As they say in poker, “If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.”
– Warren Buffett, Berkshire Hathaway shareholder letter, February 1988.
It's a truism that poker — and financial markets — can be unkind to those unaware of the caliber of their opponents. Some sponsors of defined contribution plans, however, may be forgetting this in their otherwise admirable quest to lower costs with indexed investments.
To appreciate the magnitude of this potential error, consider that as baby boomers begin stepping out of the workforce in droves, less than a fifth of them will be looking to a traditional pension for income. Instead, they'll be relying on government programs, such as Social Security, and the savings they have accumulated in defined contribution plans or individual retirement accounts.
This generation will pioneer retirement security reliance on DC plans, and no doubt pave the way for many generations to follow. Today's workers in the U.S. — and increasingly around the globe — will look to DC programs to replace upward of 40% of their final pay. To reach this lofty objective, workers must save enough and their savings need to be effectively managed.
Yet many plan sponsors, perhaps prompted by fear of litigation or signaling from regulators, have lost focus on these fundamental requirements and have engaged in a myopic search for the lowest fees possible for their DC plan. As a result, they might tend to select market-capitalization-weighted index strategies that passively track indexes such as the S&P 500 index and the Barclays U.S. Aggregate Bond index. To help keep costs low, plan sponsors might also use a purely passive target-date strategy or index-seeking managed account approach as a participant default.
So far, only about 17% of U.S. DC assets are invested in these low-cost strategies, according to the Plan Sponsor Council of America, yet a higher percentage of cash flows might move this way. If we look to the U.K., consultants report that most DC assets are passively managed, and there is concern the percentage will increase, prompted by proposed government-imposed fee caps.
By contrast, if we consider defined benefit programs or foundation and endowment investment pools both in the U.S. and the U.K., the vast majority of assets are actively managed.