Investment trends in 401(k) plans offer a few surprises
A version of this article originally appeared on 401kSpecialist.
I worked at a plan sponsor in the aughts where I oversaw the investment program for their workplace retirement plan. One of my major victories was negotiating a three-basis-point expense ratio on a broad market index fund. Today, any retail investor can find a similar deal. That's great news for participants, and plan advisors should feel good about the part they have played to bring fees down.
The decline in fees is clear in a new analysis by Schwab Retirement Plan Services. We looked at investment trends in defined contribution (DC) plans from 2013 through 2021. Some of the topline findings, such as overall fee compression, may sound familiar, but there were two big surprises and one important reminder in the details.
Behind the index story
The analysis begins a few years after my three-basis-point win. The average net investment expense of the funds in a plan's core menu was 0.41% in 2013. Over the next eight years the average net expense dropped by more than a third to 0.26% in 2021.
We all know that investment expenses in DC plans have been falling, but the magnitude of the decline is striking. The higher expense ratio funds that are left tend to be specialized investments such as commodities or real assets which may be used in an advised or managed account but are often not part of the core investment menu.
Also, the move from actively managed funds to index funds is not the whole story despite the common wisdom. Expense ratios have also been decreasing for actively managed funds and the index funds themselves. Whether your plan leans towards actively managed funds or index funds, you've likely still seen a significant expense reduction across your investments. Helping to drive the broad decline are moves to lower cost share classes of the same fund. It's also notable that among our clients, 83% of plan assets are now in funds that do not offer compensation to providers for providing shareholder services.
The percentage of plans offering environmental, social and governance (ESG) investments in the core menu stayed flat at a bit under 10% over our eight-year analysis period. But before you declare ESG to be hype, know that it is definitely on the wish list for younger employees. More than 40% of Gen Z and Millennial participants in Schwab's 2021 nationwide survey of 401(k) plan participants said they would like more ESG or socially responsible investment options in their workplace retirement plans.*
Despite this clear message from the future of the workforce, core menu adoption may never rise dramatically. There's an argument to be made that the core menu is too limiting for the wide variety of values and interests that could inform people's investment decisions. Brokerage windows can be a good solution for these values-driven participants. There is room for broad themes like climate or water, and a variety of specific passions and filters, such as women-owned businesses or faith-based investing. Roughly two thirds of plan sponsors we serve already offer a brokerage window to their retirement plan participants, providing access to more than 500 ESG mutual funds and ETFs.
Plan design still matters
Fee compression and ESG are trends across asset management for all kinds of investors. If retirement plans are just following the industry, does plan design make a difference? Once again, the details are revealing.
Almost half of all target date fund (TDF) assets are now in passive funds. That proportion has more than doubled since 2013, and it has helped drive the decline in fees. Three plan design choices have a big impact on the growth of passive TDFs. First, of course, is the selection of the TDF itself. Arguably just as important are the choices to auto enroll employees and then make the plan default a TDF.
On core menus we know that the default option is what matters most, and this has been an important factor in the infrequent use of ESG investments. When plan sponsors add them to the core menu, they simply don't see a lot of use. That's another argument for the brokerage window, where many options can exist to serve small slices of the participant population.
Plan defaults are also one of the reasons that more participants are using third party advice as part of their 401(k) plan. More than two thirds of plans (71%) offer third-party managed accounts, and the number of plans that offer a managed account as a qualified default investment alternative (QDIA) is rising. There is also growing interest in dynamic QDIAs, where the initial default is a target date fund up to a certain age and participants transition to a managed account as their financial needs become more complex.
It's a long way of saying the numbers are clear: Decisions plan sponsors make with help from their advisors really do matter.