A year after the federal government enacted 408(b)(2) regulations on defined contribution plan fee disclosure, debates continue to rage over whether actively managed mutual funds are better than passive funds for plan participants' retirement readiness. But many experts believe those debates are distractions from the real issue: Whatever their investment elections, workers simply aren't saving enough for retirement.

In fact, retirement confidence remains at a record low, according to the Employee Benefit Research Institute's annual Retirement Confidence Survey, which reported earlier this year that 28% of Americans - the highest level in the survey's two-decade history - are not at all confident about being able to afford a comfortable retirement.

"Wall Street has built an empire on the idea that all active funds should be in a portfolio, and there are a lot of people who have good strategies, but it doesn't work all the time," says Chad Parks, founder and CEO of The Online 401(k), a company that offers 401(k) plans to small businesses.

He calls the active vs. passive management debate the "Achilles heel of the 401(k) industry."

On the one hand are those who believe in the passive approach, who say cost matters and you can't beat the market. On the other are those who believe that fees paid for active management expertise are worth it.

Mendel Melzer, an adviser with the Institutional Retirement Income Council, a nonprofit think tank focused on retirement plan income security issues, doesn't think plan sponsors have to decide one way or the other. Rather, they should provide a diversified set of options to participants that span active and passive management, domestic and international funds, and fixed income and equity funds. He says active management has an added value in some asset classes and styles, while passive management has done a better job in others.

"The increased focus on fees doesn't invalidate active management," Melzer said. "Rather, it means that any active management strategy should also have low fees and that net returns over full market cycles should exceed the returns on passive benchmarks."

Tom Reese is of the passive management school of thought. As a consulting actuary and member of Conrad Siegel Actuaries' business development committee, and an investment adviser representative for Conrad Siegel Investment Advisors, Inc., he specializes in retirement plan consulting, administration and employee communication for daily valuation plans, as well as investment advisory services for retirement plans. He said his firm has analyzed historical fund performance data and found that index funds' passive approach gives investors the best odds in the long run.

He says there are a small number of active managers who outperform the market, but it's not the same managers consistently beating the market and investors can't predict who that will be. Active managers are under a lot of pressure to outperform the market to offset their fees. He says investing for retirement is a long-term process, and active management is more about outperforming other funds in the short term.

"Advocates of active management claim that it brings significant value. They can provide statistics showing a short time frame when they beat the marketplace and explain how you're getting value with the extra fee," Reese says. "The particular time frame they show will clearly prove they beat the market, but they're not showing longer periods of time needed for long-term investment."

Steve Anderson, executive vice president of Schwab Retirement Plan Services, says that plan sponsors must look at the underlying expense structures of the investments. Enrolling an employee in low-cost investments, like index funds, rather than more expensive actively managed funds, he says, could mean nearly $115,000 more at retirement.

Anderson puts most of his faith in a professionally managed approach that uses data to choose appropriate investments for plan participants. His firm looks at figures such as age, savings rate, account balance, salary, gender and Social Security age to place employees in an appropriate investment portfolio.

"We're big believers in using a managed account that is personalized ... those tend to be fee-based, but you have a more personalized asset allocation," Anderson said.


'Little interest' in fees

The Department of Labor issued participant disclosure regulations last year, requiring plan administrators to make specific disclosures to employees participating in 401(k), 403(b) and other defined contribution plans that allocate investment responsibility to participants.

Even then, less than 1% of plan participants called Schwab to ask what their fees meant, says Anderson. There was "very little interest in the part of participants," he says.

It's no secret that plan participants span the spectrum of investment acumen.

"Some fully understand the difference [between active and passive management], while others don't even understand the difference between an equity fund and a bond fund," Melzer says, adding that this makes picking a qualified default investment alternative all the more important.

QDIAs set up additional protections for plan fiduciaries as long as the default investment option is a mix of investments that takes into account the individual's age or retirement date, or is a professionally managed account that allocates contributions among existing plan options to provide an asset mix that takes into account the individual's age or retirement date.

Anderson says his firm sees around 10% to 15% of employees who are engaged and who actually look at their asset allocation, but the other 85% to 90% "really want and need professional help, because they don't have the time or knowledge to oversee a career's worth of savings."

He believes employees want help with investment decisions about what funds to go with, which is why he advocates for managed accounts that incorporate auto-features.

"If you can marry those with low-cost funds so that you're not paying more than you need to, and provide the professional management service, then you have the convergence of the best of both worlds," Anderson says.


Choice overload

Greg Kasten, founder of Unified Trust, a retirement planning and wealth management practice that manages $3 billion in assets, says investment class "choice overload" leads most employees to freeze when having to make a decision.

"If I give too many choices, you take the safest choice, and the safest choice is to do nothing," he says. For every three funds over 15 on an investment menu, plan sponsors get 1% less participation, Kasten says.

He believes part of the solution to this choice paralysis lies in giving plan participants a predetermined answer that "X" is how much they'll need for retirement, and then providing them with the funds and asset allocation that might be able to help them reach their goal.

The argument over fees, he believes, detracts from the real issue: Only one in four plan participants is currently on track to retire on time. Debating the merits of active and passive management based on fees "would make you believe that the funds cost too much. It's the minority of the problem that participants face, though," he says.

The majority of employees do not understand the fundamental difference between actively managed funds and low-cost index funds. This information is too complicated and confusing for most employees, according to Reese.

"It's more important that the plan fiduciary understands the difference, since they're helping determine the fund menu," Reese says. Fiduciaries need to understand the various fee structures and what is in the best interest for everyone in the plan. "They should not expect employees to figure out which funds are best for them."

And while participants most likely don't understand the difference between active and passive management, sometimes fiduciaries don't either, believing that that the higher-cost actively managed funds must be a better and more successful option.

"It's difficult to educate fiduciaries on long-term statistics for index funds, because many are emotionally invested in active management. These fiduciaries may have been with an active manager during a time period when they did beat the marketplace and stick with them because of that," Reese says.

Lisa Gillespie is a writer in Washington, D.C. and a former Associate Editor with EBN.




Target-date funds shift to passive

By Joel Kranc

Money within target-date funds is moving to passively managed investments, as both an underlying holding within a portfolio and as an overall investment approach. That's according to the Morningstar Target-Date Series Research Paper: 2013 Industry Survey.

As of Dec. 31, 2012, 68% of target-date fund assets were in actively managed investments. Inflows to passively managed investments (those that invest 80% or more in passively managed investments) overtook flows into actively managed investments for the first time for the 2012 calendar year.

Overall target-date funds continued to catch the imaginations of retirement investors in 2012, whether viewed on an absolute or relative basis. Target-date mutual funds took in $54.8 billion in net new flows last year, reaching a total of $484.8 billion. The first quarter of 2013 saw an addition-al $23 billion in new assets, and target-date assets as of March 31, 2013, stood at $508 billion.

Other key findings in the report show that managers of target-date funds have increased allocations to non-U.S. equities. Since 2005, international stocks have risen from 24% of the average 2040 fund's equity allocation to 36%, as of Dec. 31, 2012. Emerging-markets bond funds appeared in nine target-date funds in 2008, compared with 18 in 2012.

Joel Kranc is director of Kranc Communications. He can be reached at joel@kranccomm.com.

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