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Looking Beyond Mutual Funds
When trying to decide which funds should be on the
menu, sponsors must consider which options will leave its
participants in the best position at retirement. This may
mean sticking with more traditional options like mutual
funds that participants have grown comfortable with or make
the switch to new options for investing 401(k) money.
“The goal with 401(k) is not to pick the best funds, it’s
to have an adequate retirement,” said Darwin Abrahamson,
CEO, Invest n Retire, and a panelist at PLANSPONSOR’s Plan
Designs 2006 conference in Chicago last week. Abrahamson
stands among early believers that ETFs could provide a
low-cost investment option for 401(k) plans.
ETFs — often thought of as a substitute for indexed funds
— entered the fray of investment options in the 1990s, but
like managed funds, they haven’t yet gained a substantial
marketshare among 401(k) plans.
Like mutual funds, ETFs are diversified portfolios
of securities managed for many investors.
However, they trade like stocks, are listed on major stock
exchanges, and are valued throughout the trading day.
Because ETFs can be traded like securities, a brokerage fee
is generally tacked on to the option, which has caused some
skepticism of whether the funds will stick as a 401(k)
option (see
ETFs: Exchange Rates
).
"Even if 70 to 90% of fees are in investment costs,
very few trustees know what they are paying," Abrahamson
said. He said that no matter which investment option is
used, plan sponsors should know exactly what their costs
are and precisely what services they are paying for.
Their advantages notwithstanding, barriers remain that make
401(k) plan adoption problematic.
Abrahamson says that the custodial firms he
solicited insisted that each plan participant would have to
open an individual brokerage account, a prohibitively
costly idea for most plans. Finally a Denver-based
custodian relented and said it would allow him to overcome
the separate-account hurdle by bundling every participant
trade in his plans on a single basis and then conducting
one omnibus transaction -- a method typically reserved for
large institutional funds.
Jerry Plappert, a panelist and the CFO of
Fisher-Klosterman, a Louisville-based supplier of pollution
control systems, was one of the first 401(k) plans that
only offered ETFs to its participants. And it was
Abrahamson convinced him to do so.
During a question and answer session, Plappert was asked
what he told participants when they wanted to know what
kind of returns they would get with ETFs.
Plappert admitted "I get nervous about talking about
returns to participants. Returns are important, but as a
fiduciary I can manage costs."
The introduction of new investment options has
given plan sponsors even more to think about when trying
to figure out which ones they want to include on the
menu. They must strike a balance between wanting to offer
their participants more and perhaps offering too much,
leading participants to steer away from participation
because they are too overwhelmed.
Panelist Jennifer Flodin, PRP, Chief Operating Officer at
Plan Sponsor Advisors, said that an Investment Policy
Statement - a document for qualified retirement
plans that details the procedures fiduciaries will use
for investment selection and evaluation -- could go a
long way in helping plan sponsors figure out which
options to put on the menu. She said the process should
increase fiduciary prudence as well as help with picking
options.
One debate is whether to use lifestyle funds -- which
change fund allocations based on risk tolerance -- and
lifecycle funds -- which typically rely on age as an
indicator of how heavily weighted a participant should be
in equities and bonds.
Mendel Melzer, CIO for Newport Group, strongly subscribes
to the idea that lifestyle funds rather than lifecycle
funds should be a staple on a menu of investment options.
"Not all 45 year olds have the same risk tolerance,"
therefore they should not be restricted by a lifecycle
fund, he argued.
However, Flodin disagreed. She said that target date
funds take into account the fact that participants rarely
change their asset allocations to reflect their changing
risk tolerance. Instead, she thinks that lifecycle funds,
in which asset mix changes as participants get older,
recognize participant inertia.
An investment policy statement (IPS) can provide plan
sponsors with a mechanism that provides a discipline for
removing a consistently underperforming investment
option.
The question sponsors must answer is, how long must
a fund be performing poorly before it is removed, and how
is poor performance quantified?
"Look at the investment options that are currently included
and look at their future," said Melzer, when trying to
determine whether to scrap an option. "Then try to decide
if future performance will be worse than past performance."
The process of removing an investment choice usually
includes a period of time when the fund is watched very
closely, after a period of poor performance. During this
period, Melzer said the "watch list" funds are reported on
in fuller detail than other funds in the reports and
requires that the analyst defend the fund. Melzer and
Flodin concurred that the fund in question should not stay
on the watch list for more than four quarters.
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