How you and your employer botch your 401k

(MoneyWatch) Defined contribution plans, predominantly 401(k)s, are the primary source of personal retirement savings for many American workers. Thus, the investment decisions within these accounts are important. Unfortunately, research has found that both individual investors and plan sponsors don't make good decisions. Investors fail to effectively diversify portfolios, often making heavy allocations to their employer's stock or simply dividing their assets equally among all the funds in the plan. Plan sponsors don't provide sufficient categories of investments to their participants.

Edwin Elton, Martin Gruber and Christopher Blake, authors of the January 2013 paper "How Do Employers' 401(k) Mutual Fund Selections Affect Performance," looked at both the performance of the plan administrators in their fund selections as well as the performance of the participants. The following is a summary of their findings:

  • The mutual funds plan administrators chose performed better than comparable, randomly selected funds, because the funds they chose had lower average expenses than the average fund. However, they underperformed benchmark index funds. Thus, participants would have been better served if the plans offered passive choices, rather than active choices.
  • Plan administrators were performance chasers. They fired poorly performing funds and replaced them with "hot" funds. However, their activity didn't add any value.
  • Plan participants were also performance chasers, increasing their allocations to "hot" funds. Unfortunately, their behavior didn't add value either.

In summary, if plan administrators were following their fiduciary responsibilities, the evidence would lead them to choose only low-cost, passively managed funds, such as index funds. In addition, because participants generally do a poor job of diversifying risks, employees should be offered target-date funds, which change their asset allocations based on how close they are to a specific assumed retirement date. And these portfolios should automatically rebalance. By seeing only the performance of their portfolios, and not the individual components, investors will be less prone to performance chasing and its negative impact on returns.

Image courtesy of Flickr  user 401(K) 2013.