“Simplify too much: to simplify to such an extent as to cause distortions, misunderstandings or errors.
Lately, some very black and white and reductive views on the wisdom of active management have been making the rounds in the investing world.
For example, in Defined Contribution Plans: Challenges and Opportunities for the Plan Sponsors, of the CFA Institute Research Foundation, Jeffery Bailey, CFA, and Kurt Winkelmann say an investment committee’s first responsibility is to “do no harm” and question whether actively managed funds should ever be included in plans of defined contribution (DC).
They recommend that plan sponsors default to passively managed options and imply that by avoiding active funds for passive ones, the committee will “do no harm.”
This is an oversimplified view.
The members of the investment committee are fiduciaries under the Employee Retirement Income Security Act (ERISA). An ERISA fiduciary’s duty is to “do no harm.” Rather, the standards to which ERISA fiduciaries are held are much higher. These include acting prudently and solely in the interests of plan participants and beneficiaries, and diversifying plan investments to minimize the risk of large losses.
Trustees must focus on what is in the best interest of participants. In some cases, this might lead them to choose active funds, in others, passive funds may be more suitable. But either way, passive and “do no harm” funds are no synonymous
The idea that choosing active or passive will somehow reduce fiduciary risk is unfounded and ignores the more substantive areas ERISA fiduciaries should explore when selecting the most appropriate target date fund (TDF) .
The authors also suggest that investment committees should choose passively managed TDFs as their default option. While TDFs are often the most appropriate option, it is important to remember that there is no such thing as a passively managed TDF.
All TDFs involve active decisions by the TDF manager. Managers must choose which asset categories to include in the funds, which managers should fill those categories, the allocation of those categories for each age group, and how that allocation changes over time (i.e. , the travel path) as a minimum. The authors ignore the fact that selecting asset classes and constructing travel itineraries are critical and unavoidable active decisions made by portfolio managers, regardless of whether they choose to use active or passive underlying strategies within the fund of target date.
In fact, the selection of asset classes and the path of travel are far more important drivers of investor results than the choice of implementation through an active, passive or hybrid approach.
Since the majority of new contributions to DC plans are being invested in TDFs and many plans have selected TDF as their default, choosing the plan’s TDF is likely to be the most important decision the investment committee will make. Such a critical decision should consider much more than simply whether TDF portfolios use active or passive underlying strategies.
For example, a series of passively managed TDFs may carry excessive risk at an inappropriate time, for example at retirement age. This could result in significant losses for a person who does not have the time (or salary income) to recover. Bailey and Winkelmann focus on the perennial debate between active and passive rather than the most critical and influential consideration for retirees: income replacement.
We strongly believe that considering participant demographics, such as salary levels, contribution rates, turnover rates, withdrawal patterns, and whether the company maintains a defined benefit plan for its employees, will help the committee to determine the trajectory of TDF that is in the best interest of the participants and achieving their income replacement goals.
We also strongly believe in the role we play in helping investors achieve their retirement and post-retirement goals and believe the conclusion that plan sponsors should simply choose passive over active to reduce risk fiduciary is not aligned with ERISA standards or plan participant outcomes.
Plan demographics, track record and asset class diversification are far more critical considerations than whether a TDF manager selects active or passive underlying components.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Jed Laskowitz
