I welcome this “Retirement Insights” piece from J. P. Morgan Asset Management – as far as it goes. The piece makes several excellent points that can benefit all plan sponsors, but presents a view biased toward active management. No surprise. JP Morgan actively manages retirement plan investments – they have a point of view that ultimately promotes the company’s business and brand.
I’d like to take their excellent insights and expand them, adding what I believe is a more balanced approach to selecting small business 401k plan investments. All quotes are from the Retirement Insights piece.
“Target date fund managers should be hired based on how they mitigate risk and serve participants’ retirement investing needs, with fees considered in that context as part of a robust evaluation framework. When used as a qualified default investment alternative (QDIA), target date funds offer participants many investment benefits. Additionally, the significant differences in asset allocation, portfolio construction and glide path end dates all have implications for each strategy’s risk/reward characteristics and expected potential retirement outcomes. This makes it more complicated to review strategies, possibly leading some plan sponsors to latch onto fees because it is an aspect that is very easy to compare.”
They had me until the “latch onto fees” comment. In my mind, a “robust evaluation framework” should place a very high emphasis on fees, and investment managers should be evaluated on their ability to add value net of fees. Higher fees raise the bar for investment managers. Plan sponsors need to ask any plan vendor: What value will I get for my money, and how does it compare to other provider fee/service offerings?
For actively managed investments, the investment manager faces two benchmarks. First, managers need to be benchmarked on investment performance net of fees versus other active managers managing to the same investment mandate. Fees matter, but superior investment performance may trump fees. The lower cost provider may not always be the most prudent choice. This benchmark is appropriate for evaluating competing active managers, but does not address those managers’ ability to outperform indexed investments.
The second benchmark is how the active investment manager will perform net of fees against a passively managed portfolio with the same investment mandate. Benchmarking the passive investment is arithmetic, not latching onto fees. An investment manager charging 50 bps over the cost of a passive investment needs to demonstrate how that larger fee will produce value for participants. Further, that fee needs to be turned into actual dollar costs and evaluated on that basis. Let’s assume that we have $1mm in the plan. The 50 bp fee differential means that plan participants will be paying out $5,000 annually over the cost of the index alternative. What do they get for their $5,000? That’s a fair question that investment managers should be prepared to answer.
“Instead, costs should be viewed in the context of the value the target date fund provides to the plan and its participants. This value may be in added performance potential, a benefit that becomes clear when evaluating target date funds on a net return basis. It may also be in the form of a better general participant experience through more effective communications and/or other innovative services. ERISA safe harbor guidelines are very clear on this point: Fees must be reasonable in terms of the benefits and services the plan receives from a competitive pricing perspective. But remember, the most important consideration is whether the plan has a prudent, repeatable and documented process for evaluating its QDIA, of which target date funds remain the most popular option.”
I just disagree on this point. There is no reason that small 401k plan sponsors need to purchase investment management and participant education from same vendor. These services have been “bundled” by Wall Street to the everlasting regret of millions of plan participants. Make the hires separately – it could well be the same provider, but there is no reason it has to be. Am I paying extra to beat the market, or to get better participant services? So if the value is better educational services, why am I paying you to beat the market? Again, this question needs to be asked and answered.
“Plan sponsors primarily focused on cost may instinctively turn to passive, or “indexed,” strategies because they mistakenly think these are at less risk of underperforming their investment objectives. Whether active or passive, it is important to assess the performance of any strategy net of fees to determine its relative value in relation to cost. But one of the biggest misconceptions in the marketplace is this idea of an “indexed target date fund.” While a target date strategy may have indexed components, there is no such thing as an indexed glide path. All glide paths have been actively created by the manager, and each comes with unique risk/reward characteristics. This is true regardless of whether passively or actively managed underlying strategies are used in portfolio construction.”
This is the first time I have read that being a plan sponsor is “instinctive.” The author(s) use instinctive as a substitute for naïve. Properly researched, there is nothing naïve about choosing an index investment. Do I get value for the extra fees charged by active managers? Yes or no.
I do, however, totally agree on the comment regarding glide paths. All glide paths are actively chosen. Every participant needs to recognize how their portfolio will change over time – especially as they get nearer to retirement age. We need more clarity and transparency on glide paths, be they actively managed or indexed.
The remainder of the piece makes the case for active management in asset classes that are less efficient that US large cap equities. There is a case to be made for small cap stocks, certain bond markets and all emerging market equities. I have no problem with active management – especially in these less-researched markets. The math should win out and the benchmarking should be straightforward. Show me your fees and track record. I pay you X dollars and you provide me with the expectation of value added.
Here is my bottom line. Costs matter a lot. All plan vendors need to clearly demonstrate value regardless of service provided. Higher fees may not always be highest risk, but we need to realize that high cost providers are spotting the market a significant premium that must be overcome.