Avoid Pitfalls to Properly Replacing DC Plan Investments

“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.

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.