Understanding 401k Investment Options

Baruch Friedman was finally eligible for his workplace 401(k) benefit. As a company perk, every dollar he put into his 401(k) account would be matched up to 5% of his salary. But Baruch was confused about what would happen afterward. Would the money just sit there in cash, or would it be invested? And if it was to be invested, who was responsible for that? He hoped it wasn’t he, because he knew very little about finance.

What investments are offered within a 401(k) plan? And who is in charge of them?

The 401(k) Investment Challenge

For most Americans, workplace retirement savings plans, which incentivize putting away a bit of each paycheck, represent their primary saving and investment opportunity. A match plus tax savings built into 401(k)s is a big inducement to save, and most employees nationwide do so. But if the money sent to a 401(k) account just sits there in cash, it won’t grow. It also probably won’t be worth very much in retirement, after decades of inflation. Money headed to a 401(k) should be invested, but who should take on that responsibility? And how should it be managed logistically?

Companies Don’t Want the Risk

Most employees don’t know how to invest, but the company’s owners and managers don’t want to take on the risk and responsibility for doing it for them. It would be a major headache for them to try to satisfy employees’ varied risk tolerance and investment preferences. Furthermore, the company investing money for its employees would open it up to disappointments and even lawsuits should investment results fall short of employees’ expectations. Hiring a money manager to invest the funds communally on everyone’s behalf wouldn’t eliminate the company’s exposure; employees could sue the employer for hiring the wrong manager should investments not turn out as employees hoped.

Participant-Directed Investment

Most companies therefore go the route called participant-directed investing. (“401[k] participant” means “employee,” unlike the company, which is called the “401[k] sponsor.”) With the help of an investment adviser, the company arranges for a limited menu of mutual funds to be made available directly to employees within their 401(k) accounts. It is then up to each employee who participates in the 401(k) plan to decide which of those couple of mutual funds they want their money to be invested in. After employees decide to withhold a bit of their salaries and hopefully get their 401(k) match, that money is automatically invested by the 401(k) custodian in mutual fund(s) as per the employee’s selection.

Simpler and Safer

Participant-directed 401(k)s are simpler than, say, IRAs. Picking a mutual fund or two out of a small, curated list is a whole lot easier than becoming an amateur stock trader. 401(k) custodians must also give employees enough information to make educated selections and allow them to change their selections from time to time. From the employer’s side, proper implementation of participant direction provides the firm regulatory “safe harbor” protections (as per section 404c of federal ERISA law). As long as the menu meets certain guidelines, employees and the Department of Labor can’t sue over disappointing investment results. Participant-directed investment outcomes are the employee’s business, not the employer’s.

401(k) Investment Menus: From Tiny to Sprawling

The safe harbor can be met by offering as few as three funds—a stock, bond, and cash option. But most employers and investment advisers bulk that up and include 10 or 20 mutual funds from across the investment spectrum. There are usually a few US stock funds, an international stock fund or two, some bond fund options, and a money market or other “capital reservation” option. But I’ve seen plans with as many as 100 funds on offer. This may seem helpful since more choices might look like a good thing, but for most employees, too many choices lead to paralysis.

Target-Date Funds

Enter the opposite extreme, target-date funds (TDF). We’ve written about these amazing all-in-one funds before, which enable those who know nothing about investing to get great results with zero work. A TDF is a form of mutual fund whose aim is to invest the funds based on the expected dates of retirement of those who contribute to the fund. The premise is based on the reality that most long-term investors should have the bulk of their money in stocks and short-term investors should typically invest mostly in bonds. That goal can be obtained very simply and affordably through TDFs.

How TDFs Work

TDFs by definition begin with multi-decade time horizons and place most of the money into stocks. The money manager overseeing the pot will, over time, slowly shift the asset allocation toward a less risky stance as the target date of expected retirement approaches. So, a 401(k) menu will often include a bunch of virtually identical TDFs, one aimed to mature in 2060, another in 2055, another in 2050, and so on. All a participant needs to do is instruct the custodian to invest their account in the fund with the target date that corresponds with their age (and projected retirement), and the rest is done for them.

The Default Option

The 404(c) participant direction safe harbor first came into effect in 1996. To simplify things, the government created the qualified default investment alternative (QDIA) safe harbor in 2006. Employers could set up 401(k) plans to default employees’ contributions into something like a target-date fund on their employees’ behalf. As long as employees are notified in advance and are able to opt out whenever they so choose, the investments will default into the TDF corresponding with their age, and their 401(k) contributions will be deposited and invested on autopilot.

Employers who follow QDIA rules will be safe from blame should an employee wake up one day and say they don’t like the outcomes. And while this approach is paternalistic, it generally works out well for both employers and employees. The whole process is dumbed down to a point where both sides can go about their day without thinking about 401(k) investments. Employees get good investment management, and employers are protected from liability. In the long run, most will do quite well with this. This fact is the reason QDIAs are now standard for most 401(k) plan arrangements.

Stay Tuned

Should an employee want to design their own portfolio, the participant directed option of selecting from a menu of mutual funds is still there. The question then arises: How can one go about designing an ideal portfolio from among the list of funds? Also, not all plans offer QDIAs, not all plans offer TDFs, and not all TDFs are created equal. In another article we’ll discuss the next step of selecting 401(k) investments.

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