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Index Funds in Retirement Plans

I just read an article that suggested that a large number of retirement plans have replaced their actively managed funds with index funds for the following reasons:

  • Better Fiduciary Compliance

  • Less Litigation Risk

  • No More Bad Performing Funds

  • The End of Fund Changes

Before I comment, let me give a little perspective, almost all (if not all) of the plans we provide investment advice to has at least one index fund. And almost all (if not all) of the plans we provide investment advice to has at least one actively managed fund.  We believe in both active and passive investing.   So from here let me provide you some insight into whether just offering index funds will help achieve the above objectives.

Better Fiduciary Compliance:

The idea suggested here is that you can achieve better fiduciary compliance if you select index funds because they are low cost.  Just because a fund is an index fund, does not make it low cost.  In a study we conducted on January 2, 2014, the Morningstar database had 83 Index Mutual Funds with the name of S&P 500.  20% of these funds had an expense ratio of over 1.00%, 35% had and expense ratio of 0.50% – 0.99%, and only 6% of those funds had an expense ratio less than 0.10%.  One of those funds had an expense ratio of 2.28%.

Just because it is an index fund does not make it less expensive.  There is still due diligence to conduct in selecting the cost structure.

Less Litigation Risk:

I am not sure this is true, and it may even be more litigation risk.

  1. Let’s say you picked an index fund and you were smart enough to pick one several years ago when the lowest cost index was 0.18% (this was the case for many investors). Today you can get the same fund, from the same fund family for 0.04%.  If you did not change from the 0.18% fund to the lower cost fund, I would think that a litigator could easily argue that you were overpaying 0.14% for the index fund (since the funds are investing in exactly the same stocks). Over the last five years, we have changed index fund families at least three times because of “Index Fund Cost Wars”, so it does not necessarily get you off the hook for “I have an Index Fund so it must be the lowest cost”.

  2. Cost is not the only thing to consider in an index fund. Just because a fund is an index fund it does not mean that its performance will be the index minus cost.  There is this item we will call tracking error.  The index is a static vehicle (except every so often when the index is reconstituted) and the nuances of investors / cash flow is not a problem. In the real world managers have to deal with money coming in and going out of the funds and depending on how a manager handles the cash flow it can affect performance in a significant way.From a cost point of view, picking an index fund is no different than picking an active fund.  You need to have a prudent process to select and monitor this option in the future.

No More Bad Performing Funds:

Humor me here.  All of the following funds are large-cap blend funds.  Which of the following funds is the index fund?

Fund          Average Annual 5 Year Return (12/31/2014)

Fund A          21.40% (PXTIX)

Fund B          17.04% (VADDX)

Fund C          15.36%(FUSEX)

Ah – Trick question, they all are index funds.  In my experience, the most common index fund in retirement plans is an Index that tracks the S&P 500 Index.  Fund B and C are S&P 500 Index funds.  Fund C is market cap weighted and Fund B is equally weighted.  Fund C (Market Cap Weighted) is the one that we see as the most popular type of index fund in plans.  Fund A is a fundamentally weighted index fund.  Let’s just look at if you invested $10,000,000 in each of these funds 5 years ago:

Fund A          $26,368,986

Fund B          $21,961,983

Fund C          $20,430,370

So the most common index fund underperformed the other index funds.  Again, just because you have an index fund does not mean that it is going to get better performance.  There are a number of different types of indexes to select among.  Each are constructed in a different manner and could perform differently in different types of markets.

The End of Fund Changes:

If you are fulfilling your fiduciary role, I doubt you will “never have a fund change”.  As we stated before, we have changed our index funds several times over the past five years due to cost savings for participants.  And second, who is to say that the index to invest in today is the index to invest in in the future.  Times change, innovate occurs and organizations can change.  All of these could impact your decision to index your funds.

Consider these two examples:

  • Several years ago, a major player in the index fund business decided to change the underlying index that several of their funds use to a different type of index with and index fund organization developed out of graduate business school. The manager just announced the change and changed their fund.

  • We had a client that used a bond index fund that was targeted to match the Barclays Aggregate Bond Index. They had a low cost fund that had performed well over time. We were watching the performance and noticed that the fund had performance that was several basis points above and below the actual index performance.  The difference was greater than the cost.  This gap kept getting bigger.  We ended up changing the fund for the client.  Within several months the fund had suffered considerable underperformance against the benchmark.  The underperformance happened during the 2008 financial crisis and we discovered that the manager was taking additional risk investing in riskier bonds.

Index funds are good. Actively managed funds are good.

At the end of the day:

  1. The process to select funds to offer participants is the exact same, and

  2. The due diligence to continue to monitor the fund is the exact same.

First of all if you read this whole article, congratulations you are a diligent fiduciary.  Keep up the good work.  What you do helps many people have better tomorrows.

Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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