Active funds are a potential hazard in 401(k)s, guidebook for sponsors says

A comprehensive new guide for 401(k) sponsors advises employers to beware of actively managed funds.

The online book, published last week by the CFA Institute Research Foundation, outlines a retirement plan sponsor’s many duties and considerations, ranging from hiring an investment fiduciary to financial wellness programs and retirement income options. Its 176 pages “focus on the basic features of a well-run [defined-contribution] plan” for 401(k) sponsors and employers who want to start plans. The guide is authored by Jeffery Bailey, a senior finance lecturer at the University of Minnesota and former senior director of benefits at Target Corporation; as well as Kurt Winkelmann, CEO of quant investment research firm Navega Strategies.

“Our intent is to spark further interest on your part, resulting in you doing additional research and ultimately making better decisions,” the authors wrote. “The plan sponsor has responsibility for providing an efficient and cost-effective vehicle for retirement wealth accumulation.”

That responsibility has much liability attached to it, largely visible through private litigation that has exploded in recent years, with much focus on lawsuits being on administrative and investment management fees.

Guidance on investment selection is needed, as most decision-makers at DC plans have little to no background in the area and could be unaware of the extent of their fiduciary responsibilities, the authors noted. That is particularly true of small employers, which represent the biggest percentage of plan sponsors, they noted.

Sponsors often hand off at least some fiduciary liability to advisers, although employers always carry the duty of selecting and monitoring those professionals.

“Investment committees should follow a basic principle: Participants must be provided with and encouraged to hold investment options that will not all simultaneously fail in adverse environments but that are also suitable for their stage in life and risk tolerance,” the book stated.

Litigation filed against plan sponsors has focused on three areas: expenses, investment options and alleged conflicts of interest. Expenses represent the biggest proportion of claims by far, and such lawsuits have focused on “bundled service arrangements in which cross-subsidies result in the plan paying fees that were greater” and those with costs “that are simply more than other plans are paying for similar services,” the authors wrote.

As the Department of Labor has clarified, sponsors and other fiduciaries have a duty to show that expenses charged to participants are reasonable, not necessarily the lowest cost available. Arrangements that make it difficult to ascertain how much a record keeper is being paid, such as when revenue sharing within mutual fund fees is used to pay administrative costs, can raise questions, the report noted.

“[M]any [employers] have tightened up their expense oversight and become more aggressive about making periodic checks on the types and levels of fees paid to servicers,” the authors stated. “A sponsor should have a clear rationale for selecting a service with a higher fee than similar offerings, however, and the sponsor should thoroughly document those reasons.”

Regarding investment selection, they steer readers away from active management, although they do not recommend against it entirely. Data showing a small overall percentage of active U.S. equity managers that were in the top quartile by performance for three consecutive years, roughly less than 10% between 2003 and 2015, show the difficulty of identifying skill in a manager, they said.

“An investment committee’s first responsibility is to do no harm,” they said. If a committee is weighing the possibility of including active funds on a plan menu, they should consider whether fees are lower for passive funds, according to the report. Active funds could require more monitoring, it notes. Active managers should be hired only if they can add value after fees, if successful ones can be identified and if the investment committee is willing to educate participants about how to use such funds, the authors stated.

“With these points in mind, we believe that sponsors should adopt passively managed funds as the default choice for their plans,” they noted. “Absent a strong belief that actively managed investment options are of value to plan participants, sponsors should make available only passively managed options.”

A spokesperson for the CFA Institute said in a statement that the content of the report does not represent the views of the organization, the research foundation or the publication's editorial staff.

Editor's note: The story has been updated to mention the statement from the CFA Institute.