How (and why) 401(k) Investment Offerings are (or should be) Changing

Jeanne J. Fisher

Recent regulation (i.e. the DOL Fiduciary Rule) and increased fiduciary litigation has led to significant changes in Defined Contribution Plans. Service standards, fee structures and the very make-up of the industry is evolving daily.

With the entire industry in a state of upheaval, I venture to say that no one (or nothing) is experiencing the swift kick of change quite like 401(k) investment lineups. In my opinion there are three big areas where changes are likely to appear over the next 3 – 5 years.

Index Funds are Forcing Active Funds Out

As of 2015, index funds dethroned active funds and represented more than half of the assets invested in public pension funds. The 401(k) market is following suit with the use of index funds growing 30% in the last 6 years. This according to Morningstar, an investment research firm based out of Chicago. A whole slew of reasons contribute to the rise of index funds, but according to a recent survey by Cerulli Associates, 57% of plan sponsors who adopted passive funds did so to “alleviate threat of lawsuits/fiduciary concerns.” Let’s break down why index funds are considered by some to be the more prudent choice.

    1. Performance History and Benchmarking – Plan fiduciaries and investment advisors monitor a fund’s performance by comparing it to a benchmark. Historically, the majority of active funds (somewhere between 80 and 90%) underperform their respective benchmarks. Morningstar tracks historical performance with their Active/Passive Barometer. When a fund underperforms, the committee must place it on a watch list or eliminate the fund. If it represents a vital asset class they then have to find a replacement. Plan participants must be notified of the upcoming fund change 30 days in advance of the actual change. The entire process is cumbersome, administratively difficult and requires extensive documentation and decision-making by committee members. By definition, an index fund is designed to track a benchmark. While index funds can certainly fail other metrics that fiduciaries should be monitoring, we can potentially significantly reduce the risk of underperformance by holding funds specifically designed to match the index.
    2. Cost – Index funds do not require the human element associated with active funds, thus their internal expenses can be considerably lower. A primary fiduciary duty is to ensure that all plan fees and expenses are reasonable. Considering index funds are often a fraction of the cost of an active fund, coupled with their historical performance referenced above, one must be ready to defend selecting an active fund over a passive fund. Expense ratios of each fund will be disclosed on the firm’s 404(a)(5) Participant Fee Discloser.
    3. Style Drift – Each fund is assigned an asset class, which for lack of a better word, denotes an investment category. Large Cap Equity, Real Estate, and Government Bonds are examples of asset classes. Fiduciaries are responsible for providing their plan participants with a diversified lineup, and most advisors do so by ensuring a variety of asset classes are represented. Active funds can drift from their original asset class, making it more difficult for the fiduciaries to monitor. Index funds stay tried and true to their asset class and will not drift into a different style box. It is important to note, however, that diversification alone cannot ensure a profit or protect against a loss.
    4. Revenue Sharing – The act of ‘sharing’ revenue between service providers was, and could still be, very common in the retirement plan industry. Mutual funds used to share revenue with everyone from the advisor, to the record-keeper and TPA. Back in 2012, the Department of Labor issued their Service Provider Disclosure Requirements under section 408(b)(2) and section 404(a)(5). These requirements provided the transparency necessary for plan fiduciaries to identify who was being paid what and how. Now with the Department of Labor rule putting even more liability on the advisor, eliminating the conflict of interest created by revenue-sharing is a must. While not all active funds engage in revenue sharing, many do. Plan fiduciaries can make an effort to avoid this issue altogether by choosing a lineup of index funds.

Open-Architecture Platforms

Historically, Defined Contribution plans were sold with a pre-determined list of available investment options. More often than not, that list was limited to funds managed by the recordkeeper. For example, a Fidelity 401(k) would only offer Fidelity Mutual Funds. An “open-architecture” platform is where the recordkeeper has opened up the contract to a variety of other fund managers – even competitors. Today it is very common to see Vanguard Funds in a Fidelity 401(k) or American Funds in a John Hancock 401(k). Most advisors have embraced the open-architecture platform for their flexibility and increased competition. However, there are still plans out there on old group contracts. At this point, an open-architecture plan is no longer just the preferred course of action—it is an absolute necessity. I cannot imagine a plan fiduciary trying to defend a plan with significant restrictions on fund availability when open-architecture options are so readily available.

Institutional Share Classes

Finally, plan fiduciaries are focusing on share classes and driving line-ups toward the cheapest share class available. As with almost anything else in the world, 401(k) investors can possibly benefit from economies of scale. The theory is simple: the more you buy, the lower the incremental price for everyone. Investors in 401(k)s are a part of a larger pool of money, thus giving them greater buying power when purchasing investments.

The same mutual fund can have a dozen different share classes. As an example, let’s consider the American Funds Growth Fund of America. Let’s say all of the investors have bought into the same strategy and model, but they all can be paying different expense ratios. You can liken this to passengers on an airplane. They are all traveling to the same destination, at the same speed, but those passengers in first class have paid more for their ticket. If the fund’s share class isn’t monitored properly, you may find Retail Share Classes inside a 401(k) plan that qualifies for the much lower-cost Institutional Share Class. In my own reviews of case law, I’ve found this has been a common complaint by the plaintiff in recent fiduciary litigation. Finding retail share classes, often denoted by an “A” or “B” after the fund name, are the first indicator that the 401(k) plan is outdated and may not have the level of oversight it should.

Designing an investment line-up for a group of people is significantly more complicated than choosing investments in your own portfolio. Decisions must be made through a fiduciary ‘lens’, with the retirement committee and advisor leaning heavily on the Prudent Man Rule.

In my opinion, it would sensible for Plan sponsors and administrators to choose advisors with specific knowledge and experience of the Retirement Plan Industry to help guide them through this process.


Jeanne J. Fisher, CFP, CPFA, MBA