DOL’s New Performance Reporting Requirements: A Boon or a Risk to the 401k Fiduciary?

(The following is one of a special four part series covering an analysis and review of the DOL’s new fee disclosure requirement as revealed by using Brightscope’s list of top ten most widely held 401k mutual funds.)

In the Model Comparative Chart for its new 401k disclosure rule, the DOL broke its sample Model Comparative Chart into two parts. This article will focus on the first part – Performance Reporting – specifically, it’s suggested layout for Table 1. As we demonstrate the use of Table 1 via the top ten most widely held mutual funds in 401k plans as identified by BrightScope, some apparent issues immediately pop out. The 401k fiduciary just might find these new disclosure rules could increase fiduciary liability as we’ll explain.

First, here’s the DOL’s suggested wording for Part I: “Table 1 focuses on the performance of investment options that do not have a fixed or stated rate of return.  Table 1 shows how these options have performed over time and allows you to compare them with an appropriate benchmark for the same time periods.  Past performance does not guarantee how the investment option will perform in the future.  Your investment in these options could lose money.  Information about an option’s principal risks is available on the Web site[s].”

What’s immediately apparent from this comparison chart is its reliance on the same “snapshot-in-time” performance reporting anomaly employed by the SEC in its mutual fund prospectus reporting requirements. William A. Noyes, CFA, Vice President at Diversified Investment Advisors says changing the DOL’s introductory text to note “the performance indicates a specific point-in-time time frame, and may change significantly when alternative time frames are reviewed would be beneficial.” Unfortunately, the “snapshot-in-time” anomaly is a structural fault in most government performance reporting regulations, but remains unaddressed. By encouraging what behavioral economists call “recency,” the recommended disclosure format may inadvertently cause 401k plan sponsors to promote inappropriate decision making on the part of employee investors. As a result, the new rule may actually increase fiduciary liability of 401k plan sponsors.

Besides the problem of recency, the sample chart does not employ what the SEC already requires – a graphical depiction of performance in addition to a tabular version of the data. Different people read better in different environments. Some like numbers while some prefer graphs. This sample chart shows a bias against those who like images.

By using BrightScope’s Top Ten list, where all classes of funds were massed together, we quickly discovered a very important omission in this table – the ticker of the mutual fund.

It’s also apparent the use of benchmarks, while perhaps helpful for sophisticated investors, may be too much out-of-context information for the casual investor. We can easily imagine these investors asking, “What does it mean for different funds to have different benchmarks?” The chart does not offer an explanation. If we use just the standard index benchmarks, like the S&P 500 or EAFE, we omit how well the fund does versus its peers. On the other hand, using an index benchmark does give us a quick way to compare an actively managed fund with an index fund alternative – but only if that fund does as well as the index (which almost by definition cannot occur although Vanguard comes real close). Jeffrey M. Siegel, Vice President, United Wealth Management Group, worries that frequent changes in standard indices may skew long-term comparisons. He points out the “membership in the S&P has changed over the past few years, with car companies out and financial companies in, so they very nature of the S&P as a measuring device of risk has changed somewhat.” He’s also concerned about the ambiguity of some index labels. “For example, to say ‘Russell Midcap’ does not indicate whether it is the Russell 3000, 25000,2000, 1000 or even the Russell Midcap Index, which only holds the bottom 800 stocks of the Russell 1000,” says Siegel.

Using fund categories provided by rating agencies like Lipper might offer more information, especially when comparing funds within the same category. The risk here, of course, comes about when the rating agency mis-categorizes a fund. Morningstar, which doesn’t have a multi-cap category, is more likely to do this than Lipper, but Lipper does shift funds between categories based on its – not the fund’s – investment criteria. A couple of changes do suggest themselves. The first is to group all similar funds together. The second is to include something like the Lipper ranking (i.e., “A,” “B,” “C,” “D” or “E”) which immediately tells the reader where the fund ranks (in the case of Lipper, by quintile) among its peers.

Perhaps the best (and possibly most radical) solution to benchmarking would be to reject it altogether. After all, thirty years ago, before the ascendency of modern portfolio theory from academia to the industry, investors – both professional and individuals – focused more on the forest of total return rather than the trees of asset classes and style boxes. The traditional measurement of specific target returns would replace the panoply of benchmarks that have arisen over the last three decades. After all, it’s likely investors more intuitively understand their personal need to achieve a certain goal-oriented targeted return than try to translate the relative relevance of an arbitrary index or style box. Because this idea is possibly too radical, we’ll not include it in our revised comparison chart.

By adding the Lipper letter rankings, we discover another issue with the chart. Many of the index funds got straight A’s, yet some of the active funds with lower letter grades actually produced higher returns. In the end, it is this absolute performance which investors desire, not relative performance. This represents the best reason to compare returns in terms of goal-oriented return targets.

Here’s the breakdown of our complete series on the DOL’s new disclosure requirements:

Part I: Introduction: A Fiduciary Test Drive of New DOL Fee Chart Using Top 401k Funds
Part II: DOL’s New Performance Reporting Requirements: A Boon or a Risk to the 401k Fiduciary?
Part III: Will DOL’s New Mutual Fund Fee Disclosures Mislead 401k Investors?
Part IV: DOL’s New Disclosure Requirements Reveal Most Widely Held 401k Mutual Funds Should Worry Plan Sponsors