The Flawed Premise of 95 Percent of 401(k) Plans

I can find no credible data supporting the inclusion of actively managed funds in 401(k) plans or individual portfolios. Yet, these funds dominate the investment options in most plans.
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Here's the difference between decisions made by 401(k) plan sponsors and the decisions you make for your individual portfolio: Your lack of investment knowledge will affect only your portfolio. The poor decisions made by 95 percent (or more) of 401(k) plan sponsors can destroy the retirement goals of millions of American employees.

I meet with many 401(k) plan sponsors. They all tell me the same thing. Their broker or insurance company claims to have the ability to select actively managed funds that will outperform the indexes. My response is simple: Show me the data. Start by showing me the funds they have selected in the past, with the dates when they entered and exited the funds. If they have this ability, you would assume most of those funds beat the benchmark. I have never received this information.

Here's another question you should ask: How have the proprietary mutual funds (the ones that have the name of the brokerage firm in the name of the fund) performed against their benchmarks? If a broker tells you he can pick fund winners, you would think their branded funds would have a long track record of routinely outperforming their benchmarks. Be sure to get at least ten years of performance data.

Let's put the daunting task of picking fund "winners" in perspective. How hard do you think it is for the most sophisticated fund managers in the world to beat the S&P 500 index, when that is their designated benchmark? It must be harder than it looks because less than 40 percent of these funds do so in any given year according to a study by Standard and Poors.

Presumably, each of the losing fund managers had every expectation of beating their benchmark at the beginning of the year. How likely is it that a broker could predict in advance that the fund manager would fail to meet this goal? Do brokers know something that has eluded these fund managers and their employers?

Many state pension funds retain brokers with this purported expertise to advise their plans. They are understandably eager to reap the extra returns promised by these "experts". How has that worked out?

Not well. A comprehensive study compared the long term results of state pension plans with index based portfolios of comparable risk. Almost all of the plans underperformed.

The problem is not lack of data. It's that plan sponsors are not aware of the data and brokers want to keep them in the dark. Burton Malkiel, in his seminal book, A Random Walk Down Wall Street, reviewed the research and concluded that "It does not appear that one can fashion a dependable strategy of generating excess returns based on a belief that long-run mutual fund returns are persistent." The problem is not that no actively managed funds outperform. Some do. The issue is whether anyone has the expertise to pick them in advance.

Financial author and blogger Richard A. Ferri computed the odds of picking a fund that would beat the benchmark and found they were 2 to 1 against doing so. Ferri concluded: "The odds are against picking a winning fund, and the payouts don't justify the risk."

I can find no credible data supporting the inclusion of actively managed funds in 401(k) plans or individual portfolios. Yet, the securities industry is so clever and its advertising is so overwhelming, that these funds dominate the investment options in most plans. The cost to plan participants is staggering.

The system needs a complete overhaul.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of "The Smartest Investment Book You'll Ever Read," "The Smartest 401(k) Book You'll Ever Read," "The Smartest Retirement Book You'll Ever Read" and "The Smartest Portfolio You'll Ever Own." His new book is "The Smartest Money Book You'll Ever Read." The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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