401k's Need More Prudent Experts

The following is a 2002 editorial by our president, Susan Lee Miller. We thought our subscribers and website visitors would find it interesting, and useful to give to their friends who still insist on the virtues of active management...

According to federal regulations, the trustee of your pension plan is required "to act with the care, skill, prudence and diligence under the prevailing circumstances that a prudent person acting in a like capacity and familiar with such matters would use." In the investment business, this is known as the "prudent expert" rule.

Broadly speaking, pension plans fall into two categories. Defined benefit plans pool all employees' retirement savings, and in return guarantee a certain level of retirement income. These savings are allocated to different asset classes, and investments within each asset class are generally managed by professional investment managers, under the supervision of the plan trustee. Defined benefit plans place quite a bit of risk on the shoulders of the companies that sponsor them. If their investment performance does not generate sufficient funds to pay the anticipated benefits to retirees, the company has to increase the size of the contributions it makes to the plan, which reduces the funds it has available to distribute to its shareholders, and/or invest in new projects. To reduce their risk, in recent years companies have replaced many defined benefit plans with defined contribution plans, such as 401k and 403b plans. These plans shift most of the risk onto the shoulders of the plan participants. Under a defined contribution plan, the company only guarantees that it will contribute a certain amount to the plan each year. It does not guarantee a minimum level of income to retirees, because under a defined contribution plan, employees themselves (rather than professional money managers) are responsible for deciding how to divide their retirement savings between a limited number of mutual funds chosen for their plan by its trustee.

The prudent expert rule implies that, when making their decisions, pension plan trustees should take into account the latest academic research findings in the area of investment management. In this regard, we note that over the past few years, more and more evidence has accumulated in support of two propositions: First, because of their higher expenses, very few active investment managers can deliver higher returns than those on the relevant market index fund over a holding period of ten years or more. Second, it is impossible to identify in advance the few active managers who will, due to luck or skill, actually end up "beating the market" in the future. This implies that a trustee acting as a "prudent expert" should focus on defining an asset allocation strategy that is appropriate to their plan's long term goals, and strongly consider the potential benefits of using low cost index mutual and exchange traded funds to implement it.

Fiduciaries of the top two hundred defined benefit plans in the U.S. (which manage almost three trillion dollars in assets) seem to agree with these findings. At the end of 2001, they had indexed in aggregate thirty percent of the assets for which they are responsible. Unfortunately, this was not the case at the top two hundred defined contribution plans, where only about eighteen percent of the assets held by plan participants had been invested in index products at the end of 2001. What accounts for this difference? Three possible explanations come to mind.

The first is that defined contribution plan participants are acting rationally: given their low levels of savings relative to their retirement income goals, they have no choice but to "swing for the fences" and hope that the active managers they entrust with their funds turn out to be the next Warren Buffets. The second explanation is that investors aren't acting rationally at all, and invest in active funds because they are overconfident about their ability to identify managers who will outperform index funds over the long term. The third explanation is that these plans' fiduciaries have either failed to provide participants with adequate information about the potential advantages of indexing, and/or have failed to include in their plans an adequate range of index funds.

Whatever the cause of the problem, defined contribution plan participants' heavy investment in actively managed funds will likely generate lower long term returns than equivalent investments in index funds. And we may all end up paying a very high price for this choice. In the not-to-distant future, many people approaching the expected end of their working lives will open their pension statements and realize that their assets are insufficient to provide the income they assumed they would have in their retirement years. Of course, it might turn out that these new retirees will just accept a lower standard of living, or perhaps find part time jobs. However, given the substantial voting power of disappointed Baby Boomers, we think these two outcomes are far less likely than a third one: calls for higher Social Security benefits, and the higher taxes (or spending cuts) that will be needed to pay for them. In short, while the heavy use of actively managed funds in defined contribution plans has been very profitable for the mutual fund industry, it may end up being very expensive for the rest of us.

If you found this article to be useful and informative, more is available every month along with all of our archives back to 1997. We hope you subscribe today. Six monthly issues cost $29.50 US and a year subscription of The Index Investor is only U.S. $59.

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