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401(k)s are different
401(k)s are marvelous retirement savings accounts, boasting the highest contribution limits for the layperson, plus no income caps for Roth savings. And while 401(k)s offer a plethora of features, it is their bespoke investments that make them the focus of today’s post.
You see, IRAs boast access to private placements and other intriguing investments such as options and even real estate. Still, unless you are a CEO or an industry titan, 401(k)s are privy to institutional assets and their high minimums, which otherwise would be inaccessible to many.
So, what are institutional share classes, and how can they save you money when investing for financial independence and retirement through your employer’s retirement plan? Let’s find out!
The not so golden days
In the era before today, mutual funds were commonly sold with loads (I.e., surcharges). Such charges were tacked on top of transaction fees and made mutual fund investing expensive for the average Jill, meaning her hard-earned dollars didn’t go as far!
Thankfully, loaded mutual funds have mostly disappeared with the rise of their index brethren, as have transaction fees. Still, their skeletons remain through A, B, and C share classes (which should almost certainly be avoided and not mistaken with stock A, B, and C share classes*).
Example: Note the deferred load box in the image below. Such is an example of a C-class mutual fund that charges you a fee when sold.
*Stock share classes often refer to voting rights you are afforded as an investor, while with mutual funds, they refer to the fees you must pay
Institutional shares offer a discount
Nowadays, most mutual funds are sold as ordinary share classes without loads. However, for those lucky enough to have access to them, institutional shares offer the same investment opportunities as regular ones, but with a discounted expense ratio. That means that you will outperform the same ordinary share classes, stretching your money further!
Types of institutional share classes
Because someone clever decided to name share classes, I present the following institutional share classes: I, K, R, and Z. And sorry, only I for Institutional and R for Retirement are clever; K and Z still baffle me. Though I suppose Z could stand for the lowest price available since Z is at the end of the alphabet, but that is entirely speculative.
Oh, and K and R also have K6 and R6 variants, which are even cheaper versions than their K and R brethren. Odd, I know.
Fun Fact: Vanguard Admiral shares are not institutional funds; they are just less expensive share classes for ordinary investors with higher minimum investment requirements.
Shares of not funds
While the above list of institutional share classes is expansive, it doesn’t include a sub-category of institutional shares that are technically not mutual funds.
For qualified investors¹, investment solutions are available that are not offered to the public. Such securities are not registered with the Securities and Exchange Commission (SEC), and providers do not have to file reports, which lowers costs.
Now, because 401(k) plans are considered qualified investors and have been since 1997, they are privy to such investments. As a result, many mutual fund providers often create custom pseudo funds for 401(k) plans.
Common names for these non-funds are Pools and Trusts², and examples include the Fidelity Contrafund Commingled Pool and Vanguard Institutional Index 500 Trust. Notably, because these are not mutual funds, they have no ticker symbol.
Fun Fact: Because 401(k) plans are considered qualified investors, they can offer Hedge Funds to participants. However, this is highly uncommon, and in my previous life as a 401(k) advisor, I only saw one such plan doing this despite working with thousands of plans.
1. Qualified investors are also known as accredited investors. Essentially this designation means you have enough money that the SEC thinks you should have enough experience making investment decisions that you are allowed to invest in non-regulated (and higher risk) securities.
2. Investment trusts are formally known as CITs: Collective Investment Trusts.
Why are institutional shares cheaper?
Institutional share classes are cheaper than regular share classes because investors using them must buy in bulk, similar to when going to Costco or Sam’s Club.
With some institutional shares, there are $1,000,000 minimum investments available to anyone who has the funds to invest. In contrast, other institutional funds are offered only to institutional investors like insurance companies, pensions, other mutual funds, and retirement plans, such as 401(k)s.
As a result, institutional investors buy larger quantities than you and me, having millions and even billions of dollars they can leverage to negotiate a lesser cost.
Institutional funds tend to be active
Notably, institutional funds tend to be actively run mutual funds since index funds are already offered at low costs. However, some institutional index funds do exist, but they are not nearly as prevalent.
Should you invest in institutional classes?
That is a great question! If the choice is between an index fund or an active institutional fund, you first need to decide if you are an index or active investor. And statistically, index investors tend to perform better, so I invest most of my money in them.
On the flip side, if the question is between institutional and ordinary index funds, one should side for the institutional fund if they are otherwise identical.
If you are unsure if active or index funds are better for you (or you want to gamble a smaller portion of your savings), here is my guide to deciding between the two: Active or Index: How to Decide.
Institutional funds can be a great way to gain less expensive exposure to stocks and bonds when saving for retirement through your 401(k). Whether they be active or index funds, institutional share classes offer a level of savings that would otherwise not be available to ordinary investors. So, before rolling over your 401(k) plan, be sure to consider if the funds you have access to are worth keeping!
But enough with what I think, what are your thoughts on institutional funds? Do you have access to such funds in your 401(k) plan, and have you ever used them? Let me know in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time