09/17/2013 07:01 pm ET Updated Nov 17, 2013

Plan Sponsor's Investment Choices Can Affect Your 401(k) Returns

There is a lot of information written to "educate" 401(k) participants about how to make intelligent choices from the investment options available in their plans. Rarely discussed is the fact that your returns may be negatively affected by your plan administrator who controls the selection of funds in which you are permitted to invest. If those initial choices are flawed, you may be relegated to lower returns.

A study by three professors of finance from the Center for Retirement Research at Boston College sheds some much-needed light on this subject. The study examined filings at the Securities Exchange Commission for the period 1994-1999. It examined 43 plans with individual mutual fund data and an average asset size of $310 million.

The results were predictable for those familiar with the general data on the performance of index funds versus actively managed funds, but they may come as a surprise to many plan participants.

Over three years of investment performance, assuming equal weighting of each fund within the plan, the funds selected by plan administrators underperformed the comparable indexes by 0.31 percent. If the plan administrators had dumped all actively managed funds as investment options, and substituted index funds, the returns of plan participants would have been improved by 0.31 percent, compounded annually over this three-year period.

Plan sponsors typically engage in a time-consuming process of adding and dropping funds as options in their plans. Their determination is largely based on past performance. The plans in this study added 215 mutual funds and dropped 45 during the period analyzed.

The study found that, for the three-year period prior to the time when the new funds were added to the plans, they outperformed randomly selected funds by an impressive 1.34 percent annually. Before the dropped funds were eliminated as plan options, they underperformed randomly selected funds by 1.43 percent annually. Clearly, the choice to add and drop funds was premised on past performance. The plan sponsors added funds with stellar recent performance and dropped those that underperformed. How did this selection process work out for plan participants?

Not well. The performance bonus essentially disappeared after the changes were made. The outperformance of the newly added funds over randomly selected funds dropped from 1.44 percent to 44 percent. The performance of the dropped funds increased from -1.43 percent to +0.17 percent. The added funds did worse, and the dropped funds did better. The difference in performance was determined by the study to be "not significantly different from zero."

There is an insidious exception to this elaborate ritual of dropping poorly performing funds and adding outperforming ones. Another study found that when mutual fund families act as trustees of 401(k) plans, they are less likely to remove poorly performing funds if those funds are affiliated with the plan trustee. The study found that "subsequent performance of poorly-performing affiliated funds indicates that these trustee decisions are not information driven and are costly to retirement savers."

Let's step back and look at this process in context. Plan sponsors typically hire brokers, insurance companies and consultants to assist them with the process of selecting investment options for inclusion in their 401(k) plans. The "experts" overwhelm the sponsors with impressive charts and graphs demonstrating the stellar past performance of the funds they are recommending, which (they assert) justifies the plan sponsor in retaining their services. After they are hired, the elaborate ritual continues. The plan sponsor and the advisers to the plan meet regularly to evaluate the performance of the funds in the plan. Based on past performance, some funds are dropped, while others are added, unless the poorly performing funds are affiliated with the fund family acting as trustee to the plan. This is a time-consuming, elaborate process that no doubt makes all the players (the investment committee, the plan advisers and the consultant) feel like they are doing something valuable.

Unfortunately for plan participants, this entire process is fatally flawed and is negatively affecting their returns. The solution is disarmingly simple. All investment options in the plan should be low-management-fee index funds. Even better, the index funds should be pre-allocated in a limited number of portfolios for different risk levels, ranging from conservative to aggressive. It's not realistic to expect plan participants to put together a risk-adjusted portfolio from a list of 10 or more funds.

Is it any wonder that many believe our current 401(k) system is rigged to benefit actively managed funds, mutual funds serving as plan trustees, consultants, brokers and insurance companies, at the expense of the returns of plan participants?

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.