3-Step Guide for Employers to Select and Monitor 401(k) Index Funds

Index funds not only offer 401(k) participants superior returns to comparable actively-managed funds net of fees, they are a clear and simple way for 401(k) sponsors to meet their investment-related fiduciary responsibilities.  Sponsors need only select three or more prudent investments that allow plan participants to sufficiently diversify their accounts.  Index funds are indisputably “prudent” by meeting their investment objective for market-correlated returns at reasonable fees.

All of the nation’s largest index fund providers – including Vanguard, Blackrock and Schwab – offer excellent choices.  Returns match benchmarks and fees are low across the board.  These index funds are in sharp contrast to comparable actively managed funds, whose returns and fees can differ dramatically.

As an employer, you can’t just randomly choose index funds for your 401(k) to meet prudent standards.  You need a process for selecting and monitoring a basket of funds to meet investment-related fiduciary responsibilities for requiring diversification and ongoing monitoring.  This process can be completed in 3 steps.

Step 1 - Establish a basic investment policy

It’s a fiduciary best practice to have an investment policy for your 401(k) plan. While I strongly recommend a formal written Investment Policy Statement (IPS) for 401(k) plans with actively-managed funds – because a process for selecting, monitoring and replacing active managers can be technically-complex – I think a formal IPS can be overkill for 401(k) plans with an index fund line-up. Instead, these plans can have a simple investment policy (written or not) with just 3 basic objectives:

1. Diversification – Investments must provide participants with different, internally diversified alternatives with materially different risk and return characteristics.
2. Market returns – Investments must offer returns that closely correlate to a target benchmark over time.
3. Efficiency – Investments must possess low expenses that reduce drag on returns.

Step 2 - Select funds that meet your policy

To meet the objectives of your index fund investment policy, you want to select funds for your 401(k) plan that meet the following requirements:

Diversification

ERISA 404(c) states you must offer a diversified range of investment alternatives with differing potential for investment risk and return. Only three investment alternatives are required to meet the requirements, and it is satisfied by offering funds that cover equity (stocks), fixed income (bonds), and capital preservation asset classes.

Your 401(k) plan can meet its diversification objective by selecting at least 3 funds that satisfy the basic diversification requirements of ERISA 404(c).

Market Returns

Index funds attempt to track the performance of a particular stock or bond index, such as the S&P 500 Index.  To measure whether an index fund’s returns closely correlate to their target benchmark, you want to evaluate the fund’s Beta and R-Squared results – which can typically be found on the fund company’s website.

Your 401(k) plan can meet its market returns objective by only using index funds with a beta between 0.90-1.10 and R-squared between 0.90-1.00, based on trailing 36-month returns vs. the benchmark.

Efficiency

You have a fiduciary responsibility to keep your 401(k) plan’s investment fees reasonable because the cumulative effect of excessive fees can dramatically reduce the retirement savings of plan participants.

Your 401(k) plan can meet its efficiency objective by only using index funds ranked in the lowest quintile (20th percentile) of its peer group.

Step 3 – Ongoing monitoring

Once you’ve selected funds for your 401(k) plan, you have a responsibility to monitor these funds periodically to ensure they continue to meet the objectives of your investment policy. You should complete this monitoring at least annually.

Below is a sample monitoring report for an index fund lineup that meets diversification, market returns and efficiency investment objectives:  

⁽¹⁾Capital preservation alternative. Not an index fund.

⁽²⁾This is a proprietary Morningstar data point. A "Low" rating means fund's expense ratio ranks in the lowest quintile (20th percentile).

Index funds are a 401(k) win-win!

Index funds make it easy for 401(k) participants to earn diversified market returns cheaply. Their attributes also make it easy for 401(k) sponsors to meet their investment-related fiduciary responsibilities. In short, they can be a win-win for both parties.