A lot of simplistic and narrow-minded views about the wisdom of active management have been gaining popularity in the investment world recently.
For instance, in Defined Contribution Plans: Challenges and Opportunities for Plan Sponsors, written by Jeffery Bailey, CFA, and Kurt Winkelmann for the CFA Institute Research Foundation, the authors argue that an investment committee’s first duty is to “do no harm” and question the inclusion of actively managed funds in defined contribution (DC) plans.
They propose that plan sponsors should default to passive investment options and suggest that by doing so, the committee will “do no harm.”
This viewpoint is overly simplified.
As fiduciaries under the Employee Retirement Income Security Act (ERISA), investment committee members have a much greater duty than simply “doing no harm.” Their responsibilities include acting prudently and solely in the best interest of plan participants and beneficiaries, as well as diversifying the plan’s investments to minimize the risk of significant losses.
Fiduciaries must prioritize what is in the participants’ best interest. In some cases, this may lead them to choose active funds, while in others, passive funds may be more suitable. However, it is important to note that passive funds and “doing no harm” are not the same.
The notion that selecting active or passive funds will somehow reduce fiduciary risk is baseless and disregards the more important factors that ERISA fiduciaries should consider when choosing the most appropriate target date fund (TDF).
The authors also recommend that investment committees opt for passively managed TDFs as the default option. Although TDFs are generally a suitable choice, it is crucial to recognize that there is no such thing as a purely passively managed TDF.
All TDFs involve active decision-making on the part of the fund manager. Managers must decide which asset categories to include, select managers for those categories, determine the allocation of those categories for each age group, and manage how the allocation changes over time (i.e., the glidepath). These asset class selection and glidepath construction decisions are essential and unavoidable, regardless of whether active or passive underlying strategies are utilized within the TDF.
Indeed, glidepath and asset class selection have a much greater impact on investor outcomes than the choice between active, passive, or hybrid approaches.
Since a significant portion of new contributions to DC plans are being invested in TDFs and many plans have adopted TDFs as their default option, selecting the plan’s TDF is likely the most critical decision an investment committee will make. This decision should consider much more than just whether the TDF portfolios utilize active or passive strategies.
For example, a series of passively managed TDFs may carry too much risk at the wrong time, such as during retirement. This could result in significant losses for individuals who do not have enough time (or income) to recover. Bailey and Winkelmann focus on the perennial active vs. passive debate rather than addressing the most critical consideration for retirees: income replacement.
We strongly believe that taking into account participant demographics, such as salary levels, contribution rates, turnover rates, withdrawal patterns, and the presence of a defined benefit plan, can help the committee determine the most suitable TDF glidepath for participants to achieve their income replacement goals.
We also strongly emphasize our role in helping investors achieve their retirement and post-retirement goals and believe that the conclusion of simply choosing passive over active to minimize fiduciary risk is not aligned with ERISA standards or the outcomes desired by plan participants.
The demographics of the plan, the chosen glidepath, and asset class diversification are far more critical considerations than whether a TDF manager utilizes active or passive components.
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All articles represent the author’s opinion and should not be taken as investment advice. The views expressed do not necessarily reflect the opinions of CFA Institute or the author’s employer.
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