401K Fund Selection

One of the challenges of putting a successful 401K plan together is fund selection. Obviously, picking funds with low expenses should be a priority. But then the question is what asset classes do you choose. Do you have the options available for the sophisticated investor? Do you you keep things simple and use mostly target retirement funds? Or offer both and the run the risk of too many funds confusing participants?

Lessons from previous 401k plan

In our previous 401k plan,  we could pick 12 out of 40 preselected funds. 3 Vanguard funds were available but the rest were all actively-managed funds with expense ratios ranging from 0.50% to 1.75%. (And of course, there was the extra 0.50% asset charge to employees and another 0.50% to the employer.) We picked the best option from each category -- how successful was the lineup? Here is how plan assets were directed:

Money Market                     32% (cash)
Dodge & Cox Stock                16% (large value)
Vanguard Morgan Growth           15% (large growth)
American Funds Capital World G&I  7% (europe/japan value)
AIM Real Estate                   7% (reit)
Vanguard Total Bond               6% (intermediate bonds)
T.Rowe Price Mid Value            5% (mid value)
Bridgeway Aggressive Growth       5% (small growth)
Vanguard Index 500                3% (large blend)
California S&P Small Cap Index    2% (small blend)
John Hancock Lifestyle Growth     1% (moderate growth)

Looking at where the money went, the lineup is disappointing. Obviously, people were confused by the choices leading a whopping 32% in money market. Then there was a solid number of people picking Dodge & Cox and Morgan Growth since those two had decent track records and relatively low expense ratios (0.52% DODGX, 0.39% VMGRX). The rest of the selections ended up being random noise. One participant would choose random ABC fund at 1%+ ER, another would choose XYZ at 1%+ ER.

Of particular interest is how far down Vanguard Index 500 is on the list. We had access to Signal shares at 0.07% ER in this plan which meant people were more attracted to exciting fund names. Growth, aggressive growth, growth+income? Gotta be better than a regular index cuz they grow fast! (Yeah, I'm sure they read through the prospectuses and decide those funds fit their investment strategies better.)

Employee Fiduciary fund lineup

With this past experience in mind, I fleshed out the following criteria:

• Choose index funds not only with low expense rates but with bland names. If you don't have a "ABC Enhanced Credit/Leveraged Aggressive Growth" fund staring in your face, you won't have people mesmerized by the name thinking choosing that fund would let them get away with saving less.
• Offer a menu where picking all funds in equal percentages is a viable plan. (Thanks to The Finance Buff for posting this advice at Boggleheads.)
• A final consideration was to be mindful of what happened in the 70's. The 70's was a terrible era where both stocks and bonds returned -3% real return annually due to high inflation. If you were retired and drawing down your portfolio, some gold and commodities might have kept you off Alpo.

The question still left on the table: use a few broad index funds or many market subset indexes. Part of me wanted to go with just a few funds to reduce performance chasing behavior (although the existence of TSP market timing newsletters say you can never eliminate the possibility). On the other hand, a high percentage of plan dollars belonged to a small number of sophisticated investors -- should I limit their choices in order to force participants to choose specific investment strategies? In the end, I decided on the many fund option with the hope of education working on a small number of employees. The funds I chose were:

Bonds/Fixed Income

Vanguard Prime Money Market
Vanguard Intermediate Bonds
Vanguard Inflation Protected Securities

Domestic Stock

Vanguard Value
Vanguard Growth
Vanguard Small Value
Vanguard Small Growth

International Stock

Vanguard European Stock
Vanguard Pacific Stock
Vanguard Emerging Markets

Other

Vanguard REIT
PIMCO Commodity Real Return D*
American Century Global Gold

Target funds

All Vanguard target funds available on demand

*PIMCO Commodity Real Return D ordinarily costs 1.24% per year. However, 0.25% of this amount is a 12b-1 fee which Employee Fiduciary rebates to us dropping our effective cost to 0.99%. Over time, we will accumulate enough assets to get into Institutional class decreasing costs to 0.74%.

Model Portfolios

Core in the education campaign was the development of model portfolios for employees to choose. I knew as much as I could try to teach people about investment strategies, people would forget everything 2 days later and ask "what funds should I pick?" (And as the plan trustee, I can't answer that question.) So I picked portfolio strategies advocated by various investment/finance authors and fitted them to our fund menu. The portfolios I presented were:

• Harry Browne's Permanent Portfolio
• Larry Swedroe's Concentrated Risk Strategy
• Scott Burn's Couch Potato
• Scott Burn's Margaritaville
• Bill Schultheis' Coffehouse
• David Swenson's Yale U Index
• Equal percentage of all funds
• Equal percentage of all stock and commodity funds

Employee selections

After all the write-ups and presentations, now it came time to see whether my groundwork would be effective in (1) getting employees to participate and (2) avoiding major investment mistakes. Here are the results after a few months of contributions:

Participation

100%

Percentage of Salary Contributions

8%

Model Portfolios Chosen

Coffeehouse   35%
Swenson       20%
Equal         20%
Swedroe       10%
Couch Potato  10%
Custom         5% 

Overall asset percentages

Stock         69%
Bonds         22%
Commodities    9%

Fund percentages

Vanguard Small Value              13% (small value)
Vanguard Value                    13% (large value)
Vanguard Inflation Protected Sec  12% (intermediate tips)
Vanguard Intermediate Treasury    10% (intermediate bonds)
Vanguard REIT                      9% (reit)
Vanguard Emerging Markets          9% (emerging)
Vanguard European Stock            7% (european)
Vanguard Pacific Stock             7% (pacific)
Vanguard Growth                    6% (large growth)
Vanguard Small Growth              5% (small growth)
PIMCO Commodity Real Return D      5% (commodities)
American Century Global Gold       4% (gold)
Vanguard Prime Money Market        1% (cash)

35% of participants picked the Coffeehouse Portfolio so there is some overweighting to Large Value and Small Value. Otherwise, the fund picks look far more balanced than with the previous plan.