One of the things that continues to amaze me are the number of cases we see where participants in a retirement plan have set up unsuitable portfolios in their retirement accounts, thereby exposing themselves to unnecessary investment risk. When asked how they arrived at the portfolio’s allocation mix, they usually respond by saying that they followed one of the pie charts that they had been shown during an education meeting at their company or by the plan’s investment adviser.
In order to reduce their potential fiduciary liability exposure, many companies choose to adopt what is known as a 404(c) retirement plan. Under a 404(c) plan, the individual participants in the plan generally make their own decisions on how to invest their money, choosing from among various investment options offered by the plan’s sponsor (their employer).
Most retirement plans offer the employees some form of investment education program, with such programs usually being provided by the entity offering the investments or by an independent third-party. A common scenario is to present the employees with various computer generated asset allocation models, usually in the form of a multi-colored pie charts. The employee is then given the task to choose the model investment allocation model that they feel most comfortable with.
In order to obtain the fiduciary protections offered by 404(c) plans, employers must meet certain requirements. One such requirement is that they provide the plan participants with “sufficient information to make an informed decision” Unfortunately, the Department of Labor’s concept of “sufficient information” does not include crucial information that employees need to know in order to effectively create and monitor their retirement account portfolios.
Clients and followers of this blog know that I like to refer to the study by Schwab Institutional that concluded that 75% of the portfolios they studied were unsuitable for the investors involved, based on the investor’s financial situation or financial needs. Based on my personal experience, the percentage of unsuitable portfolios is even higher than Schwab’s findings. When we talk to employee groups about managing their retirement plans, we suggest three keys areas for them to address
The first issue we discuss is “pseudo” diversification. The Department of Labor only requires that employers provided risk and return information to employees for the investment options offered by the company’s retirement plan. At the same time, the Department advocates the use of modern portfolio theory in managing investment portfolios.
Modern portfolio theory suggests that in creating an investment portfolio, an investor factor in not only risk and return numbers, but also the correlation of returns of the investments being considered. Modern portfolio theory argues that by factoring in the correlation of returns, an investor can reduce the overall volatility of a portfolio and archieve more consistent returns.
As we discuss in our article, “Right Kind, Right Reason Investing-Positioning Your Portfolio for Success,” over the past ten years there has been a definite trend of increasing correlations of returns among equity investments. And yet, in most cases, equity based investment options are the primary investment options offered in 401(k) and 404(c) plans.
The employer’s failure to provide employees with correlation of returns information on a plan’s investment options and the failure to provide some method of computing the correlation of returns on such options usually results in employee retirement portfolios that are “pseudo” diversified in the sense that they have several types of investments, but the portfolios are not “effectively” diversified since the investments chosen are often highly correlated, thereby failing to provide the employee with the needed downside protection against market downturns.
The second issue employees need to address involves “closet indexing” and inflated active expense ratio fees. Studies have consistently found that actively managed mutual funds generally fail to outperform index mutual funds. Nevertheless, most company retirement plans are made up primarily of actively managed mutual funds. These actively managed funds carry significantly higher fees than comparable index funds, based on the premise that the investor benefits from the active management of the fund.
However, upon closer inspection, not only do most of the actively managed mutual funds consistently under-perform their comparable index fund, in many cases the actively managed fund owes most of its performance to the performance of the relevant benchmark index. By looking at a fund’s R-squared ratio, an investor can see how much of a fund’s performance is traceable to the applicable benchmark index and how much of the fund’s performance is actually due to active management. Fund’s with high R-squared ratings are typically referred to as “closet indexers,” since most of their performance is due to an index, not the fund’s managers.
Even more disturbing is the impact that such “closet indexing” has on the true, effective fees charged by actively managed funds. Ross Miller of SUNY-Albany has created a measure, known as the active expense ratio, that allows investors to assess the impact of “closet indexing” on actively managed mutual fund fees. The concept behind the active expense ratio is that if investors can achieve equivalent index fund returns at the lower fees charged by index funds, then the effective cost of the supposed active management increases disproportionately. Miller’s studies have shown that the effective cost of actively managed “closet indexer” mutual funds is often significantly higher than the fees stated in a fund’s prospectus, often five to six times higher. Higher fees reduce the return to the investors.
The final issue employees need to address has to do with an employee’s overall investment approach. In many cases employees are taught to adopt a buy-and-hold approach to investing, with occasional re-balancing back to the portfolio’s original asset allocation percentages. This antiquated concept, based primarily on misconceptions or, in some cases deliberate misrepresentations, of the historic BHB study, needlessly cost American investors trillions of dollars during the bear markets of 200-2002 and 2008.
People have been led to believe that the BHB study found that most investment returns are based primarily upon asset allocation, not upon the specific investment chosen. What the BHB study actually found was that asset allocation accounts for approximately 93.6% of the variability of a portfolio’s returns. By looking at a portfolio’s allocation between stock, bonds and cash, the BHB study simply said that higher allocations to the riskier asset increased the variability of the portfolio’s overall returns. Since stocks are historically riskier than bonds, and bonds are historically riskier than cash, the BHB’s findings are not that surprising.
However, the investment industry continually misrepresents the findings of the BHB study as evidence that buy-and-hold is the proper choice for portfolio management. Buy-and hold ignores the cyclical nature of the stock market and exposes investors to unnecessary investment risk. Two of the pioneers of modern portfolio management, Nobel laureates Dr. Harry Markowitz and Dr. William Sharpe, have both emphasized the need for investors to make adjustments to their portfolios when the conditions in the stock market and/or the economy merit such actions. Could the fact that stockbrokers and investment advisers often receive ongoing fees as long as their clients own an investment have anything to do with the promotion of the buy-and hold approach?
Putting the three steps together, in addition to looking for investments with favorable return and risk numbers, an employee’s goal should be to put together a retirement plan portfolio that consists of investments with low correlations of return and investments that are either low-cost index funds or funds that have a low R-squared rating. Employees should then monitor their portfolio on a regular basis, no less than quarterly, and make adjustments to the actual investments or the allocation of the investments as needed in order to reduce their risk exposure.
The bottom line for investors in corporate retirement accounts is that they can, and should, take steps to obtain all of the information that they need to truly make an informed decision. As the need for this additional information becomes more widely acknowledged in order for employees to be able to actually make the informed decisions contemplated under ERISA and to better protect their financial security, employers will hopefully realize the benefits of providing such information to employees and the potential liability issues for not doing so.