TYPES OF 401(k) PLAN INVESTMENTS
Access Research estimated that the assets of 401(k) 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 401(k) 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 401(k) 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
Allocation of assets in 401(k) Plans (End 1996)
||% of All 401(k)
|Type of Investment
Stable Value Accounts
Money Market Accounts
Self-Directed Brokerage Accounts
(Source: RogersCasey, 1997)
| Plan Assets
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).
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 401(k) plans (Sheets, 1996).
Typical Mutual Fund Categories
| Investment Objective
Growth and Income
High Quality Corporate
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).
Mutual Fund Window
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.
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 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 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.
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 401(k) 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.
401(k) PLAN ASSET HOLDINGS
The assets of 401(k) 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.
When the provider of 401(k) 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 401(k) INVESTMENT OPTIONS
A 401(k) 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 401(k) 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 401(k) 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.
SUMMARY: This document contains notices of pendency before the Department of Labor (the Department) of proposed exemptions from certain of the prohibited transaction restrictions of the Employee Retirement Income Security Act of 1974 (the Act) and/or the Internal Revenue Code of 1986 (the Code).
Written Comments and Hearing Requests
All interested persons are invited to submit written comments or request for a hearing on the pending exemptions, unless otherwise stated in the Notice of Proposed Exemption, within 45 days from the date of publication of this Federal Register notice. Comments and requests for a hearing should state: (1) The name, address, and telephone number of the person making the comment or request, and (2) the nature of the person's interest in the exemption and the manner in which the person would be adversely affected by the exemption. A request for a hearing must also state the issues to be addressed and include a general description of the evidence to be presented at the hearing.
ADDRESSES: All written comments and request for a hearing (at least three copies) should be sent to the Pension and Welfare Benefits Administration, Office of Exemption Determinations, Room N-5649, U.S. Department of Labor, 200 Constitution Avenue, N.W., Washington, D.C. 20210. Attention: Application No. ____________, stated in each Notice of Proposed Exemption. The applications for exemption and the comments received will be available for public inspection in the Public Documents Room of Pension and Welfare Benefits Administration, U.S. Department of Labor, Room N-5507, 200 Constitution Avenue, N.W., Washington, D.C. 20210.
Notice to Interested Persons
Notice of the proposed exemptions will be provided to all interested persons in the manner agreed upon by the applicant and the Department within 15 days of the date of publication in the Federal Register. Such notice shall include a copy of the notice of proposed exemption as published in the Federal Register and shall inform interested persons of their right to comment and to request a hearing (where appropriate).
SUPPLEMENTARY INFORMATION: The proposed exemptions were requested in applications filed pursuant to section 408(a) of the Act and/or section 4975(c)(2) of the Code, and in accordance with procedures set forth in 29 CFR part 2570, Subpart B (55 FR 32836, 32847, August 10, 1990).
Effective December 31, 1978, section 102 of Reorganization Plan No. 4 of 1978 (43 FR 47713, October 17, 1978) transferred the authority of the Secretary of the Treasury to issue exemptions of the type requested to the Secretary of Labor. Therefore, these notices of proposed exemption are issued solely by the Department. The applications contain representations with regard to the
proposed exemptions which are summarized below. Interested persons are referred to the applications on file with the Department for a complete statement of the facts and representations.
SmartRetirement: The OLDE 401(k) Plan (the Plan) Located in Detroit, MI
Based on the facts and representations set forth in the application, the Department is considering granting an exemption under
the authority of section 408(a) of the Act and section 4975(c)(2) of the Code and in accordance with the procedures set forth in 29 CFR 2570, Subpart B (55 FR 32836, 32847, August 10, 1990).
\1\ For purposes of this proposed exemption, reference to
specific provisions of Title I of the Act, unless otherwise
specified, refer also to the corresponding provisions of the Code.
Section I. Covered Transactions
If the exemption is granted, the restrictions of section 406(b) of the Act and the sanctions resulting from the application of section 4975 of the Code, by reason of section 4975(c)(1)(E) and (F) of the Code, shall not apply, (1) effective October 4, 1996, to the past and continuing receipt, by OLDE Discount Corporation (OLDE Discount), a wholly owned subsidiary of OLDE Financial Corporation (OLDE Financial), the Plan sponsor, of a portion of certain distribution fees that are paid by third party mutual funds (the Funds) to OLDE Discount pursuant to Rule 12b-1 (Rule 12b-1; the 12b-1 Fees) under the Investment Company Act of 1940 (the 1940 Act) and which are attributable to Plan assets that are invested in the Funds; and (2) the proposed cash rebate of such 12b-1 Fees, by OLDE Discount, to either the Plan or to the individually-directed accounts (the Accounts) of the participants in the Plan.