The research underscores the value of plan monitoring, and perhapseven the value third-party fiduciary advisors can bring to plans.(Photo: Shutterstock)

Plan sponsors have a clear legal obligation tomonitor the quality of investments offered to retirement investorsin 401(k) plans.

While that part of fiduciaries' obligations is indisputable, asmall body of academic research on what happens when an investmentoption is removed in favor of another has shown that the new fundsfail to outperform, and sometimes underperform, the removedfunds.

One paper, published in the Journal of Finance in 2016, found noevidence that consultants' recommendations to replaceinvestments resulted in added value to plan sponsors and investorsin retirement plans.

Or in other words, action taken from the legal obligation tomonitor fund lineups did not result in better savings outcomes.

But new research from Morningstar is pushing back on the ideathat investment menus are best served with a set-it-and-forget-itdesign.

Like previous research, Morningstar found that the decision toreplace a fund is largely based on comparisons of five-yearhistorical performance.

But unlike previous research, Morningstar found that replacementfunds go on to outperform the replaced funds over the ensuing oneand three-year time periods after the switch.

Plan monitoring not a futile exercise

“We think the breadth of our analysis is unmatched compared tothe other research,” said Jim Licato, vice president, productmanagement for Morningstar Investment Management, which houses thefirm's advisory services unit.

Licato, David Blanchett, head of retirement research atMorningstar, and Michael Finke, a CFA with the American College ofFinancial Services, tapped Morningstar's managed account platformto analyze nearly 3,500 fund replacements in 678 definedcontribution plans over an eight-year period beginning in 2010.

Prior research was based on significantly smaller data sets; one2007 study that found no performance improvement in replacementfunds was based on a sample of 45 deleted investment options.

Morningstar's analysis compared funds within the same investmentstyle of three investment categories: equity, bond, and allocationfunds that blend both.

Not surprisingly, the replacement funds tended to have lowerexpense ratios than the replaced funds, better historical returns,and overall higher ratings from Morningstar.

That much was expected, Licato told BenefitsPRO. But thesubsequent outperformance of the replacement funds over one tothree-year periods came as a notable surprise that supports thevalue in monitoring plan investments, he said.

“Plan sponsors, whether they use an outside fiduciary advisor orrely on internal investment committees, are being diligent in theirmonitoring,” said Licato of the new research. “You need to stay ontop of your menu design, and make changes when necessary.”

Replacement equity funds had the highest rate of outperformance,but each of the three broad asset classes Morningstar reviewedoutperformed the replaced funds. For all three fund groups, themedian outperformance was 22 basis points after one year, 26 basispoints after two years, and 52 basis points after three years.

What explains the outperformance?

Morningstar's analysis establishes a correlation betweenreplacement funds' historical performance and their ability tooutperform going forward, and underscores how lower-fee funds cancontribute to better performance.

But the full explanation of why replacement funds do bettergoing forward remains “elusive,” according to the report. Licatosaid Morningstar intends to conduct further analysis on morecomplete data.

Nevertheless, the research underscores the value of planmonitoring, and perhaps even the value third-party fiduciaryadvisors can bring to plans.

“If you don't have strong monitoring, that opens up potentialproblems,” said Licato. “If you simply set it and forget it, you'redoing a disservice for the investor.”

Morningstar offers 3(21) and 3(38) fiduciary advisory servicesto 401(k) plan sponsors, along with its managed account platform,which touts a capability to design personalized investmentstrategies within a plan sponsor's core investment offering.

Though still in its nascent stage, Licato thinks Morningstar'snew research proves the value of plan monitoring, irrespective ofthe firm's business interest in facilitating plan sponsors' legalobligations.

“Whether you are working with Morningstar, another fiduciaryadvisor, or your own investment committee, a sponsor needs peoplestaying on top of their investment lineup,” he said.

While historical performance can and often does translate toimproved future performance, other investment features, likemanagement tenure and turnover, and style drift, need equalconsideration.

And monitoring a plan can always prove a menu's design is rightwhere it needs to be.

“It all comes down to the funds being offered,” said Licato. “Ifa plan is working with representation from well-established assetmanagers, and there aren't any red flags, then there's notnecessarily a need to replace funds.”

READ MORE:

Risk exposure: Does your plan still offer companystock as an investment option? 

3 takeaways on trends in advisorinvesting

2019 stock market outlook: slower growth but norecession