401k Investment Committee Requirements Are Clear
401k investment committees have a fiduciary responsibility to regularly monitor and periodically evaluate the quality of a plan’s investment funds. However, the research is varied on whether or not a 401k investment committee’s practice of swapping out the funds in a plan’s investment menu actually results in better performance and improved outcomes. One thing is certain, however: even if they don’t intend to swap funds, it is important for retirement plan committees to continually monitor the investment menu. A “set it and forget it” approach can be harmful to retirement plan participants and plan sponsors.
A recent article from ThinkAdvisor, looked at research from Morningstar that supports the premise that “set it and forget it” for an investment menu may not be the best option. As the article points out, the fiduciary obligation for 401k investment committees to keep a vigilant eye on the investment performance of funds in a retirement plan is irrefutable. However, the article cites a small body of academic research, which shows that when one 401k investment option is removed in favor of another, the new funds fail to outperform, and sometimes underperform, the funds that were removed. A paper published in the Journal of Finance in 2016, found no evidence that consultants’ recommendations to replace investments added value to plan sponsors or their participants. The bottom line: action taken by 401k investment committees and other fiduciaries to monitor fund lineups purely out of legal obligation to do so did not result in better savings outcomes, according to ThinkAdvisor.
New research from Morningstar contests the “set it and forget it” mentality when it comes to 401k plan investment menu design. In corroboration with past research, Morningstar found that the decision to replace a fund is largely based on comparisons of five-year historical performance. However, Morningstar’s research came up with new findings: namely, that replacement funds can go on to outperform the replaced funds over the subsequent one- and three-year periods after the swap.
Jim Licato, vice president, product management for Morningstar Investment Management, David Blanchett, head of retirement research at Morningstar, and Michael Finke, a CFA with the American College of Financial Services, examined Morningstar’s managed account platform, analyzing 3,500 fund replacements in 678 defined contribution plans over an eight-year period starting in 2010. Previous research had been based on much smaller data sets.
Their analysis compared funds within the same investment style of three investment categories: equity, bond, and blended allocation funds with a mix of equities and bonds. The replacement funds typically had lower expense ratios than the replaced funds, better historical returns, and overall higher ratings from Morningstar. None of this came as a surprise to the researchers. What was surprising, however, was the outperformance of the replacement funds over one- to three-year periods. That supports the value for 401k investment committees in monitoring plan investments, beyond just their fiduciary duty, according to Licato, who was quoted extensively throughout the Think Advisor article.
He also said that 401k investment committees must be diligent in their monitoring, stay on top of investment menu design, and make adjustments when necessary. Equity funds had the highest rate of outperformance in the research, but all three of the asset classes Morningstar evaluated outperformed the replaced funds. According to ThinkAdvisor, “For all three fund groups, the median outperformance was 22 basis points after one year, 26 basis points after two years, and 52 basis points after three years.”
While the Morningstar research establishes a connection between the replacement funds’ historical performance and their ability to outperform in the future. It also highlights how lower fees can help contribute to better performance, according to Think Advisor. However, there is no clear and full explanation as to why replacement funds perform better, notes the Morningstar report. More analysis and more complete data are needed.
The research underscores the importance of 401k investment committees to continually monitor investment performance and keep tabs on the fund lineup. Historical performance may translate to improved future performance, according to ThinkAdvisor. Other factors that 401k investment committees need to give equal consideration to include investment features such as management tenure and turnover, along with style drift. Alternatively, ongoing monitoring of a plan’s investment menu may reveal that the lineup is exactly where it needs to be. If the plan is working well and the investments are performing according to the standards set forth in the plan’s Investment Policy Statement (IPS), then it may not be necessary to make replacements.
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