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How Employers Choose Funds to Offer in Their 401k Plans

    

With more than 8,100 mutual funds available in the market, you may wonder how your 401k plan narrowed those offerings to a handful or two.

The process of selecting 401k plan investments is not haphazard. Employers are required by law to use reasonable methods to cull this wide field in order to present your plan's choices. And some plan providers offer an additional level of vetting.

The result is that in many cases the funds offered by your plan have gone through at least one level of screening, if not two. Consequently, most funds offered in 401k plans are of high quality. "I would say if a fund isn't consistently in the top quartile (in performance), it would have trouble competing," said Ron Petrie, manager and chartered financial analyst (CFA) with Victory Capital Management.

Still, some workers may feel that their plan could do better. Often, these are savvy investors who would like more choice, or employees of small companies that faced constraints on what they could afford to offer in their plans.

Here's a look at some of the techniques employers and 401k-plan providers use to pick funds.

Fiduciary Responsibility

According to federal law, employers (known as "plan sponsors") are responsible for picking the 401k plan funds. This decision must be made in the best interests of the plan and its participants. "The plan sponsor must be a prudent fiduciary," said David Wray, president of the Plan Sponsor Council of America, a trade group representing 401k plans.

Part of that responsibility is using defined policies and methods for choosing funds. Many employers codify these methods by adopting an investment policy statement spelling out the criteria they use to add or remove funds in a plan. As a sign that 401k plan management is improving at the employer level, in 2000, 60 percent of plans had an investment policy statement, up from 50 percent in 1999, Deloitte & Touche reported in its 2000 401k Plan Benchmarking Survey.

The first step for an employer is to choose a "plan provider" or providers -- the firm or firms that provide services to administer and maintain a 401k plan. These include investment management, recordkeeping and trustee services, among others. Some providers aggregate these services from a variety of independent vendors while others provide all of them from their own resources.

The employer then decides which of the funds offered by the provider to include in its 401k-plan offering. Several factors influence this choice. First are the participants, said Ted Benna, president of the 401k Association. In most 401k plans there is typically a core group of participants (often about 10 percent) who actively manage their investments and constantly research the latest and greatest funds available. This group of participants tends to be vocal about any displeasure with a fund.

This group "has the clout" to shape not only their fund's offerings but also the entire 401k plan market, Benna said. That's why an increasing number of plan providers offer funds outside of their own proprietary ones, he said.

Another factor is the amount of assets in the plan. Typically, the more assets in a plan, the more funds a provider is willing to offer, and the more likely it is that a provider will offer funds outside of its own fund family.

A third factor is the cost of the funds. Sometimes, employers pass on a well-known fund with high administrative fees in favor of a lesser-known but similar fund with lower expenses.

At this point, plan providers put together a proposal to the employer which may consist of an off-the-shelf design, if the employer wants to keep costs low or the assets in the plan are small, or a more customized plan if the employer doesn't mind paying higher costs or the plan assets are larger. In either case, the employer and plan provider negotiate and the result is a unique plan that should be designed to meet the needs of the majority of employees.

Provider Screening

The plan provider sometimes conducts the first level of screening. Historically, plan providers, which were often mutual fund companies, only offered their own funds. But as plan assets have grown in size and participants have grown more demanding, these providers have begun offering outside funds. New, non-mutual-fund companies have begun offering plans, too.

According to anecdotal evidence from plan providers and PSCA, a growing number of providers have begun screening outside funds in order to ensure that all their offerings are of high quality. Some are screening their own funds, too.

"I know that some of our competitors have developed their own structured due diligence process. I think they should. This is the type of thorough ... oversight that needs to go into running these programs," said Michael Finnegan, CFA, vice president of The Principal Group, a 401k plan provider based in Des Moines, Iowa.

One Firm's Example

In 2000, The Principal Group began using the screening process outlined below, which is fairly typical of providers that screen.

First, the company determines what type of fund(s) it needs. It then does a first screen, using fund manager databases produced by companies such as Wilshire Associates Inc. or Frank Russell Co. It looks for the track record of the fund manager and fund management company; the size of assets under management; the fund's performance compared to its peer group and relevant benchmarks; and the investment methodology used (fundamental analysis or technical analysis).

This screen typically produces a list of 20 to 25 firms and funds that meet The Principal's standards, Finnegan said.

The next step is to send those firms a questionnaire asking for more details in five areas: the fund's organization (including the stability of the management team and manager compensation methods), the investment process (how cash in the fund is managed and what risk controls are in place), available resources (such as what trading and client service capabilities exist), performance and fees.

"All of these factors come into play, but the first three factors ... probably get 60 percent to 70 percent of the weight," Finnegan said.

The Principal Group also screens its own funds, he said.

Plan Sponsor Screening

The most critical level of screening is actually performed by the employer, also known as the plan sponsor, because it has fiduciary responsibility for the plan. Some employers hire outside consultants to assist with this process.

The first task for the plan is to figure out what asset classes it wants to offer, said Trisha Brambley, president of Resources for Retirement Plans Inc., a 401k plan consulting firm.

Once it makes that decision, the employer looks at the provider's offerings, sorts the available funds by asset class and chooses from each class. The entire process could require whittling down a 100-fund offering to 10, she said.

When selecting funds, employers typically look at some of the same factors plan providers consider. Employers may look at Morningstar or Lipper rankings (rather than Wilshire or Russell reports), expense ratios, risk statistics and past performance. Other factors might include whether a specific fund stays with its stated objective, how long the management has been in place and what the fund's investment objective is. Additionally, the employer needs to check that the investments held by the funds don't overlap, because that would reduce diversification for employees.

While these processes can help narrow a field, they can't guarantee a winner fund every time.

"After all (the review) you can still pick a dog," Brambley said.

If this happens and the plan decides to change the fund, it should begin the review process again. The important point is that the plan consistently uses the same procedures to find and maintain the funds. If you wonder if your plan has these procedures in place, you should ask your employer, Brambley said.

The employer has to keep in mind that a 401k plan is a long-term retirement savings plan, and choose funds appropriate for long-term saving. "You don't want the plan chasing funds," or changing them frequently, PSCA's Wray said.

This outlook tends to slow the introduction of new funds and often causes more active investors to grow impatient with their 401k plan's offerings. But, employers need to "balance" these complaints and suggestions against the risk associated with rapid plan changes, said Edward Stavetski, director of equity research with Pitcarin Trust Co. of Jenkintown, Pa.

Other Factors

One factor determining whether a provider offers outside funds is whether the fund company is willing to pay the provider to offer its funds. This is a common practice in the industry, Brambley said. Funds unwilling to pay providers often aren't offered. Sometimes these fees increase the costs to plan participants and sometimes they are absorbed by one of the parties offering the plan.

Sometimes, a plan provider may be unwilling to offer funds beyond its own ones, or the employer's negotiating power may be limited because it is too small to qualify for added funds. This can be a source of frustration for some investment-savvy employees. Keep in mind, however, that the trend among employers is to offer better plans and better oversight of plan investments. Remember, too, that the 401k has an edge over other tax-deferred savings plans you could use on your own, with its higher contribution limits and chance of an employer-matching contribution.

This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.


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