It’s not about the mountain of research against active funds based on performance.
It’s about one term that get’s to the heart of the construction of 401k plans: fiduciary duty.
Plan sponsors can easily be held liable if a group of participants figure out their investment fund offerings have fees that are not “reasonable.” There have been lots of lawsuits with big and small plans lately based on the concept of reasonable fees. Now, of course, that’s a relative term and there are all sorts of ways to defend aggregate fee levels through benchmarking comparisons that are today the core services provided by retirement plan consultants and other on-line service provider’s
Determining reasonableness comes down to justification of fees with active managers. It sometimes involves a plan sponsor in the middle of a subjective discussion on expected performance, how many portfolio managers have CFAs, and the potential for their style to make a comeback at some point in the future. This, of course, means that the plan sponsor is paying thousands of dollars in consulting fees over many many years with styles going in and out of favor and active managers being fired left and right every time their standardized performance over 3, 5, 1nd 10 year periods is not what was expected based on the expert consultant’s abilities to identify star managers with above-average persistent performance.
Why index funds are better for the plan?
The real question is what are the benefits from a fiduciary standpoint.
The bottom line, utilizing index funds is a prudent decision when it comes to fees, investments, and asset allocation. It’s a prudent decision both at the individual and aggregate plan level.
It’s like having a Directors and Officers Liability Insurance policy wrapper for the plan especially if you use only index funds in the plan.
- What if a plan sponsor took the index funds in aggregate to compare fees for reasonableness. They determined with the help of an indexation consultant which index fund providers were ripping them off based their methodology and execution costs. They would just drop them without hesitation.
- But where prudence plays a role, evaluation and due diligence with index funds is different than with active funds since fees represent more than getting what you pay for. Index fund performance closely matches the realized and expected performance of the underlying index it represents. The same underlying index which in many cases is tied directly to an asset class that is used in the asset allocation approach and process. Therefore participants will experience fewer periods in which their asset allocation strategy expectations have a mismatch with their own investment funds and their own asset allocation strategy performance.
- It eliminates the whole controversial debate about active vs passive which researchers say favors index funds and asset management professionals sometimes say they have a great fund that outperforms the respective index. The reality is there is no definitive process among fiduciaries that enables them to pick good active persistent managers that can prudently support the asset allocation approach. I’ve practiced investment manager research and selection on and off for 30+ years. I’ve seen empirical white paper research that says you need 15 years of cumulative aggregate performance measurements to justify active management fees yet fiduciaries and plan participants only use standardized measuring periods that usually end at 10 years utilizing compound annual growth rates. Both approaches may be acceptable on the surface to a plan sponsor but it’s very debatable across the fiduciary community that serves defined contribution plans and their sponsors. This is a hot potato. There is way too much debate around this which has left the defined contribution industry with no true protective riskless prudent standards for selecting worthy active managers. If you disagree I would be happy to provide you all the papers at the center of the debate nevermind all the marketing white papers out there on both sides of the debate.
- The bottom line, the whole idea of active management is very subjective on many different levels and extremely debatable which makes any prudent fiduciary evaluation process in a defined contribution plan fraught with risk(s) and therefore imprudent.
- AND as a fiduciary investment consultant you should never expect plan sponsors to take your word for it on any recommendations to add an active manager to an investment menu based on an analysis they may not understand completely. OR probably have little or no ability to make even a reasonable guess on whether to hire the manager. As a fiduciary investment consultant it your responsibility to be both reasonable and prudent as to whether you can fulfill your duty to educate while enabling the plan sponsor to make a sound decision which is based on your relationship with the plan sponsor and whether “you know the customer” plan sponsor.
- Ultimately the plan sponsor could easily be held liable for breach of duty due to reasonableness.
The focus should be on the asset allocation process anyways. Isn’t that what’s been said all along.