| Lummer's Logic |
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| Mom! Johnny Took My Favorite Fund and He Won't Give it Back!
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By Scott Lummer
Chief Investment Officer, mPower |
July 31, 2001
I decided to go with a ridiculous
title to protest the fact that my editors demanded that I produce a fresh article during
the summer. I thought everyone in California who had a creative job took the summer off.
Television series are in reruns. Movies are borrowing themes from the past — either
explicitly ("Jurassic Park III") or implicitly (tell me with a straight face
that you can differentiate between the plot lines of "Clueless" and
"Legally Blonde"). Even government officials here are coming up with the same
excuses for the energy problems that they used before. So why do I have to write a new
article?
OK, that's not the real reason for the
title. Actually, I came up with it after listening to the interaction between my two
wonderful children, who have spent too many days together with no school to keep them
occupied. Also, the title does convey the frustration of the reader asking this week's
question:
My company is eliminating two funds
and adding three new ones. Unless I move the money out myself, my account in the
eliminated funds will be automatically mapped to the new funds. Is this fair? Will I lose
money? Why is the company really doing this? They say that the funds being eliminated have
underperformed their peer funds and the benchmarks, and the new funds are better. Can they
just replace funds like this?
Most participants who write me about
the choice of funds in their plan have a different complaint — they want the company
to replace one or more of their funds with other ones. So, while this reader is
questioning the logic of the change, there are probably other participants in the plan who
are thankful for the decision.
Yes, Switching is Allowed
First of all, yes, the company can
replace existing funds with new ones. In fact, if members of the 401(k) committee feel the
existing funds are inappropriate for the goals of the plan, the company MUST get rid of
them. If they do so, it makes sense that they would replace the funds with similar types
of investments. However, in most cases where funds are changed, the 401(k) committee
doesn't necessarily feel an existing fund is inappropriate; it simply feels there are
better funds available.
If done for the right reasons, the
replacement of funds is "fair." (The word evokes thoughts once again about my
home life — the most common phrase in the Lummer household this summer is "it's
not fair.") Almost certainly, the company is trying to act in the overall best
interests of the participants. It is understandable to have anxiety about the company
changing the nature of the plan, but realize that your company has nothing to gain by
switching funds unless it is in your best interest. Businesses have 401(k) plans solely as
a benefit for their employees and they don't profit in any way from plan transactions.
Five Reasons to Change
There are five potentially valid
reasons for a company to replace a fund with another one.
Poor performance. This
can be a justifiable reason for replacing a fund, depending on the reasons for the
unsatisfactory performance, the magnitude of the performance difference, and the length of
time that the fund has been performing poorly. My feeling is that many plan participants
tend to be a bit trigger-happy — screaming for the 401(k) committee to replace a fund
at the first sign of less-than-favorable performance. If a fund was originally included in
a plan because of a thorough study of its good performance, and the fund manager has good
control of the risks that the fund is taking, then you should not be overly concerned if
the past 12 months of performance have been slightly below the fund's peer group average
or benchmark. However, if the poor performance persists for two to three years then the
plan should consider replacing the fund. It's important to remember that the main reason
to include actively managed funds instead of only index funds is the belief that an
actively managed fund will outperform the index. If the fund cannot demonstrate that it is
able to outperform its benchmark, there is no reason to have it in the plan.
Fees. The mutual fund
business is very competitive, particularly for larger companies' 401(k) plans. Often a
mutual fund will offer itself for inclusion in a fund lineup at a substantially reduced
management fee compared to the existing investment options. If the other aspects of the
new fund alternative are appropriate (good performance, solid risk controls, consistent
objectives) then the 401(k) committee would be remiss in not considering replacing an
existing fund with the lower-fee fund. Keep in mind that the lower fees benefit the plan
participant in the form of higher after-fee returns.
Diversification.
Surprisingly, many 401(k) plans do not currently have broad enough diversification among
their fund choices. Too many plans picked funds in the late 1990s mainly on the basis of
recent performance. As a result, these plans may offer almost exclusively large-company
growth stock funds. There may be no value-oriented funds, small-company funds, or
international funds, all of which are important in order for plan participants to
accomplish broad diversification. Now, plans may wisely choose to eliminate some of the
redundant growth funds in order to provide some alternatives.
Inconsistency. When a
fund is put in a 401(k) plan, it should be done to fulfill a specific goal such as
offering a large-company value stock fund or an international fund. However, sometimes a
fund behaves quite differently than how its marketing people describe it. I have company
clients who had a value fund in their plan that ending up holding more technology stocks
than most growth funds usually hold. Because the plan lineup already included a pure
growth fund, they decided to replace the fund with a more consistent value-oriented fund.
These types of changes are important to provide investors the possibility of adequate
diversification.
Imprudence.
Infrequently, something occurs within a mutual fund that would make its inclusion in a
401(k) plan imprudent. For example, two years ago we had a company client whose plan
contained an aggressive small-company stock fund that was performing well. One of our
analysts received a call from the fund's manager informing us that he and his entire staff
were leaving the fund to start their own investment management company. The investment
entity that was in control of the fund had no suitable replacements for the personnel.
When I informed our client of the situation, it wisely decided to replace the fund with
another aggressive small-company fund.
So, while the reader who asked the
question is understandably suspicious, it is likely that her employer's intentions are
honorable. If I could only solve my children's disputes so easily.
 Lummer's Logic Archives
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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