Administration September 16, 2019

Avoid Pitfalls to Properly Replacing DC Plan Investments

An analysis found monitoring DC plan investment menus and making necessary changes results in better performance, and researchers have followed up with four pitfalls to avoid when making investment changes.

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“Improving a 401(k)-investment menu by changing out investments isn’t as simple as replacing it with a better-performing fund. 401(k) plan sponsors and advisers should take care to document their justification for changing an investment and conduct a thorough, holistic search for a replacement,” say David Blanchett, head of Retirement Research at Morningstar Investment Management LLC, and Jim Licato, vice president of product management at Morningstar.

A prior analysis by the two of a sample of 3,478 fund replacements across 678 defined contribution (DC) plans found that the future performance of the replacement fund is better than the fund being replaced at both the future one-year and three-year time periods, and that these differences are statistically significant. The outperformance persists even after controlling for expense ratios, momentum, style exposures, and other metrics commonly used by plan sponsors to evaluate funds such as the star rating and quantitative rating.

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Licato previously told PLANSPONSOR, “We have found, and believe it is very important, for someone to be keeping an eye on retirement plan investments—whether an investment committee or investment adviser—and make necessary changes. We found not doing so is a disservice to participants.”

Now, Blanchett and Licato have followed up their research with a warning to DC plan sponsors to avoid common pitfalls in monitoring and changing funds in the investment menu.

They says fixating on random time periods that only include certain parts of a market cycle can lead to ill-informed decisions. It’s common for investment strategies to underperform at different times, so it’s important for plan sponsors and their advisers to understand the nuances of these cycles.

For example, they say low-beta funds (funds that hold stocks and are generally less sensitive to market movements) typically underperform during strong markets and seek to minimize loss during weaker markets. Though it may seem appropriate to remove this type of fund during a market upswing, it may seem less sensible when the market turns south.

Blanchett and Licato point out that high-performing funds can come with a considerable amount of risk, so swapping out a lagging fund for a top performer may expose participants to a greater—potentially excessive—amount of risk.  They suggest, rather than just looking at returns, plan sponsors and advisers may consider other return metrics that adjust for risk (such as the Sharpe or Sortino ratios).

A third pitfall to avoid is inaccurately analyzing fees. To ensure fee comparisons are accurate, Blanchett and Licato suggest, for example, plan sponsors and advisers should compare index fund fees to the fees of other index or passive funds, not to the fees of actively managed investments. The apples-to-oranges comparison of active fund fees against passive fund fees could lead to incorrectly removing a fund due to high fees.

Plan sponsors and advisers shouldn’t rely too much on a fund’s objective. Blanchett and Licato point out that some funds may move among styles over time, a concept referred to as style drift. “Although it can be time-consuming, a deep dive into a fund’s holdings can help bring to light an investment’s true style and integrity,” they say.
Compliance September 16, 2019

Proposed Financial Transactions Tax Would Hurt Retirement, Education Savers

Two analyses found the proposed tax in Senate bill S. 1587 would require investors to work two to two-and-a-half years longer before retiring in order to reach the same retirement savings goals achievable without the tax.

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Modern Markets Initiative (MMI), an education advocacy organization devoted to the role of technological innovation in creating the world’s best markets, released a report about the economic impact of Senate bill S. 1587, the Inclusive Prosperity Act of 2019’s proposed financial transaction tax (FTT).

While politicians are looking at this as mainly a tax on big Wall Street Investors, MMI CEO Kirsten Wegner says it “is in reality, a severe retirement tax on American savers from all income levels.”

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MMI’s analysis shows any transaction tax would drastically harm institutions trading large volumes of securities such as pension funds, mutual funds and other institutional investors that directly represent the financial interests of American workers, as well as average Main Street investors with defined contribution (DC) retirement or 529 College Savings accounts.

MMI found the financial implications for average American savers include:

  • $19 million in annual FTT on 529 College Savings plans, or the equivalent of a year of full in-state tuition for 1,900 students at a public university;
  • $24 million in annual FTT for a single public university endowment with $20 billion AUM, or the equivalent of 3,227 college scholarship in a given year;
  • $64,232 in annual FTT over the lifetime of a 401(k) account, or the equivalent of delaying the average individual’s retirement by two years; and,
  • $132 million in annual FTT for the typical state public pension plan with more than $68 billion in assets under management.

Similarly, Vanguard found the proposed tax would require the everyday investor to work roughly two-and-a-half years longer before retiring in order to reach the same retirement savings goals achievable without the tax. The tax would make saving for college more difficult as well. Families could take on debt to make up the difference, with a $7,800 student loan. Or, parents would need to save roughly an additional $250 per year, per child, to achieve the same balance in a college savings account.

“Even outside of saving for retirement or a college education, an investor’s ability to save for any future goal is drastically diminished by the proposed tax,” Vanguard says. It shows that the ending value of an investment of $10,000 in a small-capitalization active equity fund would be reduced by roughly 19% with the proposed tax, after 20 years.

According to Vanguard, the experience of other countries—particularly in Europe—have shown that FTTs distort capital markets. FTTs generally increase risk in the financial system by hurting market liquidity, producing volatility, increasing bid-ask spreads, encouraging financial engineering, and raising costs of capital.

At the same time, FTTs have consistently failed to deliver the promised tax revenues because FTTs shift financial activity to less-regulated markets. For example, Vanguard says, France and Italy did not raise even half the first-year revenue they had projected from the FTTs they enacted in 2012 and 2013, respectively.

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