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Fund selection and allocation choices are overly influenced by short-term performance
The long-term growth of 401(k) plan accounts is affected by plan administrators' decisions on which investment funds to add to the plan and by participants' investment choices within the plan. Unfortunately, both administrators' and participants' choices are often badly made, according to a new report from the nonprofit Center for Retirement Research at Boston College.
Plan administrators most often choose to include, as new plan investment options, mutual funds that subsequently perform worse than their comparable stock or bond benchmark indexes, according to the study, "How Do Employers' 401(k) Mutual Fund Selections Affect Performance."
A major failing identified by the study is that, when making changes to their plan’s fund offerings, administrators are likely to "chase returns" (that is, select funds with strong short-term performance records, which may indicate they are presently over-valued following a recent run-up).
Past Performance and Future Returns
The analysis looked at the performance of funds added and dropped to 401(k) plans for three years before the change was made and three years after the change. The newly added funds outperformed randomly selected funds before the change was made, and before the dropped funds were dropped they under-performed the random funds. However, "this performance bonus essentially disappeared after the fund changes were made as the added funds did worse while the dropped funds did better," the study found. "This finding suggests that plan managers were chasing returns, but their efforts to tinker with their fund selections had essentially no impact on overall performance. The outcome underscores the traditional investor's caveat that ‘past performance does not predict future returns.’"
Although newly added funds were likely to perform worse than their benchmark indexes (and mutual funds that simply track those indexes), funds with lower fees were likely to perform better than other random funds, the study found. “Lower investment fees are a large part of the explanation for the superior performance of the employer selections,” noted the study's authors.
No Added value
Participants also tend to chase returns, to their detriment, through contribution changes and asset transfers, according to the study, which found that "participants shift their assets toward the best-performing funds and decrease their holdings in the funds that do not perform as well."
As to whether participants' decisions tend to improve their 401(k) account's performance, the study indicates "participants in aggregate do not add value to the investment performance of their 401(k) through their own decisions." That's because, "Like their employers, 401(k) plan participants also tend to chase returns, transferring assets into higher-performing funds." As a result, their investment performance after reallocating funds is likely no better than they would have achieved by simply allocating assets equally among all funds available through the plan, the study found.
Stephen Miller, CEBS, is an online editor/manager for SHRM.
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