Growth

Rich and Co.

“investors in 401K plans are sacrificing significant return because plan administrators are offering an incomplete set of investment alternatives.”

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It is interesting to note why these differences in return occurred. The bulk of the differences in Sharpe ratios occurred because the plans had much more risk than a portfolio comprised of the 8 RB indexes. The problem lies not in plans selecting individual mutual funds that perform badly, but rather: in plans offering too few investment choices, choices with high risk, choices that are too highly correlated.

This means that, for 62% of the plans, the plan participants would be better off with additional investment choices. In fact, if these plans spanned the 8 RB indexes, participants’ average return would improve by 3.2% per year, which is 42% of the return on an 8-index portfolio with the same level of risk. While significant on a 1-year basis, over a 20-year period (a reasonable investment horizon for a plan participant), the cost of not offering sufficient choices makes a difference in terminal wealth of over 300%. Since, for more than one half of plan participants, a 401K plan represents the participant’s sole financial asset, the consequences are serious….
…We find that, controlling for plan size, the use of outside consultants or sophisticated investment strategies increases with the number of investment choices, increases the optimum Sharpe ratio and increases the probability of spanning.  However, none of these increases are statistically significant. Thus we have at best weak evidence that the use of consultants or sophisticated strategies leads to better results….
There is one category of investments, S&P 500 index funds, for which we can evaluate the individual funds selected by 401K-plan administrators. We find that the index funds offered by 401K plans do not perform as well as the index funds chosen by the aggregate of all investors. Finally, we examine the effect of offering company stock as an investment choice. We find that plans that offer company stock on average provide the same number of mutual fund choices as plans that do not offer company stock. The inclusion of company stock in a plan increases the variance of the plan and also leads to a slight increase in the Sharpe ratio. There is no increase in the number of plans that span the relevant space.
…The overall evidence is that including company stock does not have a major positive or negative effect on the desirability of a 401K plan for participants. 

 

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Written by Rich and Co.

January 13, 2013 at 6:10 pm

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