Employee investment performance fatigue?

 

Does your plan’s investment rating says 5 star but your investment performance says 1 star? What gives? How can this be?

I recently looked at a prospects investment returns and found a gap between the investment return and what the employees actually achieved. I asked what was the plan’s benchmark return was. The plan sponsor (investment committee) actually did not have a defined benchmark so I offered a couple. The most quoted is the Standard and Poor 500, the top 500 US companies representing all major industries. However I believe that a more realistic benchmark would be a combination of 60% of those companies and 40% bonds of similar size companies. The gap between the plan’s returns and the 60% stock/40% bond benchmark was -2.5% over a six-year period. A 30 year old employee that saves $5500 per year for 35 years and lives to 90 would have earned 683,000 more. That certainly would impact their life.

Tracking error and investment performance

The concept of investment performance gap is stated most simply in the financial industry with something called tracking error. Essentially it means how closely your performance matched the performance of the benchmark you were trying to match. This is one way for an investor to determine how well the investment manager or advisor is performing. While you can simply choose to get the average of all the companies in the benchmark, many financial advisors claim they can do better. Tracking error is a way of determining if they matched their bravado.

Investment performance and greener pastures

For many of us the grass looks greener on the other side. Meaning that we tend to hear about someone else’s good returns and decide to follow them. Popular magazine headlines often read “What to Invest in Now”. Unfortunately what they really mean is what you should have invested in months if not years ago. The question is will that investment performance continue? This is one of the problems you face as a plan sponsor when evaluating investments in your defined contribution plan.

Research from Dimeo Schneider found that top investments over a ten-year period typically spend some time in the bottom half of their investment category.¹ Let’s say that you decide to remove a former top performer because it has been ailing over a three-year period. A year or three years later you bring that investment back to the investment menu when it once again achieves its top status. Research in the Journal of Finance noted that plan participants lost 103 basis points of cumulative potential value (not including trading costs) in the three years after the investment changes made by the plan sponsors in their sample.² Would you and your employees have been better off simply staying put? Would you be singing Dr. John’s lyrics:³

I been in the right place

But it must have been the wrong time

I’d a took the right road

But I must have took a wrong turn

Would have made the right move

But I made it at the wrong time

Asset allocation and investment performance

That’s why it’s important to know the actual returns your employees achieve. Hypotheticals are only that. Fixating on the investment menu doesn’t equate to higher plan returns. Besides, several studies have pointed out that it is the mix of investments not the picks that explain more than 90% of an investor’s return. Might providing allocation advice be a better value for your employees’ money? Have you evaluated ways to help them with their mix of investments (asset allocation)? We have several approaches to help you address the investment performance gap. Ready to start a conversation?

1. This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.
2. Journal of Finance, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” August 2008
3. Dimeo Schneider, The Next Chapter in the Active vs. Passive Debate
4. Dr. John, Lyrics to Right Place, Wrong Time
5. Source: Gary P. Brinson, Brian D. Singer and Gilbert L. Beebower, “Determinants of Portfolio Performance II, An Update,” Financial Analysts Journal, May-June 1991.