Commentary: ‘Do no harm' is not nearly enough

Retirement plan sponsors are an essential component of the U.S. retirement system. Plan sponsors oversee the operations of virtually all retirement plans, hiring the service providers who perform work for the plans, selecting the investments that generate returns and generally helping to ensure that plan participants can meet their retirement goals.

But for plan sponsors to do their critically important work, they need to be appropriately and completely informed of their role and duties. Unfortunately, recent writing on the responsibilities of plan sponsors has failed to accurately portray the duty that sponsors have to act in plan participants' best interests.

A recent example of this problematic approach is "Defined Contribution Plans: Challenges and Opportunities for Plan Sponsors."This guidance for plan sponsors, written by Jeffery Bailey and Kurt Winkelmann, has recently been published by the CFA Institute Research Foundation.

Messrs. Bailey and Winkelmann inaccurately summarize a plan sponsor's role as follows: "An investment committee's first responsibility is to do no harm." In their view, plan sponsors both fulfill their responsibilities and make their work less complicated by reflexively favoring passively managed investments over actively managed ones.

However, while "do no harm" is the core of the Hippocratic Oath that doctors take, plan sponsors are held to an even higher standard. Under the Employee Retirement Income Security Act of 1974, plan sponsors are fiduciaries who have both a duty of care and a duty of loyalty to plan participants and their beneficiaries. This is one of the highest standards in the law, and it requires that fiduciaries act in the best interest of their clients at all times.

Under the fiduciary standard, plan sponsors can't default to simplistic rules of thumb when selecting investments for a retirement plan.

So, what's a plan sponsor to do?

As Alison Douglass and Christina Hennecken of the law firm Goodwin Procter LLP and authors of "Selecting, Evaluating, and Monitoring Investments in DC Plans: A Legal Perspective" explain, part of the fiduciary responsibility is evaluating the needs of the plan and having "a clear understanding of the range of options available in the marketplace."

Litigation risk should not be a factor in this evaluation. "While litigation may be top of mind," cautions Ms. Douglass, "it has no place in fiduciary decision-making."

Nor should the administrative convenience drive the decision-making process. Avoiding investments solely because they are "time consuming" for plan sponsors, as Messrs. Bailey and Winkelmann suggest, is not consistent with the best interests of participants.

The fact is, focusing on passively managed funds doesn't reduce the need for thorough analysis of potential investments. Passively managed doesn't equate to "not risky."

Passively managed funds can also be quite complicated, as Messrs. Bailey and Winkelmann themselves note. "Investors have literally thousands of indexes to choose from," they explain, which creates significant challenges in matching index to investment objective.

And plan sponsors still need to look under the hood of passively managed funds. As several research papers have pointed out, the recipe for many index funds involves a heavy dose of active decision-making.

Instead, active and passive coexist, with virtually every investment having some aspect of both.

The difficulty of disentangling active and passive is perhaps best illustrated by the example of target-date funds. Messrs. Bailey and Winkelmann recommend that plan sponsors focus on passively managed target-date funds — but fail to recognize that these funds involve a high level of active decision-making and monitoring by the investment manager.

That's because, while these funds may use index funds as building blocks to create exposure to particular asset classes, the allocation among those asset classes requires research and analysis of economic and market conditions over both the short and long term.

A wide range of actively managed strategies can add value in helping plan participants meet their goals. Indeed, only active management is equipped to evaluate the potential financial impact of long-term trends such as climate change — the type of trends that can have an enormous impact on planning for long-term goals, such as retirement.

And there are well-established and well-researched road maps that plan sponsors can follow to help them identify good active managers. Recent papers by K.J. Martijn Cremers, Jon A. Fulkerson and Timothy B. Riley and by Nicolas P.B. Bollen, Juha Joenvaara and Mikko Kauppila (both published in the CFA Institute's Financial Analysts Journal) discuss the indicators that plan sponsors can use in this process.

Plan sponsors should weigh the risks of possible investments against their potential rewards, considering the costs associated with those investments. In other words, as legal experts Ms. Douglass and Ms. Hennecken explain, "fiduciaries should focus on the value-for-cost proposition."

In a recent blog post, Messrs. Bailey and Winkelmann opine that their discussion of the value of active management has been misinterpreted and clarify that "do no harm" was intended as a "policy guideline, not a legal standard."

Having acknowledged that their guidance has been so misunderstood, it is imperative that the authors amend their paper so that plan sponsors accurately understand their legal duties. In sum, plan sponsors should be seeking the best outcomes for plan participants based on the participants' goals, not their own.

It's time to stop perpetuating old myths about active and passive management and recognize the important role that both active and passive strategies play in helping investors meet their goals.

Karen Barr is president and CEO of the Investment Adviser Association, an organization for fiduciary investment advisers, based in Washington. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.