Wednesday, February 24, 2010

Overcoming Fiduciary Fear

There are two kinds of fears that 401(k) plan fiduciaries must overcome in order to effectively manage a prudent investment process .… the fear of doing something and the fear of doing nothing.

Specifically with regard to investment maintenance, fiduciaries often demonstrate a strong reluctance to swap out underperforming investments in an investment lineup. This behavior suggests they feel the risk implicit in changing a plan investment is far higher than maintaining an underperforming investment. Inertia makes maintaining the status quo seems like the risk-less option. Some fiduciaries are simply uncomfortable making decisions on behalf of others.

A countervailing fear, the fear of inaction, is characterized by a compulsion to act immediately when an investment falls below some established performance benchmarks. A mechanistic approach to policy adherence seems procedurally correct to plan fiduciaries, yet taking action too promptly can sometimes generate unnecessary portfolio turnover and detrimentally impact participant portfolios similar to a “buy high, sell low” strategy.

To manage the first fear, plan fiduciaries need to embrace the idea that a good investment portfolio is not static. Changes are inevitable and are required. Fiduciaries need to establish a pattern of investment turnover in order to fulfill their fiduciary responsibilities. The degree and extent of change will vary based on the level and sophistication of plan benchmarking as well as the bias employed in the investment selection process. The closer a plan gets to adopting timeless, consistently executed, and well diversified investment strategies with compatible benchmarks, the less frequently changes will be necessary. The more performance oriented the selection process, the more emphasis put on heroic investment alpha rather than the value of compound investment returns, the more frequently changes will be required. One of the most important skills that differentiate a good portfolio manager and a good fiduciary is the knowledge and ability to “pull the trigger” on meaningful and justified investment changes.

As we saw recently, an excessively mechanistic and pedantic approach to performance based investment changes can backfire on plan fiduciaries who execute their investment policies to the letter. Many good investments underperformed so substantially in 2008 that their longer term performance fell below peers and benchmarks. Strict adherence to standard 3 and 5 year oriented investment policy performance guidelines might have required these investment managers be cut loose…..only to see them outperform by a similarly wide margin in 2009 as the market rebounded. While following investment policy performance standards is a primary rule of prudence, even the best standards won’t always apply to every investment or situation. Prudent judgment is also required. Good investing requires patience, a bit of contrarian sentiment and an acknowledgement that specific facts and circumstances might invalidate general policy rules. Acting in the best interests of participants means making guality decisions not merely following guidelines.

Fiduciaries are required to make investment decisions in the face uncertainty. Avoiding decisions can harm participants and create liability. So can acting without the appropriate deference to current facts and circumstances. Fiduciaries should approach investment decision making with some reluctance…a reluctance borne of patience and careful judgment not one born of fear and lack of information.

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