A number of retirement plan experts believe that 401k plan participants should only be allowed to invest in index funds. They say the additional cost that participants pay for actively managed mutual funds is not justified by better performance.
Many 401k plan sponsors have agreed, offering only index funds in their fund lineups. I don’t believe that is the best strategy.
Following is a discussion of the merits of both approaches and then my thoughts on what I feel is the optimal solution.
Arguments For Using Only Index Funds
There is no question that an index-fund-only lineup will be less volatile than a lineup that includes actively managed funds. Generally, less volatile funds are better for 401k plan participants, who tend to get emotional when markets are volatile, often selling at market bottoms and buying at market tops.
Lower litigation risk
Because index funds are the lowest cost alternative for any asset class, some experts believe that 401k plan sponsors are less likely to get sued by offering them. Given that the majority of lawsuits against plan sponsors have arisen because higher-cost fund options were offered when lower-cost share classes were available, this is probably a valid argument.
In addition, some commentators believe that litigation risk is further reduced when offering an index-fund-only lineup since this approach eliminates the risk of being sued because a fund is an extremely poor performer relative to its index.
Elimination of advisor conflicts
It would seem that offering an index-fund-only lineup would make it impossible for those advisors working for banks, brokerage firms and insurance companies (who are held to a lower fiduciary standard) to recommend funds that aren’t in participants’ best interests.
These advisors are required to place their employers interests first and are often obliged to offer proprietary funds regardless of whether they are the best solutions. Offering an index-fund-only lineup would make it impossible for these conflicted advisors to recommend funds that pay them high commissions or hidden soft dollar payments.
No poorly performing funds
Index funds will always deliver average market performance. An index-only menu would appear to forever eliminate the risk of offering a bad-performing or below-average investment fund.
Many participants have a hard time understanding the goals and objectives of some of the investment funds in their plans. They may have an easier time understanding that a mid-cap index fund mimics a mid-cap index rather than trying to distinguish between mid-cap growth, value and blended funds.
The end of fund changes
If you offer a fund menu composed of index funds only, will you ever have to make a change to your lineup? Maybe not. Many plan sponsors view this as a simplification of their plan administration process.
We all have seen the data showing that passive management has beaten active for many years in a number of asset classes. There may be enough data available to conclude that for some asset classes, it is better to choose a passive or indexed approach.
Unfortunately, there are too many actively managed mutual funds that chart their index way too closely and are in reality index funds charging actively managed fees.
These funds (and fund managers) have given active management a bad name and are the primary reason that active management has underperformed passive management in certain asset classes. Actively managed fees subtracted from index returns equals an underperforming fund.
Higher level of fiduciary compliance?
Is a plan sponsor better complying with its fiduciary responsibilities by offering an index-fund-only lineup? Because the lineup would be less volatile and lower in cost compared with an actively managed fund lineup, some experts think so.
Arguments For Using Actively Managed Funds
Less than 100% of every market downturn
Index funds are guaranteed to capture 100% of every market downturn. An important feature of actively managed funds is that a good active manager can sell out of positions before capturing an entire market fall. Although not every active manager has been able to accomplish this, many have. This is the strongest argument for the use of actively managed funds.
Inefficiencies in some asset classes
Although it will be hard for active managers to beat their index in a number of asset classes that are highly researched and followed, there still are many asset classes where inefficiencies abound. One example is international equities.
Investment management firms that have research expertise and managerial talent in these areas can significantly outperform their indexes over a full market cycle.
Misperception of active management
I have never understood the widely held belief that all active managers should outperform their fund’s index every year. First, an actively managed fund needs to be evaluated over a full market cycle, not just one or two years.
Also, some active managers are very good at defending your investment against loss, but not quite as skilled at outperforming the index during a rising market. And finally, in what industry are 100% of members above average? Yes, there are some active managers whose approach is bottom-quartile. Don’t invest with them. Invest with top-quartile managers in every asset class when choosing active management.
We live in America, where entrepreneurship and innovation are valued and rewarded. Most American’s brains are not calibrated to be satisfied with average or index returns. We expect to have above-average children, above-average pay raises and above-average returns in our investment portfolios.
Index investing guarantees average returns every single year. I talk with very few investors who say, “Bob, I’m looking forward to another average year of returns in my portfolio.” Most investors feel that if they experience a year of average returns, it was not a good year.
The Winning Formula
Without question, a winning formula in building a great 401k plan investment fund menu is to combine index offerings with actively managed choices for those asset classes where inefficiencies still exist.
Even Vanguard, the king of indexing, agrees. One of the fastest growing parts of Vanguard’s business is it’s actively managed funds area. If it only made sense to invest in passive investments, why would Vanguard offer actively managed funds?
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.