401(k) Investment Benchmarking

October 09, 2019
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How do you know if your investments in your 401(k) menu that you are providing your employees is performing great, okay, or poorly? Does it matter if you have subpar funds? How would you feel if you discovered your investment managers were being outperformed by fifty or perhaps 75% of their peers? You know the cost of hiring substandard employees, but what about the cost of investing in substandard mutual funds? The impact on retirement savings can be substantial.

For instance, suppose you have a total of $500,000 in annual 401(k) contributions (which may include employer match). Let’s further suppose your average investment in your menu is underperforming peers by 2% annually. Believe me, that may not sound as far fetched as you may believe. The spread between top quartile and bottom quartile performing funds year-over-year, according to Morningstar, can be over ten percent depending upon the asset class. If you are handicapping your employees by a mere two percent a year by offering below-average performers, over the course of ten years, you could be unintentionally costing your employees over $5.5 million in lost opportunity. Do you think that could be a liability? I would say so.  

When you purchased your house, did you just make a random offer based on the asking price or did you take a look at what comparable homes in the neighborhood were selling for and determine a fair price? The only way you can fairly assess the price and value of a home purchase is by having a benchmark or baseline to compare it to. That is why you look at comps. When it comes to investing, it is called benchmarking. The process is relatively simple but it is comprehensive. Fiduciaries have a responsibility to monitor their investment menu to be sure the selections are competitive. Not only makes good sense (after all, why would anyone want to invest their hard-earned dollars in inferior investments), but it is also a fiduciary duty. This duty is often overlooked by smaller companies.

When You Offer Your Employees a 401(k), You Can’t Just Say “Good Luck!”

When you offer your employees a 401(k), you are taking care of “other people’s money.” Those other people are called your employees, or participants in your 401(k). When you care for other people’s money, you are a fiduciary under the law which means you need to practice prudent stewardship. Although you may not be making the investment choices for them, you do have discretion over the provider selection and, consequently, the investment menu of options you offer your employees. I find too many employers, especially small businesses (who happen to employ the majority of workers in the U.S.) overlook this responsibility. Perhaps it is assumed that because the participants can move money around to different funds within the menu of options, it doesn’t matter which ones are underperforming. However, freedom of choice does not abdicate responsibilities or liabilities. The Employee Retirement Income Security Act of 1974 (ERISA) and case law have demonstrated this has not been the case for those employers who have been challenged on this issue.

Most employers these days understand the duty to ensure 401(k) plan fees are fair and reasonable, but the responsibility does not end there. It makes sense to monitor fees because you have the power negotiate your vendor and plan fees on behalf of your employees, consequently you have a legal duty to ensure that your participants are not being overcharged excessive fees. But employers also have a duty to ensure they are offering a reasonably priced and competitively performing investment menu of options.

Investment Monitoring and Benchmarking is Not About “Beating the Market”

If you are like many, you may compare your investment performance to the broad index such as the S&P 500 or the Dow Jones Industrial Average, and you may feel satisfied so long as your investments appear to be meeting or exceeding that benchmark return. You may also conclude that if your participants aren’t content with their performance, they can merely change their investments to other options within your menu. But in making these assumptions, you could be ignoring or discounting underperforming funds within your investment menu and that means you may be putting your participants at a disadvantage. When you put your employees at a disadvantage, you can imagine what kind of potential liability you could shoulder.

Investment benchmarking is a process of measuring your investments against the appropriate corresponding index or comparable peers in terms of return and risk, among other important metrics. Not every investment in your menu is bound to resemble to the S&P 500 index. In fact, prudence would suggest employers should strive to offer options that enable participants to build out a diversified and properly asset allocated portfolio that would include small-cap and mid-cap stocks as well as international investments, along with bonds and fixed income options. In other words, the investment world is as diverse and varied as your employees themselves. Therefore, you will need to benchmark your investments according to each fund’s stated objective and allocation. To compare every investment in your menu to the S&P 500 index or the Dow Jones is like comparing every employee to one singular type of personality or temperament. And to not benchmark your investments at all is not only a potential ERISA liability but it’s also akin to never conducting performance reviews for your employees.  How effective would your firm’s productivity be if no one reviewed, measured and communicated employee goals and performance? Without performance reviews, it is difficult to be transparent with your employees, build teamwork and develop a more productive workforce. Likewise, without investment reviews, it is all but impossible to ascertain the quality of your investments.  

With that said, suppose the S&P 500 was +12% for the year and your stock funds were +8%. Is that productive? Probably not. But how would you know if you didn’t look behind the curtain and ascertain what is going on. Perhaps you are comparing a global stock fund to a U.S. stock index. That is like comparing a sedan to a truck. I realize most HR executives, CEOs or even CFOs are not investment experts. But when you offer your employees a 401(k), you are required to monitor your investment menu with the same prudence and care as an investment expert. That is why engaging a qualified financial advisor makes sense. The investment world is complicated, and your company simply may not have the resources or the time to research, examine, understand and even comprehend the differences between investments and benchmark. Advisors not only have the expertise, but they also have access to tools and research to make the job efficient.

There are literally thousands of possible benchmarks available, so no matter what the composition of your individual investment menu, you should be able to find meaningful comparisons for each fund you hold in your menu. For accurate assessment, your funds should not all be measured against the same index. Perhaps the most important value of investment benchmarking is that comparing a portfolio’s returns to a benchmark is a way to measure your portfolio manager’s skill. It answers the question, “What value was added by the manager’s decisions?” Obviously, this works well for actively managed funds. Benchmarks not only measure returns but also help measure risk and determine whether the return adequately compensated shareholders for the risk involved.

But, to reiterate, investments should be benchmarked against their peers and their corresponding index. For instance, you want to compare each fund to other funds of similar objective and also against the index that would most adequately align to that fund. Of course, you wouldn’t compare the performance of a US stock fund to that of the European stock index or the performance of a short-term US government bond fund to one that is part of China’s stock market. While that seems obvious, plan sponsors are usually quite bewildered as to how to properly track and monitor investments. This is why engaging a financial advisor as an investment expert makes good sense.

What About the 3(21) or 3(38) Fiduciary Services Provided by Recordkeepers?

The devil is always in the details. Plan Sponsors who don’t understand the details may decide to go down the 3(21) or 3(38) investment outsourcing route via their plan provider or recordkeeper. Frequently, I find these employers totally misunderstand what they are signing up for, especially in terms of handing over fund menu discretion. I understand you need to free up resources to allow staff to focus on business and outsourcing these responsibilities to a recordkeeper may seem like a simple solution in benefiting from fiduciary liability relief but it may not produce the outcome you desire.  

For instance, if you include 3(21) fiduciary services offered by your 401(k) provider, you should be aware this is a co-fiduciary role and when engaged, the fiduciary services are only responsible for making recommendations to you for investment changes. The responsibility to take action still lies in your hands as the employer. Now, if you instead opt for 3(38) fiduciary services, you should know you have given your recordkeeper (or the third-party company) discretionary investment management duties. In other words, in that case you have no decision-making authority in the investment options. Did you really want to give up that control? Who knows your employees better than you? Perhaps it may be better to engage a financial advisor who seeks to work directly with you and understand you and your employees. A qualified financial advisor can serve as either a 3(21) or 3(38) fiduciary, and also may be able to offer more plan sponsor and participant services, such as a custom education program, individual participant consultations and invaluable plan sponsor support such as plan design consulting, RFP,  vendor searches and much more.

Engaging an investment expert to assist you in your role may be prudent, but how you go about this process could be the most important step. Keep in mind, 3(21) co-fiduciary services still require you to make the final decisions on your investment menu options so while this may provide fiduciary relief, you are still responsible for being involved in the investment monitoring process.

Finally, monitoring reports and analyses provided by an advisor who uses third-party services instead of those provided by your recordkeeper’s proprietary software may help prevent any appearance of conflict of interest, which is a sensitive subject these days. Arguably, it may better enable you to be fair and objective in the evaluation because provider or proprietary software may not provide that important impartiality. As a plan fiduciary, you need to be careful in your objectivity. I recommend you consider using third-party information to analyze investments. We often provide second opinions and benchmarking analysis reports, which can differ dramatically from proprietary evaluations.

Morningstar, as an example, is the leading provider of investment research used by many institutions. It is a trusted source of information on mutual funds, stocks, and so forth, and one that many plan sponsors use as a tool for evaluating their investments. Although it is not without flaws, it is considered a trustworthy and reliable industry source.

The Big Debate: Index Funds or Active Management

Perhaps one of the greatest controversies in the investment world is the argument for passive versus active management, or index funds versus professionally managed funds. Those who favor index funds often argue that active managers frequently fail to match or beat their benchmark, and they question the reliability of active managers’ methods for recognizing and predicting trends. Active managers argue that the lack of downside risk in an index fund subjects shareholders to sharper losses and compromises results because ultimately investors are more concerned with risk than they are with returns. The reason the debate has continued for over twenty years is because history has demonstrated there have been periods of favorable performance for both approaches.

Instead of siding with either of these controversial views, it is generally deemed best practice for employers to remain objective and include both index and actively managed funds in your investment menu. There is truly no right or wrong answer when it comes to the active approach versus the passive approach; it’s rather a matter of opinion. Some participants prefer the low-cost index method, while others want a management team at the helm. If you define your process through your Investment Policy Statement (IPS), your committee will know what types of investments you will include in your investment menu. A well-written Investment Policy Statement also defines the monitoring process and it is a best practice recommended for plan sponsors.

Look out for my next blog where I’ll write about the Investment Policy Statement. Long gone are the days where employers could get away with just handing their employees a 401(k) booklet and a list of investment options and say, “good luck!” Not only is it a risky practice in today’s litigious world, but it also ignores our desperate need to support and seek to build retirement readiness in the workforce.  We, as employers, need to do more to help workers secure their futures and investment benchmarking is only the beginning but as already noted, it can amount to a substantial boost in retirement values over time.

For more information or assistance with your benchmarking needs, please contact me at terri@longevitycapitalmgmt.com.

This information is not intended as authoritative guidance or tax or legal advice.

Investing in mutual funds involves risk, including possible loss of principal.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investments in a falling market.

The prices of small and mid-capt stocks are generally more volatile than large cap stocks.

Bonds are subject to market and interest rate risk if sold prior to parturition. Bonds values will decline as interest rates rise and bonds are subject to availability and change in price.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

All indices are unmanaged and may not be invested into directly.

Investing involves risk including loss of principal. No strategy assures success or protects against a loss.