Defined contribution plan sponsors are opting for all-passive investment strategies for their default target-date funds. This choice is puzzling. After all, many of the same sponsors are choosing active management or a combination of active and passive for the defined benefit funds. Are plan sponsors living up to their fiduciary responsibility and doing what is best for DC plan participants? Why wouldn’t plan sponsors also use active management — or at least a mix of active and passive management — in their default investments?
As defined contribution becomes the dominant employer-sponsored retirement plan in America, plan sponsors — as part of doing all they responsibly can to help ensure participants’ financial security — should choose the most effective investment structure for their default investments. In that regard, I see two trends emerging among plan sponsors. Many are selecting target-date funds as their default of choice and among those, many are choosing funds that rely on all-passive investment strategies.
There are many factors to consider when evaluating active vs. passive asset management. Among them are cost, risk and return.
Cost: The cost of passive managers’ operating structures is typically much lower than that of active managers. This allows them to charge materially lower fees.
Risk: Actively managed portfolios carry the risk of underperforming their benchmark. Passive management reduces underperformance risk, but does not reduce market risk.
Returns: The objective of active management is to generate superior returns through skillful security selection and portfolio structure. Active management is a net benefit to participants if active managers are able to generate sufficient excess return over their benchmarks to cover their fees and the cost of trading.
From our conversations with plan sponsors, we know that many believe in the effectiveness of active management because they use it within their defined benefit plans. We assume that their decision to invest some or all of their defined benefit plan assets actively was made thoughtfully after considering the costs and benefits of the available alternatives.
In a DB plan, the benefits of active management accrue to the plan sponsor. However, in a DC plan, the plan sponsor does not stand to gain directly from any additional return that might be generated. Further, there is extra effort involved in establishing, monitoring and managing actively managed funds within the plan. The DC plan sponsor might also perceive an additional downside: any underperformance is visible to participants and may lead to direct criticism of the plan decision-makers. As is often the case when decisions are made in the public eye and are likely to be judged critically, there is pressure to make the risk-averse one.
Even though the underlying cost-risk-return equation of a particular investment may be the same in defined contribution as in defined benefit, there is an agency consideration that may push plan sponsors toward a different conclusion. So, if a plan sponsor believes that using an active management strategy for its DB plan assets is optimal, but then uses a passive management strategy for its DC plan assets, it begs the question of whether the sponsor is living up to its fiduciary duties and doing what is best for its DC plan participants.
Plan sponsors who are reticent to embrace either all-passive or all-active management might want to consider constructing their target-date funds within a fee budget that allows for an active/passive mix. By opting for a multistrategy option, plan sponsors are more likely to receive the highest potential return in excess of fees when compared to an all-passive strategy.
The case for a partially active portfolio is too compelling to pass up when the effect is examined over the course of a participant’s career. Even a small amount of additional return can make a meaningful difference. As an example, if active management add¬ed an additional 40 basis points return per year over 40 years, the additional return would result in a roughly 7% higher benefit at retirement.
Interestingly, DC plan sponsors have faced similar challenges in the past regarding how to responsibly maximize participants’ portfolios.
Historically, some plan sponsors relied on super-conservative investments such as stable value funds as their DC plan defaults.
Faced with this realization and the safe harbor proposed by the Pension Protection Act of 2006, DC plan sponsors are beginning to change their defaults from super-conservative investments to more diversified choices such as target-date funds.
Sponsors should resist pressure to choose all-passive defaults and consider default investment choices that rely on both active and passive investments. Doing so may put plan sponsors in a much stronger position when participants ask: “Did you do everything you could to ensure my financial security?”
Matt Smith is managing director of retirement services for Russell Investment Group, based in Tacoma, Wash.
