Looking Beyond Mutual Funds

July 5, 2006 (PLANSPONSOR.com) - Chicago - Plan sponsors have been looking beyond mutual funds since they took their plunge from grace at other investment options for 401(k) plans that include the likes of lifestyle funds, managed accounts and exchange-traded funds (ETFs).

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.