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Defined Contribution Insights

March 2016

The Value of Time in 401(k) Plans

“Falling prey to natural human behavioral tendencies during the manager selection and termination process generally leads to failure.”

— DiMeo Schneider
The Next Chapter in the Active versus Passive Debate (2015 Update)

While sponsors should compare their plan’s investments at least once a year with the appropriate benchmarks and peer investments and over a series of different time horizons, the key question remains: How long should those time horizons be to ensure that the resulting decisions are prudent? 

Some refer to this quandary as the “patience trade-off curve.” At one extreme of the curve, sponsors may show too much patience to investment managers who can’t outpace their indexes and peers over the long term. At the other extreme, sponsors may not show enough patience by giving too little time for proven managers to show their long-term skill. 

So the relevant question becomes: Is it prudent to judge an investment or its manager on the results of one year? Three years? Five years? Ten years? More? 

An all too common practice is to base investment decisions on results over three or fewer years, note researchers David L. Donoho, Robert A. Crenian and Matthew H. Scanlan.1 But a considerably longer period, they conclude, is justified and necessary. Does this trend toward impatience help [participant] returns? We think not.

Focusing on the Short Term “Generally Leads to Failure”

To help answer the question of how long is long enough, investment consulting firm DiMeo Schneider analyzed top-quartile mutual funds over the past 10 years.2

“In due course, great managers will almost certainly fall to the bottom half of their respective peer group over multiple three- and five-year periods. To generate strong long-term results, investors must stay invested through the lulls. No matter what path an investor takes,” DiMeo Schneider adds, “patience continues to be a prerequisite for success.”

More specifically, the study (see Exhibit 1) found that:

  • 92% of 10-year top-quartile funds were in the bottom half of their peer groups during at least one three-year period.
  • 56% of 10-year top-quartile funds were in the bottom half for at least one five-year period.

For this reason, DiMeo Schneider suggests that a rigid investment policy requiring removal of investments that underperform over three or even five years should be avoided. “Falling prey to natural human behavioral tendencies during the manager selection and termination process,” DiMeo Schneider concludes, “generally leads to failure.”

That’s because sponsors who replace short-term underperformers in plan
investment menus can, in effect, penalize plan participants by forcing them to sell low (the dropped investment) and buy high (the added investment).

Exhibit 1: Consistency and persistency of investment returns

Asset Category

Number of 10-year
top-quartile funds
Percent of 10-year top-quartile funds
below median for a three-year period
Percent of 10-year top-quartile funds
below median for a five-year period

Intermediate Bond

50

82%

36%

High yield bond

27

93

44

International Bond

10

90

50

Large cap value

55

95

67

Large cap core

74

93

62

Large cap growth

79

92

51

Mid cap value

17

94

82

Mid cap core

19

95

37

Mid cap growth

39

90

41

Small cap value

18

100

78

Small cap core

36

94

69

Small cap growth

39

90

64

International value

13

92

77

International core

29

93

41

International Growth

13

92

54

Emerging markets

15

87

53

Weighted average

92%

56%

Source: “The Next Chapter in the Active versus Passive Debate (2015 Update).”

Sponsor Investment Decisions Can Be Costly to Participants

Plan sponsors hire and fire managers for a variety of reasons, including a change in investment philosophy, plan mergers and events at the investment management firm, such as personnel turnover or regulatory actions.

A seminal and often cited study by Amit Goyal and Sunil Wahal3 focused only on investment underperformance that led to 412 hiring and firing decisions by U.S. plan sponsors between 1994 and 2003.

The researchers compared results of the dropped investments with results of the replacement investments three years before and after the decisions to fire or hire had been made.

As it turned out, sponsors typically were attracted to investments that, prior to their selection, had outperformed the incumbent investments. However, the researchers found (see Exhibit 2) that after replacement investments were added to the plan menu, they reverted to their mean and failed to deliver the positive excess returns sponsors expected.

Worse, researchers also found that plan participants lost 103 basis points of cumulative potential value (not including trading costs) in the three years after the investment changes.

Exhibit 2: Focus on the short term When plan sponsors chase returns, participants may pay the price.

Source: Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” Journal of Finance, August 2008.

Translating Numbers Into Outcomes

Not just an academic discussion

As we’ve seen, research analysts DiMeo Schneider and Goyal and Wahal drew their conclusions from an analysis of thousands of plan investment decisions. 

But does the research hold up when applied to specific investments of an experienced manager like American Funds? 

The answer is important because this discussion isn’t just an academic one. Investment selection has real-life implications. Given the reality of underfunded pension plans and the risk, for many, of running out of retirement income, it’s crucial that plan sponsors select investment managers with proven track records of consistently outpacing relevant indexes and peers. 

American Funds vs. relevant indexes

The top-selling American Funds R-share equity funds (see Exhibit 3) have outpaced their respective indexes by increasingly greater percentages over most rolling three-, five- and 10-year periods — a critical metric for long-term investors. This trend is even more dramatic when looking at results over 15 and 20 years. 

For example, as shown in Exhibit 3, since its inception EuroPacific Growth Fund (EUPAC) beat its index in 70% of rolling three-year periods, 80% of rolling five-year periods and 91% of rolling 10-year periods. Also, although not shown, the fund beat its index 100% of the time over both rolling 15- and 20-year periods.

Exhibit 3: American Funds (R-3) vs. relevant index

*Some indexes do not have histories sufficient for comparison to the lifetime of certain funds. See General Methodology section below for details.

American Funds vs. peers

And when compared to their Morningstar peer groups (see Exhibit 4), the same five American Funds show improvement over the same rolling time periods cited above. EUPAC, for example, beat funds in its Morningstar category average (US OE Foreign Large Blend) in 87% of all rolling three-year periods since its inception, 86% of rolling five-year periods and 100% of rolling 10-year periods. More remarkable, EUPAC beat its peer average over rolling 15- and 20-year results 100% of the time.

Of course, there have been periods when the American Funds have lagged their respective indexes and/or their peers. However, as Exhibits 3 and 4 demonstrate, these American Funds have consistently beaten their respective indexes and Morningstar category averages by increasing percentages over most longer time frames.

Exhibit 4: American Funds (R-3) vs. Morningstar category average

Outcomes in dollars and cents 

Let’s put these same American Funds to a more practical test: What would the outcomes have been — in dollars and cents — if a retirement plan participant had consistently invested $500 each month in each of these funds over 20 years? Exhibit 5 provides the answer. 

Looking at the data shown below, a hypothetical long-term investor in EUPAC would have accumulated $230,775 over that 20-year period. 

At the same time, EUPAC outpaced its Morningstar category average by $40,200 and its index by $39,429.

Looking at the accumulation figures for each of these funds, we believe they created meaningful value and a significant advantage in pursuit of retirement security.

Exhibit 5: 20-Year accumulation values for the American Funds, category averages and indexes

Figures shown are past results for Class R-3 shares, with all distributions reinvested, and are not predictive of results in future periods. Current and future results may be lower or higher than those shown. Share prices and returns will vary, so investors may lose money. Investing for short periods makes losses more likely. Class R shares do not require an up-front or deferred sales charge. For current information and month-end results, visit americanfundsretirement.com.


These ending values are based on a hypothetical 401(k) plan with a $500 initial investment on 12/31/95, and subsequent monthly investments of $500 through 12/31/15, totaling $120,500 invested over the period. For additional details about the data, see General Methodology section below. The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. There have been periods when the funds have lagged their relevant indexes and peer averages.

Encourage Clients to Think Beyond the Short Term

Prepare to answer these questions when meeting with plan sponsors

Whenever a plan investment lags its benchmarks, research firm DiMeo Schneider recommends that you be prepared with answers to the following questions:

  • Are the results part of an inevitable short-term lag, or have flaws been exposed in the management team or process?
  • Are the results consistent with the manager’s process, investment constraints or management style?
  • Does the manager still have a competitive advantage?
  • Has the manager gone through critical organizational changes that may be impacting results?
  • Are the conditions that delivered success in the past still intact? Or has there been a fundamental change that could reduce the effectiveness of the fund strategy?

Third-party support can add value, but due diligence demands more

Because investment decisions are so important, many advisors are turning to third parties to help plan sponsors meet their investment-related due diligence. These third parties offer investment research, and analytical and reporting services.

For example, the Retirement Plan Advisory Group has developed an Investment Scorecard, and fi360 offers a Fiduciary Score — both designed to improve investment decision-making.

Although these services initially rank investments over three- or five-year time frames, they caution advisors not to depend solely on the output.

“While the RPAG Score is based on five years of data,” says Jeffrey S. Elvander, CFA, Chief Investment Officer, Retirement Plan Advisory Group, “our process extends the review to six and sometimes even seven years. Even with this view, we encourage advisors to extend it further where applicable. A 10-year perspective can add tremendous value if the underlying management team was responsible over that same time period.”

fi360 notes that while its score is a useful tool for investment decision-makers, “it is not intended, nor should it be used, as the sole source of information for reaching an investment decision.”

Deliver more value to plan sponsors and improve participant outcomes

In spite of abundant evidence to the contrary, many sponsors — especially those with small- to mid-size plans — continue to base plan investment decisions on short-term data.

Helping them recognize the value of considering longer time frames — rolling 10- or, at least, 5-year periods — may not be an easy conversation to have, but it’s well worth the effort when you look at the far-reaching implications it can have on participant outcomes.

Clearly, this provides you with a great opportunity to differentiate yourself as a trusted retirement plan advisor who brings an important perspective to the plan.

Even more important, you’ll be assisting sponsors in fulfilling their plan’s objective of helping their employees pursue their retirement savings goals.

General Methodology

The five equity-focused American Funds cited in this analysis and the relevant index/index blend and Morningstar category, with which they were compared, are as follows: EuroPacific Growth Fund (MSCI All Country World Index (ACWI) ex USA, Morningstar US OE (Open End) Foreign Large Growth Average), The Growth Fund of America (Standard & Poor’s 500 Composite Index, Morningstar US OE Large Growth Average), Fundamental Investors (Standard & Poor’s 500 Composite Index, Morningstar US OE Large Blend Average), Capital World Growth and Income Fund (MSCI All Country World Index (ACWI), Morningstar US OE World Stock Average) and New Perspective Fund (MSCI All Country World Index (ACWI), Morningstar US OE World Stock Average). All relevant indexes listed are the funds’ primary benchmarks. Some of the aforementioned indexes do not have sufficient history to have covered the lifetime of certain funds. These funds, indexes and periods are as follows. For EuroPacific Growth Fund, the MSCI EAFE was used for the period from April 30, 1984 (month-end following the fund’s inception on April 16, 1984), through December 31, 1987. For New Perspective Fund, the MSCI World was used for the period from March 31, 1973 (month-end following the fund’s inception on March 13, 1973), through December 31, 1987.

MSCI Indexes reflect dividends net of withholding taxes, except in the case of MSCI All Country World Index and MSCI All Country World Index ex USA, which reflect dividends gross of withholding taxes through December 31, 2000, and dividends net of withholding taxes thereafter.

Due to the dynamic nature of the Morningstar database, results for the peer groupings may change. Morningstar averages consist of all share classes of funds within each peer group. The American Funds and index returns were calculated internally. The ending dollar amounts of all hypothetical investments are calculated internally based on monthly returns.

1“Is Patience a Virtue? The Unsentimental Case for the Long View in Evaluating Returns,” The Journal of Portfolio Management, Fall 2010.

2“The Next Chapter in the Active versus Passive Debate (2015 Update).”

3Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” Journal of Finance, August 2008.


View fund expense ratios and returns. 

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses or the collective investment trust's Characteristics statement, which can be obtained from a financial professional, Capital or your relationship manager, and should be read carefully before investing. 

Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries. Small-company stocks entail additional risks, and they can fluctuate in price more than larger company stocks. 

There may have been periods when the fund has lagged the index or indexes. Certain market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. 

Investment results assume all distributions are reinvested and reflect applicable fees and expenses. 

Expense ratios are as of each fund's prospectus. 

The Capital Group companies manage equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.

Past results are not predictive of results in future periods.