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Does Changing 401(k) Plan Investments Help Employees?

Morningstar research suggests that retirement plan fiduciaries can monitor investments to drive higher returns for employees

David Blanchett and Jim Licato, Morningstar Investment Management LLC

 

Managing U.S. retirement investments is no small feat: As of March 2019, U.S. workers had about $5.7 trillion invested in 401(k) plans. As retirement plan fiduciaries, plan sponsors and plan advisors have a responsibility to select and monitor these investments while acting in the participant’s best interests. And when it comes to helping retirement savers meet their retirement goals, paying attention to the performance of these investments can be crucial.  

This retirement plan fiduciary responsibility may mean occasionally deciding to add, remove, or swap investments. There has been some research suggesting that these types of changes—especially poorly timed ones—may reduce value and negatively impact investors, but overall, little is known about whether switching investment options is valuable for retirement savers.  

To better understand the effects of changing investments, we studied more than 3,000 fund replacements, which occurred between January 2010 and November 2018, across 678 plans. To help ensure we were comparing apples to apples, we only looked at instances where the replacement and replaced funds existed in the same Morningstar Category.  

Although more in-depth research in this area is warranted, our research suggested that replacing funds has the potential to improve outcomes for retirement investors (even after controlling for various fund characteristics and risk factors). Learn more about these findings below. 

Replacement funds were more attractive in a number of areas 

Unsurprisingly, at the time of the replacement, the new funds tended to have attributes that were more “attractive” than the funds they replaced. These attributes included better historical performance, lower expense ratios, and more favorable Morningstar Ratings™ and Morningstar Quantitative Ratings™ for funds.* 

Replacement funds outperformed the funds they replaced 

Our study found that the replacement funds outperformed the replaced funds over both one- and three-year periods following the replacement.  

As shown on the chart below, the difference in performance quality was greatest about 36 months before the replacement and dwindled down to almost nonexistent by the time the fund was replaced. However, the chart also shows that outperformance increased again after the replacement date and continued to grow over the next three years.  

Source: Morningstar Direct and author’s calculations. Data as of November 2018. For illustrative purposes only.

Our research also showed that this difference in performance couldn’t be explained by differences in other factors, such as expenses or investment approach. This suggests that by keeping a watchful eye and changing out weaker funds, plan sponsors have the potential to improve investment performance and participants’ retirement outcomes. 

The important role of retirement plan fiduciaries 

Though offering an effective investment menu can be crucial to retirement savers, choosing and monitoring plan investments isn’t easy. Poor, ineffective menus can be detrimental to both participants and plan sponsors, so many sponsors opt to delegate this responsibility to a third party. Across plans, the responsibility for creating the menu can either be shared or completely outsourced to a hired investment manager.  

No matter the arrangement, retirement plan fiduciaries are responsible for keeping a watchful eye on investment options—which, this study suggests, can lead to better outcomes for participants. 

For best practices for managing plan investments, download “Keep Your Eye on the Ball.”

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*Replacement funds in our study tended to have higher historical returns at the five-year period, averaging 164, 41, and 70 basis points for equity, bond, and allocation funds, respectively. Replacement funds tended to have lower expense ratios, averaging 5, 6, and 14 basis points for equity, bond, and allocations funds, respectively. For purposes of this study, numerical values were assigned to the ratings measures (i.e., a five-star fund was assigned a “five” and a one-star fund was assigned a “one”, likewise, a fund receiving a Gold Morningstar Analyst Rating was assigned a “five” and a Negative-rated fund was assigned a “one”.) Therefore, while replacement funds in our study may have shown more favorable “ratings” than the replaced funds, the replacement funds may not have a higher Morningstar Rating, Morningstar Analyst Rating, or Morningstar Quantitative Rating level.

*Morningstar Investment Management LLC is a registered investment adviser and subsidiary of Morningstar, Inc. The Morningstar name and logo are registered marks of Morningstar, Inc. Opinions expressed are as of the date indicated; such opinions are subject to change without notice. Morningstar Investment Management and its affiliates shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only. The information data, analyses, and opinions presented herein do not constitute investment advice, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Before making any investment decision, please consider consulting a financial or tax professional regarding your unique situation.

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