Measure performance of 401(k) funds against benchmarks

Question I established a 401(k) plan for my medical practice a few years ago. The mutual funds that I selected to be included in the plan seemed to be good funds at the time; however, how do I know that still holds true today?

Answer: Given the volatility in the markets over the last few years, it can be challenging to assess the performance of any stock-based mutual fund investment. For example, even with the recent market rally, as of Dec. 31, 2003, the Standard & Poor's 500 Index produced a 4.05% annualized loss for the last three years. The technology-heavy Nasdaq Composite produced a 6.75% annualized loss for the same time period.

Therefore, when evaluating mutual fund investments, it is important to focus on relative performance. Ask yourself, how has the fund held up relative to an appropriate benchmark and other, similar funds?

Employers can monitor the plan's investments alone or with the assistance of an investment consultant. If you are planning on monitoring the investments yourself, here are some data points that warrant your review and assessment:

• Look at the investment performance of each fund as it relates to an appropriate benchmark on at least a 1-, 3- and 5-year basis. For example, if the mutual fund was selected as a large-cap core fund, then its performance should be reviewed against the Standard & Poor's 500 index or the Russell 1000 index.
• Compare the investment performance of each fund to its peers. Morningstar, which provides mutual fund analysis, categorizes mutual funds into different asset classes. Therefore, if a fund is considered to be a small-cap value fund, then its performance should be reviewed against other funds in its category. A good rule of thumb is to have funds in the top 33% of all funds on a 3- and 5-year basis. If rankings drop dramatically on a 1-year basis, the fund should be flagged for review but not necessarily removed. A greater emphasis should be placed on longer-term performance rather than shorter-term performance.
• Monitor expense ratios. In general, the expense ratio of the fund should be equal to or less than the category average. Category averages can be found on Morningstar's Web site (link).
• Check risk or standard deviation, a measure of volatility. It should be similar to that of an appropriate benchmark and/or the category average.

It is important to review these statistics on a periodic basis, but no less than annually. Also, consider developing criteria for removing a fund from your plan.

One example: Fund performance ranks in the bottom 50% of funds relative to peer rankings on a 3- and/or 5-year basis. Another example: Fund consistently underperforms appropriate benchmark for six out of the last eight quarters. Further, to better serve the participants in the plan, consider replacing funds that underperform rather than simply adding more choices to the plan investment lineup.

As a plan sponsor and fiduciary of the 401(k) plan, you play a critical role in the success of your defined contribution plan. Being proactive in your approach to monitoring the investments in the plan will ensure you are fulfilling your fiduciary duties as well as aid in developing a high-quality plan to assist your employees in achieving future financial independence.

To all those who responded, I appreciate the effort you took to express your views to me. This open exchange of ideas is an important part of what makes America so great.