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Are 401(k) Funds Second-Rate?

These funds may have been second-rate but seem no longer to be.

John Rekenthaler, 07/20/2014

For decades, the retail funds available to 401(k) investors have been unfavorably compared with institutionally managed pension funds. For example, a 2013 Forbes article titled "Pension Funds Beat 401(k) Savers Silly--Here’s Why" cites a Towers Watson study showing that defined-benefit pension funds outgained 401(k) investors by an annual 0.76 percentage points from 1995-2011.

Let’s look at that study.

As there is no official record of aggregate 401(k) investor returns, Towers Watson estimated fund performance from each company’s required Form 5500 filings. (I’ve tinkered with the estimation process on a spreadsheet; it’s fairly accurate but no match for an exact calculation. Presumably, its errors do not trend in a single direction and thus cancel each other out. That is an assumption, though.)

The 0.76% figure comes from an asset-weighted comparison of all defined-benefit pension funds in Towers Watson’s database against all 401(k) plans. I’m not sure that 0.76% qualifies as an outright thrashing, as the Forbes author maintains, but one can’t deny the overall superiority of the pension funds. They outperformed in 13 of the 17 years. In addition, the pension funds were somewhat less risky, as their best relative performance came during bear markets.

However, the results look quite different when they are separated into larger and smaller companies. For both 401(k)s and pension funds, bigger was better. Plans from larger companies handily beat those of smaller companies. But the drop-off was steeper for pensions than for 401(k)s. A small-company 401(k) is on average only moderately worse than a big-company version. But the smaller pensions trail the larger pensions by almost 3 percentage points. Now that is getting beaten silly.

Thus, 401(k) funds look to be both second- and first-rate. They are second-rate when compared with the larger pension funds but are decidedly first-rate when compared with smaller pensions.

(The bigger story, it seems to me, is the third-rate status of the small defined-benefit plans. Of course, nobody talks about the substandard returns of small pension plans. Those smaller plans toil away in near-invisibility. If they perform badly, who is to know? Or care? As long as she receives her promised benefit, the employee is content. That the pension’s investments are not well managed is out of sight and mind.

is vice president of research for Morningstar.

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