When evaluating the investment options available to you in the retirement plan, one of the first things to consider is whether your fund lineup will be an open architecture or closed architecture program. This is an exceptionally important aspect of any retirement plan because the investments you choose to offer within the plan can have a significant impact on the participants’ returns over time. The conversation of open vs. closed architecture goes quite a bit deeper than just investment options. Today, we’ll be looking into the different investment options that 401(k) providers can offer a plan sponsor and the associated fees. So let’s go to school!
First, let’s define the two types of investment platforms available to a plan sponsor. Open architecture means that you have the flexibility to select the investments to be offered to the participants within the retirement plan. There should not be limitations as to which mutual funds you can offer to the participants under a true open architecture program. Conversely, a closed architecture plan will place certain limitations and impose what's known as “proprietary requirements” on the plan. This means that you will have to include a certain number of that plan provider’s mutual funds within your investment lineup. Let’s take a deeper look into the strengths and weaknesses of each investment platform.
Open architecture programs have more flexibility as you have the ability to construct the fund lineup you believe is ideal for your particular group of participants. This is quite powerful. If you were given the opportunity to put together an investment lineup from just one fund manager or pick the investments you believe are the best options from all of the fund managers in existence, why would you limit yourself to just one fund manager? Also, each fund manager has different investment philosophies and strategies as to how the markets will perform. Therefore, by constructing an investment lineup with various fund managers, you would also be diversifying* your risk of over-concentrating your assets with just one fund manager. I like to say that selecting an open architecture plan is like building an all-star team by selecting the captains from the best teams in the league. As you’ll learn below, some retirement plan providers may charge more for the open architecture option than their own proprietary lineup.
Closed architecture plans require you to construct the fund lineup using exclusively their own fund options or a certain percentage of their funds. At the very least, these required investments usually consist of the Target Date Funds and the most conservative fund option. At most, they will require you use only their funds in the retirement plan. This arrangement can affect the plan’s pricing since the 401(k) provider is receiving compensation for the plan’s recordkeeping/administration as well as the investment fees charged to the participants within the plan. For example, let's say that you are considering Provider A to support your retirement plan. In this example, Provider A needs to charge $10,000 per year to run your 401(k) and make a profit. Provider A might recommend that you use exclusively their own mutual funds within the plan. If they anticipate that the revenue generated from the participants’ accounts (in the form of investment fees) will generate $6,000 per year, they only then need to charge the employer $4,000 per year to pay for the plan. One of the primary features of the closed architecture program is that it can reduce the costs to the employer by transferring some of the plan’s fees to the participants. However, this platform can also be less transparent which can result in charging excessive fees to the participants, placing limitations on the investment lineup, and potentially placing the plan sponsor in a position of fiduciary liability (we’ll go deeper into this later in the course).
The best way to figure out if you're working with a close architecture program is to ask the provider how your pricing would change if you used a fund lineup that didn't offer any of their own investments. If they say they can accommodate such a lineup but the plan sponsor’s costs will go up, you know that the provider was originally proposing a closed architecture program.
Congratulations on completing your freshman year at 401(k) University! You now have what you need to perform a preliminary analysis of a new retirement program or evaluate an existing retirement plan. Enjoy your summer break and we’ll see you next week for the first class of your sophomore year!
*Diversification does not guarantee a profit or protect from a loss.