Attention defined contribution participants: Beware of being the patsy!

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.

These institutions have had the winning hand. During a 17-year period ended in 2011, for instance, DB plans in the U.S. outperformed their DC counterparts more than 75% of the time by an annual average of 76 basis points, net of investment management fees, according to Towers Watson & Co. Even over the more recent five-year period ended in 2011, DB plans outpaced their DC counterparts, albeit by a smaller margin, even though DC plans had a significantly higher equity allocation.

Over a 40-year career, this small difference adds up. Indeed, for someone starting with a salary of $35,000 — and assuming 3.5% annual wage gains, a 10% savings rate (including employer matching) and annual 7.76% portfolio returns (vs. 7% for a passive portfolio) — it compounds after 40 years into more than an extra $230,000. So let me ask you: Is it possible that DC participants are being set up as the market patsy?

The stakes are huge. DC and IRA participants in the U.S. held more than $10.5 trillion of savings in the capital markets at the end of 2012, according to the Investment Company Institute. By buying into index strategies, their hands are shown: They will keep buying as stock prices go up and will buy more of those stocks the more rapid their relative price growth. In the meantime, the smart money might take advantage of DC buyers by selling to them as prices escalate.

Similarly, within the bond market, buying a market-capital-weighted index strategy forces the DC participant to give more of his hard-earned savings to issuers who are borrowing the most, without regard to the yields provided or the ability of the borrowers to repay. The smart money again may try to take advantage of this constant buyer by selling holdings at prices that do not align with fundamental value — not to mention the borrowers, more than 70% government-related for the Barclays Agg, borrowing money on the cheap. This brewing inequity and financial repression should raise concern.

To guard DC participants against becoming the patsy, here are a few suggestions for plan fiduciaries:

• Focus on “reasonable” cost for the value an investment manager may deliver, rather than simply the lowest fees.
• Align investment strategies to the desired outcome — most commonly replacing retirement income in real dollars, i.e., purchasing power — considering both expected return and risk relative to the objective.
• Consider diversifying strategies, including real assets, global strategies and alternatives, because they may offer enhanced returns, risk diversification and lower volatility, even though they might increase participant costs.
• Evaluate index construction and consider alternatives to market-capitalization-weighted approaches such as fundamental or GDP-weighted strategies.
• Tap into “best-in-class” management, carefully selecting active managers or a thoughtful index approach by asset class.

At Pacific Investment Management Co. we believe freedom to design a DC investment structure is best entrusted to plan fiduciaries. To date, the U.S. Department of Labor supports this as well and provides fiduciaries with duties of care, including applying prudence, to confirm the reasonableness of fees.

While U.S. regulators have debated requiring DC plans to offer at least one index fund and U.K. officials may impose fee caps on plans, we hope these ideas will be properly dismissed, and with good reason. Index fund or fee cap requirements in DC plans would amount to price controls with the likely unintended consequence of harming rather than helping DC participants. They would likely drive increased market-cap-weighted indexation, thereby pooling more DC participant assets and positioning participants to come up short on retirement savings.

Stacy L. Schaus is an executive vice president in the Newport Beach office and leads PIMCO's Defined Contribution Practice working primarily with plan sponsors and consultants.