Swedroe: Plan Sponsors’ Weak Returns

Institutional plan sponsors are charged with investing trillions of dollars on behalf of pension plans, endowments and foundations. As a result, the quality of the investment decisions made by these plan sponsors is of great interest and importance to a great many people.

Over the years, I’ve met with many institutional plan sponsors to discuss their investment strategy. These plan sponsors all have a fiduciary duty to their beneficiaries, and they take their jobs seriously. In my experience, they also all believe they are adding value through their investment decisions.

Are they right? Unfortunately, the evidence demonstrates that their decisions persistently destroy value.

Taking A Deep Dive

A recent study, “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors,” examined whether investment decisions made by institutional plan sponsors contribute to their asset values. The study used a data set covering 80,000 yearly observations of institutional investment product assets, accounts and returns over the 24-year period from 1984 through 2007.

The study covered a broad spectrum, and included both domestic and international equities as well as domestic and international bonds. The results are shocking, though they won’t surprise believers in the efficiency of markets. Following is a summary of the authors’ findings:

• While plan sponsors may believe they are acting in their stakeholders’ best interests, the results show that when they make rebalancing or reallocation decisions, on average, they are destroying value.
• Investment products receiving contributions subsequently underperform products experiencing withdrawals over one-, two- and three-year periods.
• For investment decisions among equity, fixed-income and balanced products, most of their underperformance can be attributed to product selection decisions, as opposed to asset allocation decisions. However, both types of decisions subtracted value.
• Much like individual investors, who tend to switch mutual funds at the wrong time, institutional investors don’t appear to create value from their investment decisions.

Quantifying Losses

The authors estimated that allocation decisions resulted in losses of more than $170 billion over the period studied —an average cost of more than $7 billion a year. Even this horrific figure understates the true damage, because it’s gross of any transition costs.

Clearly, plan beneficiaries would have been better served if plan sponsors hadn’t acted at all. And even more of them would likely have come out ahead if they’d simply chosen passively managed funds in the first place, and then stayed the course.

It’s worth noting that the plan sponsors were acting in what most people would agree was a rational way.

In their hiring decisions, plan sponsors placed great importance on historical performance measures, performance trends and product attributes. However, despite hiring managers with large, persistent and even long-term records of delivering alpha relative to appropriate benchmarks, their results demonstrate that relying on past performance is costly.

Extra Effort And Sophistication Not Worth It

Compared with individual investors, institutional plan sponsors have a much higher level of investing sophistication. They are typically staffed with professionals that have years of experience and advanced degrees.

Either on their own, or through the use of consulting firms such as SEI, Russell and Goldman Sachs, institutional plan sponsors devote considerable time and resources to selecting asset classes and products that are expected to perform well in the future. Yet the record demonstrates that their efforts have proven counterproductive.

If they fail with such persistence, what are the odds that you, or your financial advisor, will do any better? What logical reason can you come up with to justify trying to outperform appropriate risk-adjusted benchmarks when others with more resources and time have failed?

More Damning Research

Unfortunately, the experience of 401(k) plan sponsors isn’t any better. The authors of the 2013 study, “How Do Employers’ 401(k) Mutual Fund Selections Affect Performance?” took a look at the performance of plan administrators through their fund selections.

They found the mutual funds that plan administrators choose underperform benchmark index funds.

Thus, participants would be better served if the plans offered passive, instead of active, fund choices. They also found that plan administrators are performance chasers—they fire poorly performing funds and replace them with the “hot” funds at the time. However, all of this activity didn’t add any value.

Why Keep Repeating The Same Mistakes?

The question then remains: Why do plan sponsors keep doing what Einstein described as the definition of insanity—repeating the same behavior over and over and expecting different results? Why do they keep hiring managers who have delivered alpha in the past only to end up firing them because the past isn’t prologue?

The authors of one study hypothesized that it occurs because plan sponsors find comfort in extrapolating past performance, despite their own experiences that demonstrate excess performance is random.

Stakes Are High

Perhaps the real answer is that plan sponsors need to justify their existence. If they recommended abandoning active managers and instead chose passively managed funds and adhered to their asset allocation plan, many would no longer be needed.

One of our most famous economists, Paul Samuelson, put it this way: “[A] respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business—take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed. Few people will commit suicide without a push.”

The issue of the performance of plan sponsors is of great importance, given the dollars involved. In addition, in the case of public plans, future taxpayers will have to bear the burden of losses incurred by plan sponsors. It’s past time for the process of selecting investment managers by plan sponsors to change.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.