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Here’s how our small business 401(k) plan clients use low-cost investments. Not the conventional wisdom. Part 2 of 3

Greg Carpenter

December 29, 2022

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Last week I discussed how the trend toward index investments among our clients is accelerating – even for the smallest 401(k) plans. This week some thoughts on how our clients are using index investments for long term asset allocation strategies.

When we polled our over 2,000 clients, we found that low-cost index investments (including mutual funds, ETFs and indexed target date funds) account for approximately 50% of plan assets for those plans making investment choices in 2011, 57% for 2012 and 66% for plans choosing investments in 2013.

Conventional wisdom holds that small business 401(k) plans are less sophisticated and pay higher fees in general because of a lack of “buying power.” A growing number of our clients challenge this belief, holding low-cost investments with annual expenses that are often less than 20 bps (0.20%).

High 401(k) Fees

The role of ETFs

Our clients choose ETFs with low costs and passive management. ETFs are positioned as core alternatives providing broad market exposure at a low cost. We are not seeing actively managed ETFs or narrow sector strategies being employed with any significance. Typically, ETFs are used to provide exposure to either large cap or small cap equities, or to the broad US equities market.

ETFs account for less than 2% of market value in our clients’ plans, but share of assets is growing rapidly, albeit from a very small base.

The role of Target Date Funds (“TDFs”)

TDFs are rapidly growing in popularity in our clients’ accounts. Virtually all of our clients that use TDFs choose TDFs composed of index funds – think Vanguard small business 401(k) plan - in proportion to the asset allocation of equities and fixed income. The Vanguard 401(k) target retirement funds are the leading investment for our small business 401k plan clients choosing TDFs.

For plans that allow for investment in TDFs, TDFs comprise the majority of assets. TDFs are often the affirmative or default choice for participants that do not want to determine their own asset allocation. As we bring on new clients, we are seeing an ever increasing percentage making use of TDFs and prominently using them as their plan’s default fund. For plans making new investment selections in 2013, TDFs represent over 21% of plan asset value, up from 16% in 2011. Based on client feedback – and industry surveys – check out this 2013 research paper from Morningstar - we do not see an end to the trend toward TDFs.

“Set it and forget it.” A few thoughts.

In general, I am pleased at how our clients are using low cost investments. Sponsors are giving participants a broad range of investment options, and participants are opting for “set it and forget it” allocations. Small investors seem to understand the power of asset allocation and they are embracing it by quietly investing in age-appropriate asset allocation strategies. We also see very little trading between positions. This approach is a key to retirement readiness.

I do have two caveats. First, sponsors should continue to monitor investments in accord with proper fiduciary standards. While low-cost ETFs and TDFs are a solid choice, sponsors need to stay on top of trends and new technology. As more investment firms offer low-cost investment choices, sponsors should periodically review investment selections. Fees may be dropping!

Most importantly, the industry (and regulators) needs to address transparency in asset allocation “glide paths” for TDFs. Currently, disclosure rules do not require investment managers to disclose how asset allocations will change over time as the investor approaches retirement. These disclosures are particularly important the closer one gets to retirement age, as managers may be inclined toward keeping equity allocations high in order to boost earnings in the short-term and tout returns. With the growth of TDFs, this issue needs to be addressed sooner rather than later. (I know. Good luck with that.)

Next – “leakage” in the small plan market. Stay on the frugal cutting edge!

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