Passive investors like the low costs and broad diversification of index funds. Passive investing can also assure that the portfolio has the same risk profile as the index. Active investors want fund managers with the ability to choose certain securities and sectors that are likely to outperform, and to reorient their portfolios when economic conditions change. Active investing can be particularly helpful in mitigating the risk of rising interest rates in a fixed income portfolio; portfolio managers can allocate assets to fixed income sectors that have less interest rate sensitivity.
Although most assets in defined contribution plans continue to be actively managed, at the end of 2011, 20% were in index funds (“Indexing in Defined Contribution Plans” Cynthia A. Pagliaro and Stephen P. Utkus Vanguard). Interest in index funds is growing both in retirement plans and non-retirement accounts. The Vanguard Total Stock Market Index Fund is now the world’s largest mutual fund, with net new inflows of $24 billion in 2013. Passive equity funds as a whole outpaced active flows by $167 billion (Morningstar 2013 Global Flows Report: The Tide Turns Toward Equities March 2013). Most plans want to offer at least an S&P 500 index fund, and a growing number of plans want to see a full index suite. As fiduciaries focus on fees, investment trading expenses and transparency, their interest in passive management should continue to grow.
What effect does the use of index funds in defined contribution plans have on plan and participant costs? The answer is “it depends.”
A plain vanilla, stripped-down S&P 500 index fund can be made available to participants for a few basis points. For example, the Vanguard 500 Index Fund includes an Investor class that costs 17 basis points (0.17%). Although Vanguard provides a 0.9% recordkeeping credit if the plan is recordkept on the Vanguard platform, there is no recordkeeping credit for funds held on other platforms. For the most part, the fee is designed only to cover the investment management costs; it does not provide for the considerable expenses of running a defined contribution plan. Compliance, legal, communications, administration and the other plan necessities all cost significant amounts of money.
To help defray those costs, slightly more expensive index funds have been created that provide revenue sharing to help offset plan administrative costs. TIAA-CREF’s S&P 500 Index Fund Retirement share class, costs 31 basis points (0.31%), and provides 25 basis points (0.25%) of revenue sharing for plan expenses. In this way, that index fund can still remain a low cost option while also contribute revenue sharing to help defray the cost of the retirement plan.
Determining which index fund to offer means dealing with issues of fairness. Is it better to have the lowest cost index funds and more expensive actively managed funds? That approach would make passive investors happy, but in many cases would put the costs of the plan onto the shoulders of the active investors. Or is it better to have a more expensive index fund which provides revenue sharing? That route would help both active and passive investors share in the plan costs more equally. Or should plans offer the least expensive fund share class for both the actively and passively managed funds, and then add a surcharge to each participant account for the plan costs? The latter could possibly be the most equitable solution; however, such fees would be listed directly on each participant’s quarterly statement. Participants are not used to seeing charges, since most fees are imbedded into the net asset value of the fund, rather than explicitly listed on the statement.
Any of these fee sharing options is acceptable for the plan sponsor to use. As the use of index funds continues to rise, however, it is important for defined contribution plan committees to discuss the subject.
Denise M. Burns, MBA, CFA,® Vice President, Head of Investments | Paula Boyer Kennedy, MBA, AIF,® CFP,® Vice President, Cammack Retirement Group
Cammack Retirement Group provides investment advisory, consulting and actuarial services. For more information on its services, contact Mike Volo, Practice Leader, at 781-997-1426 or mvolo@cammackretirement.com.
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