With more than $5 trillion held in 401(k) plans, watching over retirement savings is no small task for plan sponsors and advisors. Maintaining these plans involves several duties: choosing and changing investments, communicating these changes to employees, and more.
Additionally, this fiduciary responsibility includes acting in the best interest of plan participants.
In a previous post, we discussed our research, which showed that replacing investments can improve investment outcomes. Still, plan sponsors and advisors should take care to properly investigate and document potential replacements, as inadequate research and poorly timed changes may be detrimental to the 401(k) plan overall.
Because the tasks of monitoring and making changes to a plan’s investment menu can be complicated, it’s important for 401(k) plan sponsors and advisors to do their best to avoid a few common pitfalls.
1. Focusing on arbitrary track records
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 advisors to understand the nuances of these cycles.
For example, 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.
2. Ignoring risk for return
Focusing on a category’s highest-performing investment, without considering risk, can lead to unwanted surprises during market downturns. 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.
Rather than just looking at returns, 401(k) plan sponsors and advisors may consider other return metrics that adjust for risk (such as the Sharpe or Sortino ratios).
3. Inaccurately analyzing fees
Fees play an important role in evaluating investments, and it’s a key part of a plan sponsor’s fiduciary responsibility to make sure they’re prudent. Plan sponsors should conduct reviews regularly to evaluate both recordkeeping and fund fees. However, when considering cost during investment selection and replacements, it’s important to ensure that fee comparisons are accurate.
For example, 401(k) plan sponsors and advisors 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.
4. Relying too much on a fund’s objective
Each investment has a particular approach, or style objective. For instance, market capitalization and value/growth qualities determine the style of a stock fund, while credit quality and maturities are determining factors for a bond fund’s style. Some funds stick to their objective, while others may move among styles over time, a concept referred to as style drift.
Building portfolios with drifting funds can be problematic, as individuals may end up investing in an unintended style. 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.
These pitfalls are just a few of the things that those with this fiduciary responsibility should keep in mind. 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 advisors should take care to document their justification for changing an investment and conduct a thorough, holistic search for a replacement.
David Blanchett is a retirement researcher for Morningstar Investment Management and Jim Licato is a product manager for the Morningstar Retirement Solutions product group.