Defined Benefit Investment Returns Outperform 401(k) Plans

Watson Wyatt Insider is reporting (hat tip: planadviser.com):

"most recent comparison finds that between 1995 and 2006, DB plans outperformed DC plans by an average of 1 percent per year. Earlier studies also found that, over time, DB plans attained higher returns than did 401(k) plans."

This may be an unsurprising outcome to most readers, since Defined Benefit plan investments are typically professionally managed and therefore, presumably, because of higher level of investment knowledge applied in their management, produce better returns than participant-directed 401(k) accounts (the thesis being that the average participant is not a professional investor). As the conclusion of the study notes:

"Trustees for DB plans have a fiduciary responsibility for investment performance. They or the professionals they hire also usually have considerable financial education, experience, discipline and access to sophisticated investment tools — advantages not typically shared by individual participants in 401(k) plans. These advantages help DB plan investors maximize their returns and maintain well-diversified portfolios, so they can generally ride out market fluctuations more smoothly than 401(k) plan participants. Time will tell whether 401(k) participants will learn to manage their new investment responsibilities more effectively to ensure adequate retirement income in the future."

What does surprise me however, is that better (professional) investment management of DB's produced a "nominal" excess of around 1% per year. I would expect that the excess of returns over that of a participant-directed ("dart-throwing") investment method in a 401(k) plan would be more than a nominal excess return of 1%. The article makes an attempt to address this issue:

"Size Matters"

"Between 1995 and 2006, returns in large 401(k) and DB plans were higher than those in small plans. Large DB plans outperformed small ones by an average of 3 percentage points. Large 401(k) plans outperformed smaller ones by an average of 74 basis points. Size seems to have less effect on 401(k) returns, perhaps because small DB plans cannot hire as much expertise as bigger plans, while both large and small 401(k) plans often offer essentially the same funds to participants."

Here's the chart of returns on the "largest 1/6th of plans" based on the data in the report:

At the risk of sounding biased towards 401(k) plans (which I am not), I would call this "good news" for most 401(k) investors in the largest of plans. My guess is that they have the benefit of better investment education of participants by the plan servicers afforded to plans of significant size.

Note that the three year moving average (black line on the chart) of the per year return differences has become more steady since about 2003. Although more quantitative research would be required to conclusively prove this, but my educated guess once again (hey, it's my blog, ain't it?) is that the introduction of diversified risk-based single funds such as the so-called "lifestyle funds," "managed accounts," and "model portfolios," have had some effect on narrowing the disparity of returns.

I would go one step ahead and call this a "democratization trend" of professional investment management - a good development in our industry. Furthermore, as the trend to introduce new financial products in order to bring more professional oversight to 401(k) plans continues, I look forward to an update of this research sometime say in 2009-2010 time-frame with data through 2008, when target-date funds started to become mainstays in 401(k) fund line ups. Once again, Wyatt notes this in the conclusion:

"Plan sponsors and regulators have implemented devices and strategies to help offset the knowledge gap between institutional and individual investors, such as the recent regulation that defines default investments for participant-directed plans. In the absence of investment direction from a 401(k) plan participant, the regulation allows the fiduciary to invest the participant’s assets in a qualified default investment alternative, which must be a life-cycle/target date fund, a balanced fund or a professionally managed account. These default investments may help mitigate the risk many 401(k) employees incur by failing to rebalance their assets over time. While these results do not reflect the effects of the new “autopilot” investment options, future analyses will investigate whether these widespread design changes will help close the gap in returns."

Let's turn our attention now to the "largest one half" of all plans covered by the data in the Wyatt study. The chart looks like this:

This picture looks about the same as that of the largest 1/6th of plans, except the disparity in returns as evidenced by the (black) 3-year moving average trendline appears to be close to zero in recent years.

Finally, a bit of a surprise on the smallest 1/6th of plans:

In the small plan arena, 401(k)'s actually outperformed DB's! I invite the readers to share their thoughts (via comments) on why this inversion occurs in this arena. Some relevant thoughts offered in the Wyatt article refer to expenses, and their impact on reported returns. The basic premise here being that DB plans report their asset values on the Form 5500 net of expenses, presumably including Schedule B preparation. The conjecture here being that this may possibly have a larger impact on the net return of smaller DB plans than those of larger DBs.

I invite the readers to view the data tables on the original Wyatt article to see for themselves that net 401(k) returns in the three plan size segments included in the study are pretty consistent, i.e., size appears to be less of a factor in the disparity of 401(k) returns. The DB returns by themselves show more of a pronounced disparity in comparing the three segments.

The article also looks at plan-weighted median rates of return and finds that the average spread between the median returns narrows to "only" 30 basis points! On the other hand, Wyatt points out in the study that although the spread on the average is narrower, on a year-to-year basis, there is a wider disparity (greater standard deviation) of returns in 401(k) plans:

"This is not surprising — 401(k) plans have millions of participants with varying financial skills choosing different mixes of investments, while DB plans have more consistent investment styles and performance. Moreover, many 401(k) participants choose asset allocation strategies at the extremes — all equities or all money market funds — and tend to be market-trend followers.6 There should be less volatility in the distribution of returns for DB plans."

Percentage of Equity May Affect Returns:

The study addresses this very important issue:

"In comparing asset-weighted medians, DB plans consistently outperformed 401(k) plans during the 2003-2006 bull market. But during the earlier 1995-1999 bull market, 401(k) plans outperformed DB plans. This reversal could be due to differences in equity allocations."

More astute observations on this issue from this article:

"from 1995 through 1999, 401(k) plan participants had a higher and growing allocation to equity in their asset portfolios compared with DB plan participants, so they reaped the rewards of high returns when the market was up. But the difference in returns was less pronounced than one would expect, which might be because DB plan fund managers maximize equity returns through greater diversification or more sophisticated investment techniques.

This advantage to professional investing was particularly evident during the bear market (2000-2002). DB plans had similar or higher allocations to equities, yet they outperformed 401(k) plans during this period. Many 401(k) plan participants seem to have bought high and sold low in the stock market. Some also might have been heavily invested in company stock, and, when the bubble burst at the beginning of this decade, their returns on this form of equity investment were poor."

This is a great study and hopefully one that Watson Wyatt will continue to update over the next few years as new Form 5500 data becomes available.