Research and Regulatory Changes Drive Greater Use of Passive Investing in 401k Plans

a new era for 401k plans Gary Droz, Managing Director, MainLine Private Wealth

MainLine P R I V A T E

W E A L T H

Summary

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eginning in 2012, when new disclosure requirements for defined contribution plans took effect, 401k plan sponsors faced increasing pressure to fulfill their fiduciary responsibilities to provide plan participants with prudently selected investment fund choices while minimizing administrative expenses. Combined with recent

… active portfolio management can actually compromise fund performance, resulting in substantial shortfalls from its pertinent benchmarks.

academic research showing that actively managed funds within an investment portfolio contribute little additional return relative to their passively managed counterparts, these disclosures are creating a new investment climate that suggests that ETFs (Exchange Traded Funds) should play a more important role in 401k plans. This style of ‘passive investing’, rather than traditional active professional portfolio management, is already being employed by the world’s largest pension and institutional fund managers, but as of yet has failed to make substantial inroads into the retail 401k arena. Further, the new regulations that require disclosure of all service and investment related fees to plan sponsors and plan participants will place additional pressure on plan sponsors to reduce these fees. An 8-step process to integrate passive strategies into 401k plans in order to create specific portfolio allocations, reduce performance tracking error, and minimize fees is provided.

Why Mutual Funds Perform Badly Current Research Findings on What Creates Performance Recent research has shed considerable light on the factors contributing to the performance of investment strategies. The academic conclusion, contrary to the way most retail investors view good investment strategies, is that active portfolio management (investment selection) has very little impact on the performance. Ibbotson, Xiong, Idzorek, and Chen, four of the leading academics in field of asset allocation, have found that, of the three contributing factors to success (market return, asset allocation policy return in excess of market return and return from active portfolio management), “…taken together, market return and asset allocation policy... dominate active portfolio management.”i

Implications of Research Findings The implication of these findings is that market movements and the allocation of the strategies will be far more important in determining the ultimate performance of any individual 401k account than who is making investment selections or their process for making those market selections. Most performance variance between different investment products is driven by market movement alone. In fact, active portfolio management can actually compromise fund performance, resulting in substantial shortfalls from its pertinent benchmarks.

This report is not intended as investment advice and should not be construed as the giving of investment advice. MainLine Private Wealth provides investment advisory services only through advisory contracts with its clients.

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Tracking Error: The Enemy of Wealth Growth What is Tracking Error? The performance of a mutual fund is generally measured against a pertinent benchmark, such as an established market index. When the mutual fund does not perform as well as the pertinent index, it demonstrates tracking error. Tracking Error: The deviation of an investment security’s return from its benchmark index.

– Morningstar Methodology Paper, December 31, 2010

... on both a 3 and 5 year basis, most active funds underperform their benchmarks in all categories.

Although there are instances where actively managed mutual funds produce better performance than their respective benchmarks (positive tracking error), these are unfortunately the distinct minority of the universe of mutual funds. Most publicly traded, actively managed mutual funds, when properly benchmarked, demonstrate a deficit in relation to the performance of their style-blended benchmarksii, which produces negative tracking error. In fact, the Mid-year 2011 edition of Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA®) reports that on both a 3 and 5 year basis, most active funds underperform their benchmarks in all categories.

The Problem and Cause of Tracking Error Over time, tracking error will substantially inhibit the growth of a 401k account. It is not unusual for a mutual fund to demonstrate a -1.0 – 5.0% tracking error from its benchmark, which, when compounded over the life of a 401k account of 25 to 40 years, can deplete the account’s final value by as much as 50 or 60%. For larger 401k accounts this can literally mean hundreds of thousands of dollars. Tracking error results principally from two characteristics of active portfolio management: •

High Fund Expenses. Active management incurs fees. If the expense structure of a fund is 1.0% to 1.5% the likelihood that the manager can make up for that expense over the index, particularly in the large capitalization space, is low, compromising the fund’s performance from the very beginning.

• Poor Investment Selection. Many active managers of mutual funds have simply not proven capable of adding value through investment selection. The combination of high expenses and poor investment selection can produce tracking error at a 2.0% - 5.0% level.

The chart shows the impact of tracking error on a typical 401k account

ASSUMPTIONS: Participant Beginning Age: 45 Beginning Balance: $250,000 Maximum annual contribution of $16,500 to age 50, then $22,000 No distributions and all interest and dividends reinvested

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Addressing The Tracking Error Problem Asset Allocation Issues Because of tracking error in actively managed mutual fund portfolios, the most dependable way to succeed at investing is to develop a diversified asset class and style-based asset allocation that does not require active portfolio management. Creating this type of investment portfolio involves two key sets of decisions: asset class and asset style. • Asset Class. The most important issue in allocation is how to segment a portfolio by asset class such as stocks, bonds, cash, commodities, real estate and private equities. • Asset Style. The second decision is how to segment a portfolio by asset style. For example, domestic equities might be divided into large cap growth, large cap value, small cap growth, and small cap value. If those decisions are made in a thoughtful way after understanding the participant’s goals and objectives, active management is simply not necessary to achieve performance benchmarks, except for annual “rebalancing” to ensure that each category is properly capitalized. This is the process that many large institutional investors and non-profits have been implementing for decades.

It is not unusual for a mutual fund to demonstrate a -1.0 – 5.0% tracking error from its benchmark, which, when compounded over the life of a 401k account of 25 to 40 years, can deplete the account’s final value by as much as 50 or 60%.

By carefully constructing portfolios that are both risk-based and asset allocated, volatility can be more effectively managed. Volatility, unlike performance, can be dependably predicted. The historical volatility as measured by the standard deviation of asset classes and styles of a particular combination of indices remains historically consistent. If the allocation minimizes tracking error, the unpredictable volatility can be dramatically reduced.

How Passive Investing in ETFs Leads to Successful Allocation Because asset allocation and market movements are the major determinants of investment success, index-based ETFs can provide greater assurance that benchmarks will be achieved. By ‘owning’ those benchmarks, investors can effectively reduce or eliminate tracking error from a portfolio’s benchmark goals, minimizing tracking error to under 75 basis points (in some cases almost down to zero), and creating a consistent pattern of increased performance over a similar allocation in an actively managed fund. ETF investment strategies are preferable to actively managed mutual funds for a number of reasons: • Better Performance. Given the same allocation of well-chosen actively managed portfolios, passive strategies usually outperform those actively managed funds. •

Class and Style Purity. Passive strategies that employ indexing ensure asset class and style purity because one is simply investing in the indices, whereas actively managed funds shift investment styles and, as a result, the targets in the asset allocation break down very quickly. This change in styles creates unmanaged risk and unpredictable performance.

• Simplicity. ETFs make the allocation and investment choices simpler for the average 401k participant to understand. • Easier Benchmarking. ETFs make benchmarking easier because certain ETFs represent the benchmark.

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Why Haven’t ETFs Been Used In 401k Programs From The Beginning?

With advances in technology smaller recordkeepers can now afford the technology, platforms to provide fully featured interactive and web based technology at affordable prices.

This “passive investing” technique was developed and has been utilized by the largest institutional investors for over 30 years. Because of the administrative complexity, this strategy has not been possible to implement with smaller portfolios and particularly individual 401k accounts, so this strategy has not been readily available to smaller investors. For example, Blackrock, Inc. and State Street Global Advisors, the two largest managers for large pension plans and non-profits (Ranked #1 and #2 by Pensions and Investments May 30, 2011) use passive investing for 77% and 97.5% of the respective assets that they manage, representing over $500 billion of large institutional investors’ assets. Now, improved management technology has made it possible for this strategy to be employed by small-to-midsized investors and plan sponsors. Here are some of the conditions that prevented a passive 401k model from being employed: •

ETFs are a Young Retail Investment Vehicle. Only in the last few years has the necessary diversity of index-based ETFs been available for effective ‘passive’ allocation. Barclays Global and its iShare brand started the popularization of ETFs in the early 2000s, but only in the last few years have ETF offerings been widely available.

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No Bundled Fees. Because there is no hidden compensation such as 12b-1 and shareholder service fees, ETFs were not promoted by the financial service industry as they are not profitable for fund managers. Bundled fees in 401k programs are in part what drove the industry.

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Lack of Open Architecture. The technology costs of fully featured recordkeeping platforms kept smaller open architecture recordkeepers and Third Party Administrators (TPAs) out of the picture. Only the large mutual fund and financial service companies had the resources to provide those platforms. Many of them had “product” agendas that kept them from truly open architecture. With advances in technology, smaller record- keepers can now afford the technology platforms to provide fully featured interactive and web-based technology at affordable prices. Trading Complexity. Because ETFs trade like stocks and not mutual funds, the trading and custodial services are far more complicated than mutual funds which are priced at 4:00 PM EST for everyone who purchased them at anytime during the day. ETFs trade minute by minute and the issues of partial shares are very difficult to reconcile for the small lots created by 401k trading. There are still just a handful of custodians that can accommodate custody of 401k accounts that trade ETFs.

The Role of Actively Managed Mutual Funds Although a strong case can be made for including only ETFs and indexed mutual funds, limiting the 401k participant’s choice to only passive strategies runs counter to good 401k investment selection planning. One of the tenets of good 401k planning and implementation is choice. The participants should be able to make informed choices and not be limited to only one style of investing. As will become apparent below, the plan fiduciary has a legal responsibility to be knowledgeable about investing and should always put the success of the participants first. Limiting participant choice will only create pushback from the participants. The actively managed mutual fund selection process, however, needs to be thoughtful and annually reviewed to determine if potential tracking error and style-shifting has occurred. The replacement of underperforming mutual funds is critical to a successful plan implementation.

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Regulatory Changes Impacting 401Ks The 401k industry is currently contending with the impact of the changes experienced by plan sponsors as a result of the new regulations promulgated in ERISA 404 and 408(b)(2). Plan sponsors have a host of new responsibilities as a result of these regulations. When coupling the new disclosure requirements with the previously promulgated fiduciary rules (§404), it is clear that significantly more pressure has been placed on plan sponsors to take their investment focused fiduciary responsibilities more seriously. When looking at the new disclosure requirements in combination with the current case law, many plan fiduciaries will need to rethink the process of implementing their investment responsibilities to their 401k plans.

When looking at the new disclosure requirements in combination with the current case law, many plan fiduciaries will need to rethink the process of creating and implementing their investment responsibilities to their 401k plans.

ERISA §404 Fiduciary Responsibility to Plan Participants The Fiduciary Standards of ERISA Section 404. A fiduciary is expected to apply the prudent maniii standard of care when choosing and managing investment selections in the 401k plan. The role of plan fiduciaries includes providing benefits for the participants while defraying reasonable expenses of administration to the plan.iv More specifically, §404(a) delineates one of the fiduciary responsibilities as “minimiz[ing] the risk of large losses.”v In addition, ERISA requires that the fiduciary must know the role of each investment choice and understand each investment choice’s opportunity for gain or loss in that investment. The fiduciary must also provide diversity within the portfolio. vi

Responsibilities of Plan Sponsors Even under the previously promulgated fiduciary rules, the plan sponsor is required to understand investments to the extent that they can make prudent choices. In July of 2010, in an important fiduciary breach lawsuit (Tibble v Edison International), the plan participants sued the plan fiduciary. Judge Wilson clarified the investment responsibilities of plan fiduciaries in his opinion: “A fiduciary may secure independent advice from counsel or a financial advisor when making investment decisions and indeed must do so when he lacks the requisite education, experience and skill.” It is clear from analyzing the old fiduciary rules and the current case law, that fiduciaries have always had the responsibility of providing a high level of skill and expertise in the investment decisions as they relate to the plan’s fund choices.

The New Mandatory Disclosure Requirements For All Defined Contribution Plans Together, these traditional fiduciary responsibilities and the new disclosure requirements highlight potential fiduciary breaches in an entirely different way, empowering the plan participants with a knowledge base, as never before. There are two basic sets of disclosures.

Investment Related Disclosures There are three key investment related disclosures that must be in statements for every investment choice: • Historical Returns. Every investment choice for each quarter must show the 1, 5 and 10 year returns for that investment choice. • Benchmark. A“pertinent benchmark” must be shown alongside that performance on a 1, 5 and 10 year basis. • Fees. All fees and expenses for each fund need to be shown next to that fund every quarter. 6

The Department of Labor (DOL) even recommends the “spreadsheet style” format that plan sponsors should use to disclose these expenses and performance metrics.

Service Provider and Conflict of Interest Disclosures In addition, a number of disclosures relating to service providers and conflicts have to be made at both the inception of the plan and annually, including: • Unbundling. The DOL requires that covered service providers unbundle and disclose to each plan sponsor the expenses of the service provider broken out separately by service performed. • Conflicts. The plan sponsor must disclose any conflicts of interest for any of the service providers. • Participant Account Review. Unbundled expenses must be aggregated and reported to each plan participant for each investment option, both in terms of per $1,000 invested as well as reflected as a percentage of his or her account. Every defined contribution plan starting in July of 2012 was required to have this level of detail describing the expenses and performance of each part of the retirement plan. These disclosures created a difficult transition for recordkeepers and TPAs, but all must provide this information annually.

By requiring the new disclosures, the plan participants have a new yardstick to measure the effectiveness of their investment choices.

Potential Impact of the New Disclosures Coupled with the Fiduciary Rules Combining the previously promulgated fiduciary investment responsibilities with the requirement for these new disclosures has created a far more educated participant base. For example, if a fund consistently underperforms its benchmark or fund choices end up with market expenses over other analogous 401k choices, the participants will at some point begin to demand that the plan sponsor replace that fund. The fiduciary will need to analyze investment choices differently from how it had done so previously. It is clear that the DOL wants to change the behavior of plan sponsors/fiduciaries. By requiring the new disclosures, the plan participants have a new yardstick to measure the effectiveness of their investment choices. The performance efficiencies of the investment choices have become obvious when displayed next to the relative benchmarks. The expenses of each choice reinforce the sponsor’s responsibility to provide for the reduction of unnecessary expenses which create tracking error and in the end, smaller retirement accounts for all of the participants. Advice from the DOL on how to react to this new environment is clear from its “Meeting Your Fiduciary Responsibilities” publication disseminated in October 2010. “More and more employers are offering participants help so that they can make informed investment decisions. Employers may decide to hire an investment advisor offering specific investment advice to participants. These advisors are fiduciaries and have a responsibility to the plan participants.” Participant education and involvement is an effective way to avoid claims of fiduciary breach. While it has always been the plan sponsor’s responsibility to act as the fiduciary, the DOL is attempting to empower the participants in 401k plans to take more of that responsibility by making more educated choices. However, the plan fiduciaries must take the entire investment selection process much more seriously under these guidelines. The analysis of the investment choices going into a plan, as well as well as the ongoing monitoring of fund performance and expenses, is going to become a much higher priority with the new disclosure requirements. It is clear that if the plan sponsor is not specifically qualified to perform such analyses and evaluate performance and expenses, it should seek outside expertise and document a process by which those responsibilities have been met.

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8 Steps To a New Era 401k Investment Success With Fiduciary Compliance These are the 8 steps to constructing an effective 401k plan to ensure investment success and fiduciary compliance: 1. Unbundled Solution. An unbundled solution allows plan sponsors to obtain competitive pricing from all service providers. 2.

Open Architecture 401k Recordkeeper. By using an open architecture recordkeeper the plan will be able to not only offer ETFs and indexed mutual funds in the 401k plan, but any other publicly traded mutual fund that is determined to be appropriate for the plan. Make sure the recordkeeper/TPA is fully compliant with the new DOL regulations as well as all other ERISA compliance responsibilities.

3. Process. Create a process that engages the plan participants. Form a participant advisory committee that is involved in the approval of plan investment choices as well as an ongoing process of approving appropriate replacements. 4. Passive Fund Choices. Include enough ETFs or indexed mutual funds so that carefully considered asset allocation models can be constructed out of passive choices only, thereby creating allocation purity and very little tracking error. 5. Active Managed Fund Selection. In choosing actively managed mutual funds, choose funds that have low expenses and low tracking error over a 1, 5 and 10 year basis. 6. Periodic Allocation Review. All mutual funds must be subject to an annual review determining potential tracking error or significant style shift. Don’t be afraid to replace a manager who performs poorly relative to the benchmarks. 7.

Education of Participants. Participants should be educated about the fund choices and model portfolios in the 401k plan either through live group sessions or e-group sessions. Part of this education should be to explain a process that is easily understandable to participants on how to make fund choices. The fund should have pre-built models, the choice of which should be driven by a risk profiling process. If a 401k participant would like to analyze the funds and construct his or her own asset allocation, that would be ideal, but for those who do not want to take the time to do that, risk profiling and prepacked models rebalanced at least annually create a far better approach than what is typically used.

8. Outside Assistance. If the fiduciary is not qualified to make investment judgments he or she should seek outside assistance from a qualified and registered investment advisor.

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i Xiong, Ibbotson, Idzorek, Chen; March/April 2010 Financial Analysts Journal ii A blended benchmark is used to measure the relative performance of the entire portfolio against a blend of indices. To take a simple

example, if an investor's assets are allocated 70% to stocks and 30% to bonds, the portfolio's performance would be measured against a blended benchmark consisting of 70% in a stock index, and 30% in a bond index. iii The prudent man rule directs trustees "to observe how persons of prudence, discretion and intelligence manage their own affairs, not in

regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested." iv ERISA §404(a)(1)(A) v ERISA §404(a)(1)(C) vi 29 CFR 2550. 404A-1(b)