When Choosing Passive or Active Funds, Consider the End Result

Data shows passive U.S. equity assets have passed active U.S. equity assets, but there are pros for each and retirement plan sponsors should have the right goal in mind when making a decision.

Preliminary numbers show that passive U.S. equity assets passed active U.S. equity assets by about $25 billion, according to Morningstar’s August Fund Flows report. At the time of publication, it was still waiting for 70 or so funds to report their total net assets as of month-end.

If this result holds, passive’s share of U.S. equity open-end and exchange-traded fund (ETF) assets would be 50.15% versus 49.85% for active funds. Morningstar says this milestone has been a long time coming as the trend toward low-cost fund investing has gained momentum.

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Active U.S. equity funds have had outflows every year since 2006, with roughly equivalent inflows into passive funds during that time. Over the past 10 years, active U.S. equity funds have had $1.3 trillion in outflows and their passive counterparts nearly $1.4 trillion in inflows.

Nick Nefouse, head of DC investment strategy and co-head of LifePath at BlackRock in NYC says, “Many plan sponsors are saying now they want to own an index. It gives transparency into what they own. If an investment benchmarks the Russell 2000, it’s pretty straightforward what participants are getting. Explaining underperformance of active funds is difficult; explaining it for passive funds is easier.”

But, Steve Deschenes, research and development director of Capital Group in Los Angeles, says the fact that index funds expose participants to the full brunt of market downturns is important to emphasize. This characteristic, he says, can make what should be a “safe” investment an “enormously risky one.” According to Deschenes, “Strong active managers can provide less volatility and a smoother ride.”

Nefouse agrees that plan sponsors are paying active managers to smooth out volatility, but he says some plan sponsors are moving to passive investments because an active manager may not be able to perform so consistently over time.

Capital Group has done a lot of research over five or six years about what works in active management and selecting active managers, Deschenes says. If plan sponsors choose a low-cost active manager, it will perform better. In addition, manager ownership in their funds has been proven to produce value over and above the fees it’s charging.

Deschenes also points to research from Capital Group that looked at 60-year case studies and analyzed how participants fared using an index strategy versus using Capital Group’s active funds. The study covered 20 years of retirement plan participation, 20 years of transition and 20 years in retirement. “Our funds resulted in $120,000 per year in retirement income versus $85,000 from using an index strategy—even if a participant had a higher lifestyle and more withdrawals. Our funds also resulted in $2.5 million in ending wealth at age 85 versus $1.5 million using an index strategy,” he says.

On the passive side, Nefouse points out that if a client wants a lower volatility portfolio, BlackRock can build an index that provides that. He adds that fund performance comes up a lot in conversations. “Comparing our indexes to other active manager strategies, we are line.”

The Bottom Line

The active versus passive debate has been going on for decades and will continue. However, Deschenes and Nefouse both agree that investor outcome is the important factor when deciding which funds to offer retirement plan participants.

“Neither active nor passive is monolithic; no one provides all passive or all active investments,” Deschenes says. “Good plan sponsors that have developed an investment policy statement (IPS) are looking for things that are proven, things that consistently add value and things that can improve participant outcomes.”

He points out that in the Employee Retirement Income Security Act (ERISA) and related guidance, nothing says plan sponsors have to always choose the lowest-cost funds; it says fees should be reasonable. “Fees must be taken in context with the value created for participants,” Deschenes says.

Nefouse says plan sponsors should look at client outcome, transparency and value for service. “If a fund can offer the desired outcome, with transparency and at a lower cost, plan sponsors should choose it. Start with the desired outcome then weigh active versus passive choices,” he says.

The investment conversation within the industry has been “myopically focused on fees,” according to Deschenes. “Fees are important, and investors should seek out low-cost funds if they help their chances of achieving greater than average outcomes. And those outcomes—sending a child to college, having a secure retirement—are actually what people care about,” he concludes.

Unwrapping Compliance on Gift-Giving and Donations

Whether it’s World Series tickets or a luncheon, are these gifts compliant with government and company rules concerning retirement plan sponsors and providers?

Compliance matters for retirement plan sponsors don’t stop at excessive investment fees or poorly performing funds, they extend to rules on gifts and donations, too.

Questions concerning gifts and donations among plan sponsors and providers is often a murky subject, filled with open-ended queries both parties must fully understand themselves. What constitutes a gift? What appropriate spending or price limits can employers and providers offer, and what rules are to be understood prior to gifting or donating?

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Stephen Rosenberg, partner at Wagner Law Group, streamlines these questions into one answer: the act of gift giving, donations or contributions cannot signal favoritism or include conflicts of interest.

“You can have lunch with [clients or firms], but you really can’t allow it to look like any linkage,” he clarifies. “You have to ask yourself, would you be embarrassed if this showed up in the front-page tomorrow morning?”

In the plan sponsor space, conflicts with gift giving and donations generally occur when employers are selecting providers, says Rosenberg. “Plan sponsors have to think of various vendors for the plan prudently,” he says. “It can’t be based on gifts or anything that has the appearance of gifts.” Should employers select vendors based on this conflict of interest, they’re breaching their fiduciary duties and run the risk of a lawsuit.

For those in the vendor capacity—recordkeepers and registered financial advisers—the Securities and Exchange Commission (SEC) and FINRA have implemented stricter regulations on both giving and receiving. The SEC’s Compliance Program Rule for one, requires firms to implement written policies and procedures reasonably designed to prevent violations to the Advisers Act, says Jack Rader, partner at ACA Compliance Group.

“Under this rule, firms will adopt a policy outlining restrictions and also imposing certain guidelines on employees,” he adds. “In many cases this involves reporting and pre-clearing gifts and entertainment.”

Providers must check in with their compliance department prior to gift-giving, in order to pre-clear any entertainment or donations, whether that includes season tickets to a sports game or holiday gifts.

Gifts to and from advisers

Additionally, many financial firm policies will restrict or require disclosures on offering or receiving gifts. Before an adviser can give or take a gift, he will have to report it to the firm’s compliance department to ensure it is reported and approved. Broker/dealers are dealt with specific, stricter requirements regarding pay-to-play restrictions that impact services to government entities, says Francois Cooke, managing director at ACA Compliance Group. Pay-to-play is the act of exchanging money or monetary goods for services. Under FINRA 2030, investment advisers are prohibited from providing investment advice to government entities for two years after the firm, or a covered associate, make a contribution to that entity.

“This becomes more serious under the topic of pay-to-play, which limits the amount of money that a financial adviser can contribute to a government official or political party,” Cooke says.

When it comes down to specific prices, under FINRA 3220, advisers cannot accept or offer gifts exceeding a set $100 limit. The rule states, “No member or person associated with a member shall, directly or indirectly, give or permit to be given anything of value, including gratuities, in excess of one hundred dollars per individual per year to any person, principal, proprietor, employee, agent or representative of another person where such payment or gratuity is in relation to the business of the employer of the recipient of the payment or gratuity. A gift of any kind is considered a gratuity.”

Should advisers receive or provide gifts surpassing $100, they may have to return it, says Cooke. Similar to employers, violating these rules opens advisers to ERISA [Employee Retirement Income Security Act] lawsuits, deficiency letters, or even fines.

“Risks may include anything from a deficiency letter, to not being able to offer certain types of products and services, to being fined,” says Cooke. “In terms of fines, you’re talking about anywhere between $5,000, to $20,000, to $40,000.”

Punishments and lawsuits send a message

Several lawsuits surrounding pay-to-play and gift-giving in the past years have seen firms harshening their stances on contributing and receiving. Navnoor Kang from the New York State Common Retirement Fund is currently serving 21 months in prison for fraud charges involving a pay-to-play scheme. Earlier in the year, Fidelity faced a third lawsuit alleging the company collected “secret kickback payments” from mutual fund providers on its recordkeeping platform. In September, Fidelity was involved in another ERISA lawsuit for allegedly donating millions of dollars to the Massachusetts Institute of Technology (MIT), after the university allegedly allowed the firm to offer high-fee investment funds in the retirement plan.

Now, more firms are moving towards a restrictive approach, say Rader and Cooke. “This has resulted in firms being more conservative,” says Cooke.

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