All passive DC plans: Whose interest do they serve?

 

I recently saw some interesting statistics from a Defined Contribution (DC) plan sponsor survey. Sponsors were asked why they implemented passively managed funds in their plan. Nearly 75% of these sponsors said their primary reason was either “alleviate threat of lawsuits” or “fiduciary concerns.” The others said “they do not believe active managers outperform” or cited “cost of investments is the most important factor.”

As I interpret these results, it seems the first two reasons could be classified as “what’s in my best interest as the plan sponsor?” The other two are more aligned with their plan participants’ interests.

What does ERISA require from a fiduciary? First and foremost, it requires plan sponsors do what’s in the best interest of participants. Further, it requires fiduciaries to ensure fees are reasonable, but not necessarily at the lowest cost. In other words, good value doesn’t mean cheapest.

While I may disagree with the conclusion, I take no issue with those who opt for passive management, if they have done thorough research and analysis on what’s the best investment solution for their participants.

I do have concerns with sponsors who base their decision to go passive because of a fear that higher fees for actively managed funds could expose them to potential lawsuits or put them in a fiduciary bind.

I know being a DC fiduciary is tough. There is a lot of scrutiny—some leading to class action lawsuits. I’m sure many wonder “What’s the upside for offering active funds? If they outperform I get no credit, but if they underperform I get criticized for wasting participants’ money.”

I would respond by saying:

    1. The current scrutiny is not so much about fee levels, but more about sponsors not appropriately understanding, monitoring and benchmarking fees.
    2. Focus on a fund’s potential value in terms of helping participants meet income needs in retirement, not absolute fee levels. A 20 basis point bond index fund is cheaper than a 30 basis active bond fund, but I’d argue the active fund could be a better value.
    3. Participants, particularly those defaulted in target date funds, are relying on your expertise as a plan sponsor to choose what’s best for them from a total portfolio perspective. Most institutional investors (e.g. those overseeing defined benefit plans or an endowment or foundation, etc.) mix both active and passive management in a thoughtful way. Why wouldn’t you do the same for your participants?
    4. There is no such thing as a total passive solution. Consider an “all passive” target date fund. While the underlying asset classes may be implemented passively, someone is “actively” making decisions around the glide path, the asset allocation (e.g. how much in U.S. versus non-U.S.) and the benchmark to index the fund to.

I’ve had some interesting conversations recently with a few sponsors who implemented all passive solutions but are having some remorse. Now that they are offering a bond index fund, benchmarked to the Barclays U.S. Aggregate Bond Index, they are not comfortable with the excess exposure to U.S. government securities in today’s low interest rate environment. Because their committee was convinced they wanted to reduce fee and tracking error risk in an effort to lower fiduciary risk, they are now stuck with excessive interest rate risk.

When discussing active and passive management in DC plans, I am not looking to be an apologist for active management. We can devote other discussions to where active and passive management may make sense. But, I’d caution against offering a plan that’s just “Good Enough” by dogmatically picking all passive investments. It’s in the best interest of your participants to take a more thoughtful approach to these decisions.

Note: One of the nice things about working at Russell is the sabbatical program—a chance to take a prolonged break after each ten years of service. As a result, Bob Collie shall be away from the office until late July. The Fiduciary Matters hot seat will be filled by guest authors over that period.  


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