Greetings! I hope you had a wonderful summer.
While I took a short break from blogging, the debate over active vs. passive management—and which is more appropriate for your firm’s 401(k) lineup—was really ramping up online. This is surely in light of the DOL’s move to implement the highly anticipated Fiduciary Rule. While the new regulations primarily affect financial advisors, as a plan sponsor, you might be particularly aware of the uptick in legislation against many publicly- and privately-held companies on behalf of their participants. The majority of these lawsuits center on poorly-performing funds that come with high price tags and complicated fees, which in many cases did not benefit participants but rather plan vendors. This fear of litigation has started to impact choices plan sponsors make in their fund line-ups—running toward the lowest cost funds out there (such as passive index funds) and assuming that alone will cover their fiduciary liability. To be sure, plan sponsors must be prudent and, as such, keep costs in mind—but is this race toward passive management the most appropriate reaction?
Before we dig into the issue, let’s take a moment to review the difference between “active” and “passive” when it comes to mutual funds:
Passive strategies seek to replicate a specific index (such as the S&P 500), generating a similar return as that index over time. Since they’re not being continually analyzed and traded, they’re known for their low costs.
Active strategies seek to outperform the markets, and utilize fund manager analysis and specific trading strategies in their efforts to do so.
While many are of the mindset that passive strategies perform best, the truth is that since the inception of the mutual fund industry, there have been times where each has outperformed the other, and for very specific reasons.
So, which is best for your company’s 401k plan? Are you required to have the lowest cost fund, and will that alone protect you from litigation? Not necessarily. In fact, relying on cost alone does not satisfy all aspects of your fiduciary duty—and could in fact work against you. A recent white paper on this topic explores this question in great detail, and offers five “guiding principles” for plan fiduciaries to follow in regards to investment selection. I agree with several of points made by the author, an ERISA attorney named Alison V. Goodwin. When it comes to fund selection, there are many aspects that need to be examined, and one essential element is a consideration of the value for cost proposition—not cost alone. Also remember that what’s most important is to have a deliberative process that provides plan participants with a broad range of choices which are in line with your written investment policy statement (IPS). Consistently following this process—and proving you’ve done so—is what meets the standard for prudence. Don’t fall into the trap of allowing fear to guide choices for your plan.