Types of Retirement Plan Investments

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). 

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 401(k) 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 401(k) 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 401(k) plans into mutual funds has been dramatic, increasing from 5% of assets in 1990 to 40% in 1996 (Reid & Crumrine). 

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 401(k) plans (Sheets, 1996). 

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 401(k) 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). 

  A recent development in the design of 401(k) 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.

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 401(k) 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 401(k) 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 401(k) 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 401(k) plans after mutual funds, constituting 19% of 401(k) 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 401(k) 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 401(k) 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 401(k) 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.