Are 401(k) Funds Second-Rate?

Convergence
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.

There is a real cost to the underperformance, though. Poor investment results lead to one or more of the following: The company puts more money into the pension fund, which leaves less money for it to give wage increases; the company lowers its benefit projections for incoming workers (or eliminates the plan entirely); or, most drastically, the company defaults on its obligation. Once again, that default might not affect the worker directly because of pension insurance, but it carries a cost that is spread throughout the system.

The 401(k) marketplace has changed substantially since the mid-'90s, when the Towers Watson study began. Investor fees have declined because the low-cost 401(k) providers have gained market share; indexing has become more popular; and cheaper collective investment trusts have replaced retail mutual funds in many large plans. Also, most new 401(k) assets now flow into target-date funds, which barely existed in 1995.

Which leads to a second question: If 401(k) fund performance has lagged that of the bigger pension funds over the past two decades, does that mean it will also do so over the next two decades?

Of that, I am not certain. Along with costs, the other leg up that pension funds have had over 401(k) plans has been their access to alternative investments. Hedge funds, private-equity funds, venture-capital funds, and commodity funds comfortably outgained mutual funds for the first decade of the period covered in Towers Watson’s study. The big pension funds owned them, 401(k) plans did not, and the small pension funds did not. It was no surprise, therefore, that the big pension funds triumphed.

However, alternative funds have fared much worse in recent years, even as the pension plans keep buying more of them. It's hard to know if the alternative funds have disappointed because they were overbought by pensions, so that too much money is now chasing too few trades, or if the weaker returns are just one of those things that sometimes happen in financial markets. It's easy to know, though, that alternative funds are expensive. Thus, as 401(k) plan costs are declining, the effective costs of many large pension funds are rising.

Converging costs and the underperformance of alternative investments suggests that 401(k) plans might be looking better in recent years. And, indeed, they are. Courtesy of Charles Skorina & Company, here are the five-year total returns and Sharpe ratios for 10 of the largest university endowment funds through the most recently available date of June 30, 2013, compared against that of the largest 2030 target-date fund,  Vanguard Target Retirement 2030 (VTHRX). 

Collectively, these are among the most highly regarded and prestigious institutional funds in existence. The Vanguard fund was not cowed.

That table did not come by stretching the point. If I wished to make the endowment funds look worse, I would have sought estimates for their returns through June 2014, as the most recent five-year stretch will be less kind to their relative performance. Or I could have selected a longer-dated target-date fund. And while it’s true that Vanguard’s target-date family is a strong one, the asset-weighted five-year return average for all 2030 target-date mutual funds through June 30, 2013, was 4.87%--still higher than the typical endowment fund.

Looking forward, the bigger, better institutional funds will likely outdo 401(k) funds for the combination of risk and return. They should be the better bear-market performers because of their alternative investments. But for pure total return? Over the next two decades? That’s a tough call; the pension formula isn’t as effective as before, and the 401(k) competition has become tougher. It’s quite possible that a clueless 401(k) investor who is defaulted into a target-date fund later this year--and who owns that fund without even knowing its name--will beat most institutionally managed pension or endowment funds over the next two decades.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.