While some retirement plan sponsors have loaded their investment menus up with passive, low-cost funds as a result of the increasing lawsuits being brought against retirement plans, investment experts say that is a faulty approach.
Retirement plans need to offer participants a choice of both active and passive investments, says Dan Keady, chief financial planning strategist at TIAA.
“Sponsors need to offer both passive and active choices because there are many participants who want to invest in actively managed funds,” Keady says. “Another advantage of the mix is that it offers participants another form of diversification, and it is prudent for people to have the ability to express themselves in both active and passive funds.”
Rich Weiss, chief investment officer (CIO) of multi-asset strategies at American Century, adds that passively managed funds have limitations. Weiss says it is also wrong for sponsors to select index funds simply because of their lower price.
“There is no question that fees are a factor to consider in investment manager selection—but there are many other factors, some of them more important,” Weiss says. “Buying anything based solely on its price, be it a fund, a car or a toaster oven, you get what you pay for. There may be reasons to utilize passive approaches, but you get what you pay for, and that is especially true in the multi-asset arena. Commodities and emerging bonds are completely left out of passive strategies because they cannot be indexed efficiently. Passive has its limitations and can even present more risk.”
This is also true for index-based target-date funds (TDFs), Weiss says. “In TDFs, we compete against Vanguard and BlackRock, the two largest index providers. There are some aspects of their approaches that are deficient, namely that passive approaches do not offer broad diversification and do not include some asset classes. This is not an obvious risk, but a nuanced risk, and it is a big one if only investing in a passively run TDF. The problem is that they are all cap weighted, as demanded by the index, and there is no active management of the sub asset classes, so a passive TDF will offer more growth or value, or emerging markets or developed markets, or corporate bonds versus Treasury bonds, at the whim of the market cap. Instead, one should be looking at net risk-adjusted returns, not just the cost, and these can be higher in actively managed funds and TDFs. In fact, in many cases, the higher-cost active strategy might be the better fit.”
However, Brian Miller, senior investment strategist, at the Portfolio Review Department, at Vanguard, counters: “Vanguard Target Retirement Funds [TRFs] are a clear manifestation of Vanguard’s mission to give investors the best chance for investment success. Covering 89% of the liquid global market, Vanguard Target Retirement funds provide investors with broad, market-cap-weighted diversification at 83% less cost than the industry average. Additionally, Vanguard TRFs’ blend sophisticated design and portfolio management with a straightforward glide path provides a low-cost, all-in-one portfolio solution that makes it a top choice as a QDIA in retirement plans and took in more cash flow than any other target-date series last year.”
Weiss says sponsors can also protect themselves from a fiduciary standpoint by offering both active and passive choices to plan participants.
In fact, when the Department of Labor (DOL) issued recent guidance on the selection of environmental, social and governance (ESG) investments as the qualified default investment alternative (QDIA) in plans, it said all decisions on investments should be based on pecuniary facts, i.e., risk and return, Weiss notes. “This may have ramifications for index funds and index TDFs, because a passive approach makes no assessment of risk and return,” he says.
Josh Cohen, head of institutional defined contribution (DC) at PGIM, says retirement plan sponsors should follow the lead of defined benefit (DB) plans run by endowments and foundations. “They take an institutional approach, which means a thoughtful mix of active and passive,” Cohen says.
Like Weiss, Cohen notes that there are certain asset classes that are more inefficient than stocks, and, therefore, cannot operate well in an index fund, such as real estate.
Adding actively managed funds into a portfolio can give participants additional alpha, Cohen notes. “If you can achieve even just 35 basis points [bps] of alpha over a lifetime, that means six additional years of savings added to your nest egg,” he says. “Most institutional investors view this as a low hurdle to achieve, which is why they have a mix of active and passive. That can create a very meaningful difference in retirement readiness outcomes—for TDFs as well.”
Cohen says those plan sponsors that have created an all-index fund investment menu have largely done this in an effort to avoid lawsuits. “We did a survey and found that nearly 50% of plan sponsors choose passive investments to alleviate the threat of litigation or because they are easier to monitor,” Cohen says. “We think that, actually, is acting in the plan sponsors’ best interest, not the plan participants’. ERISA [the Employee Retirement Income Security Act] requires sponsors to act in plan participants’ best interest, so when I look at these lawsuits, I don’t think that the lesson is necessarily that passive is the solution. In fact, in many lawsuits, the sponsor had a passive TDF, and they still got sued. An all-passive approach leaves participants overexposed to market risk, under-diversified, subject to opportunity costs and without solutions to complex issues, such as retirement income, potentially putting retirement outcomes at risk as a result.”
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