It is well-accepted that plan sponsors—usually through their committees—must, in their role as investment fiduciaries, prudently select and monitor 401(k) investments and, if necessary, remove and replace inferior investments. This article is about the process for monitoring.

There are three time frames involved in monitoring investments: the past, the present, and the future. Of those three, the future is the most important. That is because the objective of monitoring is to determine whether an investment is likely to perform reasonably well in the future as compared with similar investments, i.e., its peer group. The roles of the past and the present are to help make decisions about the future.

For our purposes, the past and the present are quantitative and qualitative analyses. Fiduciaries should examine past data, or quantitative information, to help make the decisions about the future. Correspondingly, fiduciaries should evaluate the present, or qualitative information, to make decisions about anticipated future performance. These concepts have found their way into the law through court decisions and DoL guidance. Those authorities have taken the position that ERISA’s investment principles are based on prevailing investment industry practices and generally accepted investment theories, which include the use of quantitative and qualitative criteria to select and monitor mutual funds and similar vehicles.

The past—or quantitative analysis—includes looking at performance for the preceding periods (such as three and five years) and comparing that with index and peer group performance; comparing an investment’s expense ratio with the expenses of its peer group; and comparing volatility and other common quantitative (or numerical) criteria with those of the appropriate peer group. As a starting point for the analysis, fiduciaries ordinarily would want to see performance that is superior to the average, expenses that are below the average, and volatility that is below average, but those are just the starting points. For example, ordinarily the preference is that expenses be more than just marginally below average. On the other hand, where it can be justified, expenses that are above average may be appropriate; however, there should be a specific justification for the higher expense that is considered and approved by the committee (and documented in the committee minutes).

Benchmarking is a fundamental part of the monitoring process. For example, for the quantitative analysis, the committee should determine the appropriate benchmarks (e.g., peer group and indexes), compare the plan’s investments with those benchmarks, and understand and evaluate any variances.

In terms of present—or qualitative—measures, committees should examine factors such as current investment style, manager turnover, staff and analyst turnover, accusations and/or proof of wrongdoing, disruptive change in the investment management organization, and so on. In other words, the qualitative factors that could affect future performance should be identified, investigated, and evaluated.

It is only after the fiduciaries have examined and benchmarked the quantitative measures, and evaluated the appropriate qualitative factors about the present condition of the manager, that the committee is properly positioned to make its assessment of the future of the investment.

The moral of this story is threefold:

  • The purpose of monitoring is to make an informed decision about future performance. Past data and current information are tools for that process.
  • It is not enough just to look at past performance. Going forward, committee members must understand how the past performance was earned and evaluate the qualitative issues. In fact, the qualitative measures may be more important than the quantitative criteria.
  • As the 401(k) marketplace matures, the expectations of fiduciary performance are increasing.