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TYPES OF
401k PLAN INVESTMENTS
Access Research estimated that the assets of 401k
accounts had a total 1996 value of $675 billion (Barneby). The Investment
Company Institute, the trade association of the mutual fund industry, has
separately estimated this value to be $857 billion (Reid and Crumrine). The
average account balance in 1996 was reported to be $32,000, with over 1.9
million individual accounts of $100,000 or more (Barneby). How are these funds
invested?
· The
typical 401k plan offers participants the choice of a variety of investments,
and in many plans this choice includes investments from differing categories
of financial instruments. (The selection of investment instruments influences
the magnitude of fees imposed on 401k investment accounts, as will be
discussed further in Section III.) Listed below are these investment choices.
This is followed by a discussion characterizing these investment
choices.
· Mutual Funds
-- Retail Mutual Funds
-- Mutual Fund
Windows
-- Institutional Mutual Funds
· Stable
Value Accounts
· Company Stock
· Money Market
Funds
· Self-directed Brokerage Accounts
Table II-3
Allocation of assets in 401k Plans
(End 1996)
|
% of All 401k |
| Type of Investment
Equities
Bonds
Balanced
Stable Value
Accounts
Company Stock
Money Market Accounts
Self-Directed
Brokerage Accounts
Other
(Source: RogersCasey, 1997) |
Plan Assets
47%
4%
13%
19%
10%
5%
1%
2%
|
This distribution may not be an absolute indication
of employee preferences among these investment options, because not all plans
contain all of these investment choices. For example, in 1995, 95 percent of DC
plans contained an equity mutual fund option while only 59% contained a stable
value account option (Foster Higgins, 1996).
MUTUAL FUNDS
In a mutual fund, contributions to
the plan are used to purchase mutual fund shares on the same basis as an
individual investor would buy the fund shares. These mutual funds may be retail
funds, available to the general public and whose prices are quoted daily in the
financial press or institutional mutual funds, available to a limited set of
investors.
Mutual funds are pools of financial instruments
that may include stocks, bonds, commercial paper, cash, and other instruments.
Shares of mutual funds are bought by investors, including 401k plans. The shares
represent an undivided common interest in the pool of investments. The share
holders benefit by receiving the earnings of the investments in the form of
additional shares and by a capital gain when the shares are redeemed from the
mutual fund.
In 1996, for the first time, mutual funds became
the largest segment of assets held in 401k plans, constituting just over 40% of
asset value (Foster Higgins). However, for several years the inflow of funds to
mutual funds had been greater than to other investment options. The shift of
investment by 401k plans into mutual funds has been dramatic, increasing from 5%
of assets in 1990 to 40% in 1996 (Reid & Crumrine).
Retail Mutual Funds
Mutual funds are marketed to a wide spectrum of
investors including individuals. Mutual funds may be categorized by the type of
underlying security equity, bond, or mixed and by the investment objective.
Investment objectives are often expressed, at least in part, in the terms of the
risk-return considerations. The following table illustrates the range of retail
mutual funds that are likely to be found in typical 401k plans (Sheets,
1996).
Additional non-profit websites
that include relevant unbiased information about 401k plans
include: www.403bplans.net
and www.mutual-fund-401k.com.
Table II-4
Typical Mutual Fund
Categories
| Underlying Assets
|
Investment Objective
|
| Stock Funds
Bond Funds
|
Aggressive Growth
Long-Term
Growth
Growth and Income
Sector
International/Global
High Quality Corporate
Junk
(high-yield)
Government
Mortgage Securities
|
The distribution and marketing of mutual fund
shares is governed by the Securities and Exchange Commission (SEC) which
prescribes how expenses of the fund must be disclosed. These expenses are
expressed as an annual ratio of expenses divided by total assets. The expense
ratio is debited from shareholders' assets as compensation for the fund's
investment management services.
Retail mutual funds are widely advertised, and
their expense ratios are published weekly in the financial press. About 80% of
401k mutual fund assets are in retail funds (Wang, April 1997). Expenses of
retail mutual funds vary widely according to investment objective, whether or
not actively managed, category of instruments held, sales commissions, and other
criteria. The range of expenses in funds likely to be found in typical 401(k)
plans begins at 20 basis points for the least expensive index funds to over 200
basis points (Fortune, December 23, 1996).
Mutual Fund Window
A recent development in the design of
401k plans is the addition of an option allowing participants to chose from a
larger variety of funds. The mutual fund window provides access to one or
several families of mutual funds. The mutual fund window can be either the sole
investment vehicle for all options, or it can be one of many options within an
array of investment offerings. In 1997, 3.7% of plans offered access to a mutual
fund window, according to one survey of plan sponsors (Buck
Consultants).
Fees and expenses for mutual fund windows are
similar to those for other mutual fund options, and they will likely be the
retail expense ratio.
Institutional Mutual
Funds
Many of the larger financial service providers -
banks, mutual fund families, stock brokers, or insurance companies - offer sets
of mutual funds that are bought by institutions and are not available for sale
to individuals. Among the purchasers of institutional funds are 401k plans,
other DC plans, and the trustees of DB plans who might buy institutional mutual
funds to fund their defined benefit liabilities.
Institutional mutual funds resemble retail funds.
They display a similar range of investment objectives and may invest in similar
ranges of securities equities, fixed income, large capitalization versus
small, U. S. versus international, etc. However, they are not sold through
broker/dealers, and their performance is not generally displayed in the
financial press.
Institutional mutual funds typically charge lower
expense ratios than do the retail funds with similar holdings and risk
characteristics. One estimate is that the typical institutional fund has an
expense ratio that is 50 basis points lower than comparable retail funds (Wang,
April 1997).
Larger 401(k) plans often obtain some savings in
their investment management expenses by taking advantage of a type of
institutional mutual fund known as the commingled account. In this
arrangement, a set of established investment vehicles is available to a pool of
participating plans. These institutional funds are similar to retail mutual
funds, in that they typically reflect a range of broad asset allocation
objectives. Many of them are provided by the major retail mutual fund families.
Other major providers include the trust departments of larger banks and
insurance companies.
However, these funds are only sold to larger
investors, including 401k plans. Investment in any of the investment vehicles
within the commingled account typically requires a minimum investment of $1
million to $2 million in the commingled account (Hack).
Very large plans can achieve even greater
investment management savings by establishing separate accounts for their
401k assets. In such an arrangement, the sponsor can define its own investment
objectives and target portfolios. The investments are administered either
through an external investment manager or in conjunction with the sponsor's DB
plan investment apparatus.
Separate accounts require substantial minimum
investments of $15 million to $25 million per account. However, large plans
typically, with total assets of over $500 million, can realize substantial
savings through such instruments. Total investment management expenses can
commonly be reduced to one-fourth of the expenses incurred through retail mutual
funds (RogersCasey).
In general, direct use of retail mutual funds or
the provider's institutional funds is the most common investment arrangement
among smaller plans, those with assets of $50 million or under. Mid-sized plans,
those with assets of $50 million to $500 million frequently add commingled
accounts. Finally, separate accounts are found among very large 401(k) plans,
those with assets over $500 million (Hack).
STABLE VALUE ACCOUNT
Stable value accounts represent the second largest
class of holdings by 401k plans after mutual funds, constituting 19% of 401k
assets in 1997 (RogersCasey). These contracts represent a claim on the future
investment earnings of the seller's investment portfolio or on a segregated
group of the assets in this portfolio. Stable value accounts include guaranteed
investment contracts (GICs), typically offered by insurance companies and bank
deposit accounts (BDAs). The investor in a stable value account receives a
guaranteed rate of return over a specified period of time, typically three to
five years. The yield on a stable value account is comparable to that of a high
quality fixed income investment. In 1995 the average net return on GICs held by
DC plans was reported to be 6.5% (Foster Higgins).
Stable value accounts are appealing to investors
who are risk adverse. This investment shields the purchaser from the credit and
interest rate risks to principal that would be assumed by the purchase of a
fixed income mutual fund. These instruments also have low rates of return
compared to the historical long-term returns on equities, and particularly
compared to the recent performance of equity investments. The trend in recent
years has been for increasing percentages of 401(k) contributions flows to be
directed to equities rather than stable value accounts and other fixed income
investments (Foster Higgins).
Administrative fees and expenses placed on GICs and
BDAs are typically not disclosed directly to the purchaser. Investment
management fees and distribution charges are incorporated into the computation
of the guaranteed rate of return. Thus, there typically is no disclosure of
these expenses to the sponsor nor to the participants (Hack).
When stable value accounts are provided by a full
service provider from an outside source, there will be a separate charge to the
plan for recordkeeping. This is typically a fixed charge.
COMPANY STOCK
Company stock may be an investment option for
employee contributions to 401k plans. (However, some analysts view company stock
as potentially very risky for an employee saving for retirement, since it
represents a narrow, undiversified investment option and links future and
current income to the same source.)
One survey of plan sponsors showed that 37% of
plans offered this investment option in 1997 (Buck Consultants). In 1996, 9% of
the assets of DC plans were invested in company stock (Foster Higgins). A 1997
survey of 401k plans reported 10% of total assets invested in company stock
(RogersCasey). Company stock is also typically offered as part of the employer
contribution to the plan or in a combined 401(k)/profit sharing arrangement. In
1997, 21% of the 401k plans making matching contributions provided company stock
or a combination of stock and cash as the company match.
The bundled service provider typically charges a
recordkeeping fee to plans that includes company stock as an investment option.
These fees are charged in a variety of ways: per-capita charge, fixed fee, fixed
fee plus per-capita charge, or stock commission.
MONEY MARKET ACCOUNTS
Money market accounts are actually mutual funds
that invest in short term (typically 90 days or less), fixed income securities.
As such, they are often considered as cash equivalents. In the unusual
conditions prevailing in the mid-80's, with an inverted yield curve, these
accounts were widely used as prime investment instruments. However, in recent
years, money market accounts are most often used as parking accounts for money
waiting to be invested in other instruments, as sweep accounts for the
collection of dividends, or by very risk averse investors. Money market accounts
were offered by 58% of DC plans in 1996, but just 7% of assets were invested in
these instruments (Foster Higgins). A 1997 survey of 401(k) plans reported 5% of
total assets invested in money market accounts.
SELF-DIRECTED BROKERAGE
ACCOUNTS
A small number of plans offer participants access
to a self-directed brokerage account (1.6%, Buck Consultants; 4%, RogersCasey).
This type of account is similar to a mutual fund window, but it offers the
ability to purchase individual stocks and bonds in addition to mutual
funds.
Self-directed brokerage accounts have appeared in
response to demand from certain types of 401k plans. These accounts are
generally appealing to companies where the typical individual account is large
and the participants are financially sophisticated. Typical plans offering
self-directed brokerages would be professional corporations such as law firms,
accounting firms, and medical practices.
Providers are charging administration fees for
self-directed brokerage accounts in a rather uniform way, generally on a
per-capita basis. The range of charges is typically $50 to $100 per participant
per year (Cerulli). Participants also pay the transactions charges levied by
their brokers for trades in the accounts.
401k PLAN ASSET HOLDINGS
The assets of 401k plans are generally held and
invested in common under the control of the trustee of the plan. With the
exception of the self-directed brokerage assets, the holdings of individual
participants are not discretely identified except by accounting
entries.
Contributions to the plan, by the individual
participants and by the sponsor, are invested in accordance with the
instructions of the individual participants and their accounts are annotated to
indicate where the investments were made. Similarly, investment gains are
apportioned among the individuals' accounts in the plan's portfolio of
assets.
INSURANCE PRODUCTS
When the provider of 401k investment products is an
insurance company, the plan's assets are often packaged in a characteristic
insurance product, the variable annuity. Such a plan's asset holdings
would contain a set of investment instruments similar to those in plans serviced
by other providers. However, when wrapped into an annuity, usually by an
insurance company provider, such an account then becomes an insurance product
and is exempt from the Securities Act of 1933.
The group annuity wrapper qualifies the plan as an
insurance product. This provides certain tax preferences and excludes it from
the accounting and disclosure provisions that apply to regulated securities.
(The tax preferences do not provide any advantages to 401(k) plans since such
plans already receive tax preferences.) An advantage to the provider in this
arrangement is that the fees are not subject to the SEC rules that apply to
other 401(k) products (Hack).
Group Variable Annuity.
The group variable annuity is simply a
wrapper placed around a bundle of other investment vehicles such as mutual funds
and general account investment options. The wrapper consists of a set of
guarantees that include:
· A minimum
death benefit expressed in terms of the member's and firm's
contributions,
· A post-retirement rate of return, if the
participant elects a pay-out in the form of an annuity, and
· A
guaranteed level of expense to be assessed against the assets of the
account.
In a group annuity, each participant has an
individual account, but the guaranteed annuities apply to every participant
identically. The group annuity arrangement requires daily recordkeeping of
accounts at the participant level.
Administrative fees and expenses are assessed on
two levels within the group annuity (plus itemized expenses that may be charged
directly to the plan). There are investment management fees assessed against the
individual mutual funds and general account investments within the annuity wrap.
In addition, there is a wrap fee assessed against the total assets in the
annuity.
Individual Variable Annuity.
This product is similar to the group annuity except
that the individual accounts are separately designed and packaged for each
participant. This adds to the administrative cost of recordkeeping and
administration. The individual annuity is usually used for very simple, small
(less than 25 participants) plans (Hack). A typical use would be in a company
with highly compensated, professional employees such as a law or accountancy
firm.
The administrative fee and expenses structure for
individual annuity plans is similar to those for group plans, but the wrap fees
are substantially higher. One estimate suggests that the mortality and expense
fee (see Section III for a definition) plus distribution charges would total 200
to 300 basis points for individual annuities (Hack).
REPRESENTATIVE 401k INVESTMENT
OPTIONS
A 401k plan sponsor typically will select a variety
of investment options from which the plan participants may select targets for
their contributions to the plan. These options are typically pre-defined retail
mutual funds correlated to a particular category of financial instrument or to a
general asset allocation objective. They may be also include institutional funds
with specified objectives and investment parameters, with plan sponsors
directing assets to these funds on a pooled basis through a commingled account,
or on their own through a separate account.
However, as a background to developing assessments
of typical plan investment costs, some notion of benchmark 401k plan portfolios
should be defined. A recent and useful typology was offered by Pellish and Buehl
(Journal of Pension Plan Investing). They articulate three prototype
model portfolios that might be offered within a 401(k) plan. Within each of the
three model portfolios, specific investment vehicles are listed in order,
starting with those expected to have lower risk and lower returns over time,
ending with those expected to have higher risk and higher returns over
time.
"Core Options" Portfolio
A potential array of investment options for
newly-forming plans, and/or plans with participants who are relatively
unsophisticated about investment strategies is displayed below. This is a simple
portfolio; relatively easy to shop for, purchase, and administer; and
well-equipped to minimize participant confusion.
1. Stable value account (e.g., GIC) or short-term
bonds
2. Balanced fund
3. Large cap U.S. equity fund
4. International
equity fund
5. Smaller company U.S. equity fund
"Enhanced Core" Portfolio
This plan would diversify the options available at
the low-risk/low-return end of the investment spectrum. It would also introduce
pre-packaged "lifestyle funds" intended to provide a composite set of
investments designed to achieve a particular overall asset allocation
objective.
1. Money market fund
2. Diversified bond
fund
3. Conservative lifestyle option
4. Moderate lifestyle option
5.
Aggressive lifestyle option
6. Large cap U.S. equity
7. International
equity fund
8. Smaller company U.S. equity fund
"Full Array" Portfolio
This model portfolio maintains the notion of a
plan-defined array of specific options. However, it diversifies the options at
the higher-risk/higher-return end of the spectrum, and introduces the use of
mutual fund windows and/or self-directed brokerage approaches. These features
typically are targeted to the demands of participants who consider themselves
highly informed about investment strategies, and consider the traditional core
offerings as unduly restrictive.
1. Money market fund
2. Diversified bond
fund
3. Conservative lifestyle option
4. Moderate lifestyle option
5.
Aggressive lifestyle option
6. Large U.S. cap equity fund
7. International
equity fund
8. Smaller company U.S. equity fund
9. Emerging market equity
fund
10.Mutual fund window
11. Self-directed brokerage
These prototypical sets of investment options
illustrate the range of choices typically offered to 401k plan participants.
Within each of the fund types, investment management expenses vary widely.
Section IV presents information concerning the range of investment management
expenses observed for different types of investment options in recent years. rrp
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