ERISA Fiduciary Guidance - Making a "Watch List" Work

By: Daniel R. Sharpe

Submitted by Firm:
Bond, Schoeneck & King, PLLC
Firm Contacts:
Louis P. DiLorenzo, Thomas G. Eron
Article Type:
Legal Update

For most professionals who sit on 401(k) or 403(b) plan administrative or investment committees, there is a fair amount of routine. The committee probably adopted an investment policy that dates back to the time the plan’s current outside recordkeeper and investment consultants were engaged or maybe earlier than that.

The investment policy need not be revised frequently because it ought to stand up as a long-term policy, guiding the committee in its choice of investment alternatives for participants and as a basis for making changes in those alternatives. The policy likely has a benchmark for measuring performance of each investment fund against an appropriate outside standard such as the S&P 500 or a bond index. Typically, the policy also provides for a "watch list." An investment alternative is put on a "watch list" when the investment committee determines that a closer review of the alternative is necessary, based on criteria such as "style drift," e.g., a small-cap value fund has invested in mid- or large-cap stocks or in "growth" stocks rather than "value" stocks, a change in managers, negative news about the investment or its management, or because the investment has underperformed its peers or the benchmark over some period of time.

When committees are first organized, meetings might be scheduled quarterly. This is because Wall Street and the financial industry are run on a quarterly time-clock. Most service providers and financial consultants are ready and able to produce quarterly investment reports, with fund performance tracked on calendar quarters.

Investment policies properly state that plan investments are to be viewed on a long-term basis, and careful consultants will mention market "cycles" as a reasonable basis for assessing performance. Some investment managers describe their investment style as being one that does better in down markets or in up markets, and to the extent this is true, it is important to review performance over both a down and up period to assess the value of retaining such a manager.

Despite the stated interest in long-term performance, most quarterly reports begin their narratives and comparisons by looking at performance over the last calendar quarter. It is only human nature to focus on how an investment has done recently. Most plan investments are valued daily, and participants can track their accounts, and make investment changes, on a daily basis. Performance figures for the last quarter, therefore, might be viewed as old news and thus somewhat of a long-term view when put in the context of daily values and activity. Comprehensive quarterly investment reports, however, typically include three-year, five-year, and sometimes ten-year performance data.

While some attention is paid to changes in fund management, for example, it is almost always investment performance that is the reason for placing a fund on a "watch list." Some investment policies require that a fund be placed on a watch list if performance is below a stated standard for three out of the last five quarters or on some other similar basis. The changing of a fund’s principal management team may be noted in a report, but if the recent performance remains at or above the benchmark, there usually will be little or no reason to make a change. Once a fund is placed on a watch list, and despite the long-term outlook of the investment policy, short-term fund performance is put in the spotlight.

The nature of the watch list process has the tendency to tempt a committee and its advisors to do the very thing that investors are warned to avoid: selling low and buying high. As the watch list tracks investment performance, three, four, five, or six quarters of underperformance might almost create an imperative to remove a fund from the investment lineup and replace it with another fund that has outperformed the watch list fund over the same period. This makes it likely that the committee decision is to eliminate a fund at a relative low point and add another fund at a relative high point. Most committees are cognizant of this problem and, therefore, are careful not to act precipitously. Five or six quarters of underperformance can seem overwhelming, however, even if the fund’s five-year record is relatively good. A committee may be concerned about its failure to act after a fund has been on a watch list for multiple quarters, and the alternative investment choices presented by a consultant often look attractive and prudent. The committee acts, and the change is made.

It could be that the committee decision is the right one. As long as the newly added investment choice looks reasonable over the coming quarters, there is little reason to second guess the move. For the most part, plan committees, with guidance from their consultants and advisors, are choosing reputable investment funds with well-publicized public records.

The proposal of this article comes at this point. Generally, the performance and fiduciary review for the quarters following an investment fund change will substitute the new fund in the lineup. Its performance will be tracked against the benchmark for the last quarter (and for three-year and five-year trailing periods), and the new fund will be ranked against peers in its investment category. The old replaced fund is largely forgotten.

What is not typically done, and what is proposed here, is that the committee continue to include its former eliminated investment funds in the quarterly reviews. By tracking these comparisons with replaced funds, the committee will build a history of its decision-making and the effects of the investment changes. This ongoing tracking of a replaced fund should continue over a "market cycle" which is often articulated as the proper measurement period for performance under the plan’s policy. This history can be the one thing that brings to the committee a genuine accounting of its decision-making. This accounting has the potential of improving future decision-making by creating an objective report on the effect of these decisions. The report may confirm the prudence of some decisions and highlight the errors made on other decisions. Having this historical data will provide insight into the weight given to the various elements intended for inclusion in the watch list decisions. Ideally, a committee that learns from the history of its decisions will be better able to sell high, buy low, and improve the retirement accounts of all participants.