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The folks responsible for picking the mutual funds for your 401k are apparently making the same dumb mistakes that average investors make -- they're chasing hot funds, too.

And this could be a big problem, according to a new report from the Center for Retirement Research at Boston College.

Two important decisions have to be made with 401k plans:

● Administrators have to review and select which mutual funds to offer employees.

● Workers then have to pick from that list which funds to invest in for retirement.

The researchers discovered that employers select mutual funds that perform better than comparable, randomly selected funds, but worse than passive index funds. They also found that participants don't add any value through their own decisions.

In other words, plan administrators aren't doing a very good of selecting funds, and that's not helping workers, who are already prone to making poor investment choices and decisions.

What's more, when replacing funds inside a 401k, plan administrators tend to do the very same thing that plan participants do: They chase hot funds.

Now lest you think that plan administrators are no better than monkeys throwing darts at a wall of mutual fund ticker symbols, the researchers did note that plan administrators are selecting funds that are better performers than a random set of funds.

And that's largely because the funds they select have lower fees than the random set. "Lower fees, by definition, improve returns by leaving more money in the investor's account," the researchers wrote.

Still, plan administrators could do a better job of helping their workers save for retirement by picking better funds. In fact, the researchers suggested that plan administrators ought to consider selecting passive funds rather than active options for their 401k plan, and that by doing so the overall performance of the funds in their plans would be improved.

What do the experts say in response to CRR's research? What might plan administrators and plan participants do or not do because of the findings?

Lobby for passive funds

Since the study clearly concludes that "lower investment fees are a large part of the explanation for the superior performance of the employer selections," Rick Meigs, the president of 401khelpcenter.com, said, employees should be lobbying their employees for a selection of low-cost index funds.

"Not only will the employee obtain lower-cost funds, but they eliminate the mistake of chasing rates of return, which often happens with a selection of actively managed funds," Meigs said. "If the plan already has passive options, employees should use them."

And if the employer won't add passive funds, Meigs said, employees should then choose a balanced or target-date fund where asset allocation is being performed for them by the active manager. "This reduces the propensity of employees to chase returns," he said.

Don't chase hot funds

Others say that 401k participants should develop diversified portfolios using different asset classes that fit their risk tolerance. "Done correctly, your portfolio will need little if any tweaking over the course of a year," said Michael Stillman, a senior vice president with International Research and Asset Management. "Appreciate how natural it is for your funds to move in opposite directions. This is the nature of being diversified."

Stillman also cautioned plan participants against chasing performance. "Don't allow emotions to get the better of you and cause you to make unnecessary changes," he said. "If you are making multiple fund changes throughout the year, you should probably adjust to a less aggressive allocation."

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Reduce and group

Chris Carosa, the chief contributing editor of Fiduciary News, typically recommends that plan sponsors reduce the total number of investment options available to 401k plan participants and group those investment options into four categories, or tiers, each with one to five mutual fund options.

The specific categories Carosa recommends are:

  • A default option, including one traditional profit-sharing option, for those who don't want to think about investments but know they need to save.
  • Lifestyle-allocation options, including three or four balanced options -- such as conservative, moderate and aggressive -- for those who don’t want to classify their needs too specifically.
  • A traditional long-term portfolio, including three multicap options, for those who are willing to do the work of identifying their specific long-term needs.
  • And, do-it-yourself options, including four or five index-fund options, for those who think they can handle their own asset allocation.

Plan sponsors should read Carosa's article at Fiduciary News.

With that sort of 401k investment menu, Carosa would advise plan participants first to choose the appropriate category of investments, then, if necessary, to pick an appropriate fund or mix of funds if the participant chooses the do-it-yourself option.

Worst case? Work 4 more months and save more early

Of course, even your plan administrator doesn't pick the right funds for your 401k, and even if you chase hot funds in your 401k just right, consider this: According to Carosa, a recent study suggested that 401k plan participants need only work four more months to make up the difference in investment returns between the optimal asset allocation and the typical asset allocation.

"It further concluded that, rather than investment specifics, participants focus on saving more and saving earlier -- things more easily in their control," Carosa said.

And one last thing: Carosa cautioned that a different time period or different types of 401k plans might yield entirely different conclusions than those of the CRR research report.

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