Required
The Department of Labor requires that 401(k) sponsors offer a minimum of three investment options, a cash option, a fixed income option, and an equity option. Nowadays, employees have come to expect more than three options. Striking a balance without duplication can be tricky.
Morningstar Box Approach
There are several means for categorizing investment options. For the purposes of 401(k) plans, the most common tool utilized are the Morningstar Category Boxes. Investment options are assigned to their appropriate category to help expose duplications. To avoid confusion, a popular strategy for selecting a fund menu is to offer investments in each of the main Morningstar boxes in addition to a cash alternative and target date fund series.
To Avoid Offering an Excess of Funds
Some plan participants have very specific expectations as to what investments they would like to hold within their 401(k) account. Growing fiduciary pressure spurred by a class action lawsuit targeting “too many funds made available to employees,” has caused many plan sponsors to look for ways to appease employees without increasing the plan sponsor’s own fiduciary risk. Offering a self-directed brokerage option is a great answer. Through the self-directed brokerage window, employees can access a universe of investment options outside of the 401(k)-fund menu while waiving the sponsor’s liability for those investment choices.