Analysis Shows Importance of DC Plan Fund Menu Monitoring

An analysis from Morningstar suggests monitoring defined contribution (DC) plan fund menus can have a positive impact on performance, and investment management providers weigh in on how to determine when a fund change is needed.

A Morningstar report, “Change Is a Great Thing,” finds that monitoring defined contribution (DC) plan fund menus can improve performance, although more research on why this effect occurs is warranted.

The report cites previous research which found that institutional investment managers hired to replace terminated underperforming managers perform much better before they are hired, but this outperformance disappears after they are selected.

Morningstar researchers used a large data set of plan holdings from three different recordkeepers between January 2010 and November 2018, to investigate the monitoring value provided by plan sponsors. For each plan, a list of available funds is available at some interval, typically quarterly. They employ a matching criterion to determine when a fund is replaced within the same investment factor style based on its Morningstar Category over time. The analysis results in a sample of 3,478 replacements across 678 DC plans. They find that on average replacement funds had better historical performance and lower expense ratios, along with more-favorable comprehensive metrics such as the Morningstar

Rating for funds (the “star rating”) and the Morningstar Quantitative Rating for funds, than the funds they replaced. The largest performance difference in the replacement and replaced funds is the five-year historical returns, suggesting this historical reference period is the one that carries the most weight among plan sponsors.

They also found that the future performance of the replacement fund is better than the fund being replaced at both the future one-year and three-year time periods, and that these differences are statistically significant. The outperformance persists even after controlling for expense ratios, momentum, style exposures, and other metrics commonly used by plan sponsors to evaluate funds such as the star rating and quantitative rating.

“Our findings suggest that monitoring plan menus can have a positive impact on performance,” the researchers conclude.

Jim Licato, vice president of product management at Morningstar in Chicago, and co-author of the report, tells PLANSPONSOR, “We have found, and believe it is very important, for someone to be keeping an eye on retirement plan investments—whether an investment committee or investment adviser—and make necessary changes. We found not doing so is a disservice to participants.”

He says that the prior studies did not include as robust a data set as the Morningstar analysis and that may be the reason it found different results than prior research. However, he adds, “We still have not dug through the detail about why exactly replacement funds are overperforming. It will require further research as it remains elusive as to why.

“What we can say,” Licato continues, “is that prior to replacement, plan sponsors were looking at a number of areas—past performance, expense ratios, Morningstar ratings, etc.—and all improved with the replacement fund.”

Considerations for fund replacement

Other than declining returns, Mike Goss, EVP and co-founder, Fiduciary Investment Advisors in Windsor, Connecticut, says one big factor in considering a fund for replacement for his firm is a fund manager change—whether a lead portfolio manager or a key member of that team. When this happens a fund may be put on watch because generally the manager is ultimately responsible for the funds track record and which securities to own. A fund manager change could change the fund’s track record or style, he explains.

Other factors in considering a fund for placement on a watch list or for considering a fund change is the change in ownership of the investment firm. “It’s a potential change that could lead to poor results,” Goss says. Those tasked with monitoring a DC plan’s investment menu also want to watch out for a fund style change or drift—for example, from value to growth—and for a strange in strategy or fund turnover—for example, some funds own stocks for a long time and some trade frequently. “Both can be good strategies, but if a fund changes strategy it should cause a plan fiduciary to ask why,” he says. “Plan sponsors select funds based on a certain process, style or philosophy. Any change would be a red flag.”

According to Licato, fund expenses should also be monitored to make sure they are in line with what similar funds are charging.

He says when a fund is put on a watch list, it can remain on the watch list for one quarter or a few quarters. Those monitoring the DC plan fund menu will look to see whether what triggered putting the fund on the watch list has been improved or gotten worse. If it’s gotten worse, the fund should be replaced. “There is no set number of funds that need to be replaced or put on watch. It’s more about fund monitoring and staying on top of things,” he adds.

According to Goss, his firm’s rule is that a fund cannot be on watch more than year. “There’s no law or necessary best practice, but we think a year is enough time to make a quality assessment to either maintain the fund in the DC plan investment menu or change it,” he says.

Goss warns that DC plan fiduciaries should never try to time the market. “That’s no reason to add or delete a fund. Hopefully, if they’re doing very good due diligence when they select a fund to include on the investment menu, they should not have a significant turnover of funds. We very rarely turn funds over,” he says. Goss adds that one of the things fiduciaries can outsource through a 3(38) investment manager is the ability to have the manager select, monitor and replace funds.

Licato points out that fund turnover can be disruptive for recordkeepers and participants—the paperwork and moving of assets is never a good thing from an administrative standpoint. However, he says, if a plan fiduciary is contemplating not removing a fund because it will be disruptive, it is not looking at the best interest of participants. “If it will benefit participants, do it.”

He adds that the main lesson from Morningstar’s analysis is, “Don’t’ set the investment menu on cruise control and not look at it for years. During that time there could be many red flags.”

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