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4 Easy Steps 401k Plan Sponsors Can Take to Insure a Well-Documented Investment Due Diligence Process

April 03
00:03 2012

(This is the first installment of a special three-part series)

Investment due diligence presents one of the most difficult tasks for 401k plans sponsors, but it doesn’t have to be. The challenge stems from the often misunderstood nature of the fiduciary’s duty regarding investment due diligence. Many 401k plan sponsors incorrectly assume they must design a process that picks the best investment options for their employees. While this is a laudable goal, the Department of Labor (DOL) is wise enough not to hold 401k plan sponsors to this impossible task. What the DOL desires, quite simply, is to see a clearly articulated process that the 401k plan sponsor faithfully implements and executes continuously. The DOL doesn’t want to get in the middle of the active vs. passive debate or the value vs. growth argument. As long as 401k plan sponsors act consistently to an established due diligence process, they have fulfilled at least this portion of their fiduciary duty.

Stripped done to its bare bones, the 401k Investment Due Diligence Process consists of these four steps, each of which should be incorporated directly in the plan’s Investment Policy Statement (see “How Should a 401k Plan Sponsor Construct an Appropriate Investment Policy Statement?”, June 11, 2011):

  1. Documented Selection Process – This process specifically defines and outlines the components used in initially selecting investment options. Since many 401k plans have multiple categories, this is usually the first level of the selection process. The second level details the key criteria the plan will use to select specific investment options within each category. For example, we might only pick funds whose portfolio manager has at least five years of experience with that specific fund or whose portfolio consists of no more than 50 stocks.
  2. Documented Monitoring Process – This portion of the process identifies the monitoring methods to be used by the 401k plan sponsor (or by the fiduciary adviser the plan sponsor chooses to delegate this duty to). Though it’s likely the same key criteria above will be mentioned, here we’ll expect to see how sensitive each individual criterion is to any specific variance. Again using the examples above, we might say we’ll need to remove the fund if the experienced manager leaves, but we can continue holding a fund until its portfolio exceeds 60 stocks.
  3. Consistent Analysis and Comparisons – This step is admittedly tricky, well, at least part of it. The consistent portion represents the easy half. It is the decision as to what you should compare things to in a consistent fashion that poses the greatest grapple for the 401k plan sponsor. For example, although it’s assumed a mutual fund should be benchmarked to an index, this isn’t necessarily the best idea. For one, each mutual fund is required by the SEC to choose its own index benchmark (this is listed in the fund’s prospectus). As a result, different funds in the same category might choose different indexes. It’s better to choose a benchmark that can be evenly applied across funds in the same category.
  4. Periodic Documented Review – Here’s the easiest step often made more difficult because of this nasty tradition of viewing investments on a quarterly or monthly basis. On one hand, confirming the assets are in proper order is something that should be done monthly through the custodian statement. On the other hand, mutual funds are like aircraft carriers – they take a long time to turn. As such, 401k plan sponsors are probably better off conducting an investment due diligence review on a semi-annual basis.

It goes without saying the 401k plan sponsor must undertake the due diligence process in an unbiased fashion. That means any outside provider who assists in the due diligence process needs to be an independent provider, i.e., one having no connection to the investments chosen.

In the next part of this series, we’ll take a look at some key components 401k plan sponsors incorporate into the first two steps of their Due Diligence Process.

Part I: 4 Easy Steps 401k Plan Sponsors Can Take to Insure a Well-Documented Investment Due Diligence Process
Part II: The Ten Commandments of Selecting a Mutual Fund as a 401k Option
Part III: The Checklist for the Ideal 401k Investment Due Diligence Process


About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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