Fund Choices in a 401(k) Plan, Do's and Don'ts

Myth: Choice is Good inside a 401(k) Plan

Americans love freedom and choice! So isn't it good to have many fund choices in 401(k) plans? To answer that question, we have to address diversification.

Diversification: The Employee Retirement Income Security Act (ERISA), the Uniform Prudent Investor Act (UPIA) and the Restatement 3rd of Trusts (Prudent Investor Rule) all agree that the key to long term investment success is broad diversification of risk.

Therefore as a plan overseer, one of your most important duties is to increase the probability that each participant has maximum diversification in their account. If you want to know more about why diversification is so critical, please contact us.

Too many funds choices is bad because it takes away from diversification. What's "too many"? See common mistakes, next section below.

Common Mistakes

1) Tyranny of Choice: If your plan participants invest in more than one fund in the same asset class - they unknowingly concentrate their assets, causing less diversification, more volatility which hurts their long term returns. This problem occurs most often in the large cap space. Here's a great article on this problem, "The Tyranny of Choice."

2) Bundled Plans: Often a bundled plan of funds - one fund family - will share their "best investment ideas" among the funds. So you will find the same stock in many different funds and participants' assets become concentrated in certain individual stocks. Again, this lowers diversification, increases volatility and hurts long term returns.

3) Retail mutual funds: Often retail mutual funds have the problem of style drift or not investing as their fund name would suggest. This leads to, yes, you guessed it, less diversification, higher volatility, lower returns.

What to Do Next

Easiest Solution: You're probably not trained as an investment advisor. Use an ERISA Section 3(21) independent advisor that insists on bringing an ERISA Section 3(38) independent advisor with them. The 3(38) advisor takes over responsibility for fund selection and monitoring. They do it for you, relieve you of significant fiduciary liability and are cost competitive. They are investment experts - and specifically for 401(k) plans which are uniquely different than an investment advisor investing your personal account..

If you are delaying a move to a 3(38)-based plan, then you just need to avoid the most common mistakes listed above. Break the myth, be a "choice contrarian" and help your participants get better long term returns through greater diversification and lower volatility!

Most plans ought to be able to achieve good diversification and avoid concentration with about 10-15 funds. A few of your participants may rebel a bit at first, but you can confidently move forward knowing that you are doing what's best for everyone in th plan and fulfilling your fiduciary oversight responsibility with flying colors!

We can provide a free benchmark of your plan which you are supposed to be doing anyway, contact us for more information or click on the Schedule a Meeting button below.

Fiducaries vs. Financial Product Salesperson (8/10/2010)

Follow the Money It's important to know how your advisor gets compensated because it impacts their behavior: so follow the money!Two ways for a financial advisor to get paid:1) Commissions from the products they sell you, or from security trades they make for you or2) A percentage fee charged on the assets under management  - called "fee-only advisor".The problem with commissions is they influence advisor loyalty toward their boss or to the products they sell, rather than to you.   It's not an indictment of the person receiving the commissions.  Their intentions are probably good, but all things being equal why deal with the possibility that their judgment could be impacted?  Often hidden fees and penalties are present in this environment as well as we point out in an example below.The only investment professionals held to a fiduciary level of responsibility are Registered Investment Advisors (RIA) often called fee-only advisors.Lynn O'Shaughnessy wrote a wonderful article, "Financial advice better from fiduciary than broker" on this important topic. Common Mistakes 1) Using a commission-based advisor (broker) and not demanding (in a nice way)complete disclosure of all fees.    Be specific and get it in writing.2) Comparing expenses of a fiduciary RIA vs. a broker before getting a complete disclosure of the broker's fees.    You may mistakenly assume the RIA is more expensive since they fully disclose.   Usually RIA's are competitive, and often provide superior service for the same or less cost.(We know of a recent situation where an RIA was charging an initial one-time financial planning fee of $2,000 with ongoing planning at no cost.   The prospective client decided to hire a broker with "no up front fee".  However, when the client asked further disclosure questions at our advice, an up front hidden fee of more than $20,000 was revealed.   At that point $2,000 sounds pretty good and the client received a comprehensive initial strategy for it.)3) Using multiple advisors as a fail-safe or diversification strategy.   Unfortunately this puts you in charge of allocating assets between the advisors which is likely not your area of expertise   It's best to have one trusted advisor with access to excellent diversification vehicles allocate all your investable assets.  You overall level of diversification will be higher. What to Do Next Thinking about trying a new advisor?   We encourage you to work with a fiduciary RIA fee-only advisor since their fee structure is aligned with your interests.    No matter who you work with, demand fee transparency - disclosure in writing.Begin with The End in Mind:  For any successful journey, you need a compelling vision AS THE OVERALL FIRST STEP.We help people put their vision on paper using a tool called Financial Road Map for Living Your life on Purpose.    We facilitate Road Maps for individuals/couple as a community service, even knowing in advance that you may not be a fit to us. Contact us to schedule a Road Map meeting.  We can also provide a 20-30 minute Road Map demo on the phone.You may wish to read articles about how to choose an advisor.   Be sure tounderstand their fees.    Call us.   We have a book we can share with you that includes advice on how to find a good advisor, what to ask, how to interview.Newsletter Archive

Until our next issue... Sincerely, John O'ReillyO'Reilly Wealth Advisors

Investing 101: Discipline & Diversification (7/13/2010)

New, Practical & Brief NewsletterOne of these newsletters could save you from making a big mistake. This is basic and "ready to act on" advice for those serious about making smart choices.By Luck or On Purpose?We want to help you grow your wealth. To prove that, we are willing to show you how to implement these ideas on your own.If you can invest with discipline and diversification over long periods of time, your returns will be higher than most everyone else. Your success will be purposeful; the few that exceed your results were lucky. Luck or on purpose? Your choice!Discipline: 1) Stay in the market, 2) stick to your strategy long term and 3) manage other aspects of your finances so that your portfolio can grow undisturbed.Diversification: Own a little bit of everything using low expense ratio funds. To accomplish this we use Dimensional Fund Advisors (DFA) which is available only to select advisors. The next best approach is using Vanguard index funds as your portfolio building blocks. We are willing to share our Vanguard portfolio designs, contact us.Discipline and diversification are fundamentally sound and can be found in lofty documents like the Uniform Prudent Investor Act (UPIA) and Restatement 3rd of Trusts (Prudent Investor Rule). There are many great articles on these concepts, click here for one of our favorites.These complex concepts have been presented briefly. Not convinced; need more explanation? We would happy to help, just contact us.Common MistakesTypically mistakes can be traced to, you guessed it, poor discipline and diversification.1) Poor Discipline. Moving in and out of "hot" mutual funds. Continually switching advisors. Timing the market. Abandoning your long term strategy at a whim. Often these behaviors can be described as "chasing performance".2) Poor Diversification: Individual stocks. Retail mutual funds with less than 500 holdings that overlap each other. Multiple advisors. All of the aforementioned hurt diversification which means greater volatility and lower long term returns.3) The Allure of Active Investing: Active investing (to be covered more in a future newsletter) seems to make sense - I can "work hard, analyze and study my way to market-beating returns". However active investing lacks substantial diversification and/or relies on market-timing - common mistakes #1 and #2 above.What to Do NextOur culture and media would have you believe that investing is 90% of personal financial success. Actually, it is 10%. The devil is in the details. If you do the other 90% poorly, the good investing work could be blown up.Next steps on investing: we offered above to show you how to implement a diversified strategy on your own. Contact us whether to seek our help, or to learn how to do it yourself w/Vanguard.Begin with The End in Mind: For any successful journey, you need a compelling vision as THE FIRST STEP OVERALL.We help people put their vision on paper using a tool called Financial Road Map for Living Your life on Purpose. We facilitate Road Maps for individuals/couple as a community service, even knowing in advance that you may not be a fit to us. Contact us to schedule a Road Map meeting. We can also provide a 20-30 minute Road Map demo on the phone.You may wish to read articles about how to choose an advisor. Be sure to understand their fees. Call us. We have a book we can share with you that includes advice on how to find a good advisor, what to ask, how to interview.Newsletter ArchiveUntil our next issue.Sincerely,John O'ReillyO'Reilly Wealth AdvisorsSave 25%Times are tough. For those of you joining us in our top two tiers of service that include free ongoing financial plan updates, get 25% off the cost of your initial financial plan.