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How Investment Theory Explains 401k Plan Sponsors’ Evolving Fiduciary Duties

September 17
00:50 2013

The advent of the 401k hit the mid-1980’s with all the lusty allure of self-determination. No longer did we face the life-long indentured servitude required to qualify for pension payments. We could now fund our own retirement. If 352856_9171_feto-evolution_stock_xchng_royalty_free_300we maintained our discipline, we even had the chance to avoid relying on the tenuous promise of Social Security. We didn’t need big brother – whether in the form of the paternal corporation or the maternal government. We finally had the chance to live the words of Thomas Jefferson and, as individuals, declare our independence from, well, just about everything?

What happened? More importantly, how could 401k plan sponsors allow it to happen?

The original notion of the 401k plan oozed with comfortable easiness. First, it was exciting, the same kind of excitement we felt the first time we went to the circus. And, like that circus, all the action occurred in three easy-to-see, easy-to-understand rings. The 401k was easy because it relied on the generations-old concept of the traditional investment goals – growth, income and safety. Indeed, the government required plan sponsors to offer three “materially distinct” investment options.

What’s more “materially distinct” than stocks (growth), bonds (income) and cash (safety)? Everything lined up perfectly. We had decades of experience managing our personally portfolio in terms of these three investment goals. We could, in an almost second nature way, map our investment philosophy directly on to our 401k investment options. We got our valuations once a year at the end of the year. We didn’t have to think about changing our allocations because: 1) We were told we didn’t have to; and, 2) Even if we wanted to, we could only do it at most once a quarter. Life was simple. Life was easy. Life was good.

Readers might also be interested in: 401k Plan Sponsors: Is Your Investment Policy Statement Still Using Outdated Language?

Then the world changed. It didn’t change overnight. It took about five years. Where once individually managed portfolios dominated 401k investment options, the mutual fund industry soon convinced the world “daily valuation” was a critical feature. This wasn’t too off the track. After all, at that time, mutual funds had to declare themselves as having investment objectives such as “Growth,” “Income” and, well, you get the picture. (N.B.: It is little known but an artifact of that era remains to this day as mutual funds still must report their “objective” in their semi-annual filings.) Eventually, this led to allowing 401k investors to change their investments on a daily basis. Soon, we could track our retirement assets every day.

And then Modern Portfolio Theory became ascendant. What once started as merely a mathematical convenience, (i.e., not something practical enough to use in the real world), left the ivy-covered towers and spread like a virus through all those textbooks upon which MBAs and CFAs rely upon. It was only a matter of time before someone (in this case Morningstar) segregated the investment world into a nine (or is it twelve) component “style box.”

Mutual fund families quickly adapted to this strange new world and we saw them ignoring their “Growth,” “Income” etc… objectives and lauded their position within the style box (i.e., “large cap value,” “small cap growth,” etc…). Just as quickly, 401k option menus exploded from the simple three to the complex multitudes. Some plans had nearly 100 funds.

Plan sponsors found their fiduciary mandate questioned. In the quest to give employees more control, they gave employees almost all control (e.g., in the case of self-directed options). Employees, for their part, now had the option of seeing their valuations updated every day. They had the opportunity to change (i.e., trade) their retirement plan every day. Moreover, they had this Modern Portfolio Theory which virtually demanded they do so. Life suddenly grew more complicated, more difficult and quite brutish. For many, it was easier to not play the game rather than learn all the new rules.

For more information, read: Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio

For years we sat in this soup of alphabet classes with dozens of mutual funds dancing the style box tango. The convoluted nature of selecting investment options exposed 401k plan sponsors to the dark side of the financial services industry. In the damp underbelly of confusion, where it’s often hard to tell the different between a fiduciary and a broker, conflicts-of-interest ran rampant. Plan sponsors bought merely “suitable” investments for their plans rather than investments that focused on the “best interests” of the plans and their beneficiaries.

At the same time, just as 401k plans began the migration towards the style boxes of Modern Portfolio Theory, behavioral economists emerged from the background. Soon to dominate the academic arena, these tiny studies exposed the practical limits of tidy stochastics of Modern Portfolio Theory. Having been burned once by academic gurus, plan sponsors moved more hesitantly this time.

But the compelling argument made by the behavioral economists could not be ignored. Eventually, its common sense appeal won out, as more and more studies showed how at least giving the appearance of reduced choices can encourage employees to get back in the game of saving for their retirement. With each day, we see an increase in the number of 401k plans ousting the style box approach and replacing it with the category style option menu. This and other strategic insights from behavioral economics will no doubt help employees have a better chance to retire in comfort. In the end, isn’t this ultimately the aim of the fiduciary duties of the 401k plan sponsor: To make life simple. To make life easy. To make life good.

Looking for more on this? Read: Adding Categories: A Sample of a New and Improved 401k Investment Option Menu

Understanding the dominant investment theory of the era helps explain the fiduciary motivations of 401k plan sponsors. It is both instructive and ominous to see how plan sponsors respond. In the early era, sponsors set up their 401k plans to mimic traditional investment goals. Yet, they quickly abandoned those tried and true methods when inundated by the marketing literature of an industry that saw an opportunity to expand revenues at a phenomenal rate. During the current mature phase of 401k plans, we see plan sponsors moving much slower. Why the snail-like pace when it’s been academically proven the category-based approach provides better outcomes for plan beneficiaries than the style box approach? The best reason might be to look again at the impetus behind the move from the three-ring circus of the initial 401k plans to the style box era. Like the early days, the category-based approach uses fewer funds. This may not be aligned with the interests of the financial services industry.

That’s something 401k plan sponsors must consider.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. Dale F. Smith
    Dale F. Smith September 17, 16:42

    Chris: I’m extremely impressed with the perspectives and historical recap you’ve enunciated in this timely article. As usual, I’m envious of your draftsmanship. Your theme is perhaps commonplace to many of the experts in our field, but it’s novel to me: evolutionary investment theory is producing a correlative structural change in fiduciary duties. But I’m not optimistic of the direction we’re heading. There are so many heavyweights in our industry, and there are correspondingly many differing directions they can enforce/espouse. We need leadership to fill the existing void, so that all practitioners are headed in the same direction.

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author September 17, 17:04

    Thanks, Dale, for those kind words. And take heart, the many voices you hear is the normal background noise that’s always required during the invention of something totally new. And what is “evolution” if not the constant invention of something new.

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