The Prudent Fiduciary

Scott Pritchard | Principal

A look at the major issues that are shaping fiduciary best practices today.

The Lake Wobegon 401(k) Plan

November 2009

“Where all the women are strong, all the men are good looking, and all the children are above average.” This was Garrison Keillor’s famous description of his fictional home town, but superiority bias is applicable far beyond the shores of Lake Wobegon. It also permeates the world of 401(k) plans.

In our work as an independent fiduciary advisor, we review a great many investment line-ups for plan sponsors. And, as you might imagine, the vast majority of plan sponsors believe their investment offerings are above average.

“Scott, just look at these five-star funds we have… they are from some of the largest fund companies in the country…these funds have tremendous track records…”

And there is the rub. Most 401(k) committee members are investment laymen and the easily understood method for evaluating an investment option is past performance. The only problem is that the fine-print disclaimer, “Past performance is not a guarantee of future results,” is there for a reason. There has never been a single study that found any correlation between past performance and future results. That’s why the regulators require that disclosure.

So here’s how it happens in the hypothetical “ABC 401(k) Plan”: 

  1. In constructing the line-up, the committee chooses an extensive menu of five-star funds from the “recommended list” of their provider (which also happens to be compensated by those very same funds).
  2. Over time, with the inevitable variability of returns, some of those five-star funds begin to under-perform. So, the funds are added to the watchlist and eventually replaced by the latest five-star funds suggested by the provider.
  3. The churning continues. As yesterday’s winners become tomorrow’s losers, they are replaced by the latest batch of five-star funds in the endless quest for an above-average fund line-up.

But who is missing from this conversation? The participant. The person whose best interests all fiduciaries are duty-bound to protect. Participants are the ones who actually have to invest in these “above average” funds that rarely remain above average going forward. The unfortunate reality in most plans is that participants invest in a fund with great historical performance only to get in too late and ride the fund down to its inevitable reversion to the mean. The fund is then replaced and the cycle is repeated. It’s the classic “buy high / sell low” experience that dooms the average retail investor.

How do we solve this problem? As with anything, the first step is acknowledging that there is a problem. In the wake of the downward slide of 2008 and the whipsaw rebound of 2009, I see many more plan sponsors awakening to the fact that the old model of chasing five-star funds hasn’t worked.

Plan sponsors are recognizing that participants are struggling. And an increasing number of plan sponsors are taking their fiduciary responsibility seriously and are taking a hard look at their perhaps not-so-above-average investments and their not-so-above-average “advisor”.

So, if you are a plan sponsor, or if you advise a plan sponsor, challenge your process for selecting investments. In an effort to truly fulfill your fiduciary duty to serve the best interests of plan participants and their beneficiaries, look beyond past performance and star ratings. Choose funds that provide the broadest asset class coverage at the lowest cost.

Perhaps we’ll never get to where “all plan sponsors are prudent, all advisors are objective, and all participants are well-diversified”, but it never hurts to dream.

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