Washington - 401(k) plan participants appear to be better at asset allocation and money manager selection than professionals overseeing defined benefit plans - at least in a bull market.
401(k) plans, most of which are participant-directed, outperformed defined benefit plans, most of which are directed by financial executives, during the stock markets' Fat City days between 1995 to 1998, according to a new study by Watson Wyatt Worldwide, Washington. The study, based on Form 5500 data, compared an average of 3,118 companies that have both defined benefit and defined contribution plans.
In 1997, 401(k) plans earned a median return of 17.32%, compared with 16.47% for defined benefit plans. In 1998, the median return for 401(k) plans was 14.27% vs. 12.31% for defined benefit plans.
The higher returns could have been the result of better education of participants or the 20%-plus returns of the Standard & Poor's 500 during those years. This caused participants to shift at least their future contributions into equities, the study said.
Hunch but no proof
Sylvester Schieber, director of Watson Wyatt's research and information center, thinks rebalancing could account for the results. "I've got a hunch but I don't have proof," Mr. Schieber said. "The professionally managed (defined benefit) funds will be rebalancing to pursue already-laid out investment strategies and they rebalanced (to reduce the overexposure to equities) as the markets were taking off.
"In 401(k)s you have herd thinking going on," Mr. Schieber said. "(Participants) probably did not rebalance, and so their relative holdings gained against defined benefit plans."
In addition, the difference in returns could result from the differing investment behavior of defined contribution participants and professional managers, Mr. Schieber said. "I believe, that behavior on the part of individuals is different than the behavior of professional managers. When the markets get dynamic, you see things turn around," he said.
The study indicated how 401(k) plans outearned defined benefit plans in 1997 and 1998. In years when overall investment returns were relatively low, rates of return for 401(k) plans approached those of defined benefit plans, the study said. For example, defined benefit plans returned a median of 5.7% in 1990, and defined contribution plans did slightly better, earning 5.8%. Median defined benefit plan returns also lagged 401(k) returns by 0.2% in 1993 and -1.6% in 1994.
And size counts. Larger plans - both defined benefit and 401(k) plans - earned higher rates of return than smaller plans. Companies with defined benefit assets of $53 million or more earned higher rates of return than did smaller plans. From 1995 through 1998, the largest one-sixth of defined benefit plans had an average median return of 17.46%, while the average median return for the largest one-sixth of 401(k) plans was 16.08%.
During the same time period, the smallest one-sixth of defined benefit plans returned an average median of 12.09%; 401(k) plans returned an average median of 14.81%.
Big is beneficial
Size has a more powerful effect on defined benefit plans than on 401(k) plans because larger defined benefit plans can hire more investment experts. Participants in 401(k) plans, however, choose their investments regardless of the overall plan size, the study surmised.
The study also found that 401(k) plan returns were higher at companies that offered both a DB and a DC plan. "This suggests that employees with both types of plans tend to invest their 401(k) plans more aggressively, knowing they can fall back on their defined benefit plan," the study concluded.