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When Do Index Funds Raise A Fiduciary Issue With 401k Plan Sponsors?

When Do Index Funds Raise A Fiduciary Issue With 401k Plan Sponsors?
February 25
00:03 2020

Recent news stories have told of outflows from active funds to passive funds, with index funds either nearly passing or already passed active funds in total market share. While individual investors are free to choose what ever investment they desire, 401k plan sponsors find themselves in a unique fiduciary position when it comes to approving plan investment menu options.

Without documented and consistently applied due diligence procedures, 401k plan sponsors may create a fiduciary liability that’s easily avoided. Even the omnipresent index fund fails to act as a risk-free panacea when it comes to due diligence. Here are several scenarios where index funds can raise a fiduciary issue.

Let’s start with the most obvious. Just because it’s an index fund doesn’t mean it can’t contain various conflict-of-interest fees. For example, several years ago in an interview with FiduciaryNews.com, Martin Smith, the producer of the PBS Frontline episode “The Retirement Gamble” explained his own company’s 401k plan (for which he serves as plan sponsor) contained an index funds with a 60 basis point expense raise (see “Exclusive Interview: Frontline Producer Explains Controversial 401k Documentary – The Final Take,” FiduciaryNews.com, May 3, 2013).

At the time, this was several multiples above the lowest expense ratio mutual funds which could have easily been placed in the plan. Because, unlike actively managed funds, index funds contain a passive portfolio, it is a greater challenge to justify an uncompetitive expense ratio since it can cause lower returns.

“The biggest fiduciary issue involving index funds is their potential deviation from the benchmark index due to higher fees and mismanagement, and therefore consistent underperformance relative to their benchmarks,” says Dimitry Farberov, Investment Adviser at Miracle Mile Advisors in Los Angeles, California.

Plan sponsors sometimes only offer funds from a single fund family. This is one reason why index funds can have higher expense ratios. “Only recommending funds from only one company does not necessarily give the client an accurate depiction of the fund universe,” says Gregory J. Kurinec of the Bentron Financial Group, Inc. in Downers Grove, Illinois.

But don’t fall for the claim that it’s only about a low expense ratio or even about have no conflict-of-interest fees. Kurinec says, “Just because an ETF or fund is ‘low cost’ does not mean that it is most appropriate fund.”

There are many factors that determine what retirement plan investment option reflects any particular retirement saver’s best interest. Expense ratios and fees are just two of them.

“Being required to put client best interest first means the investment must be appropriate for the client,” says Georgia Bruggeman, CEO at Meridian Financial Advisors, LLC in Holliston, Massachusetts. “As great as index funds are there are so many now that are esoteric and inappropriate for most people. Just because you are buying an index fund for a client does not mean it was the right thing to do for them. It is irrelevant that they are low cost and tax efficient if that allocation is not appropriate for the plan participant.”

 

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Investing in the equity market involves controlling behavioral impulses. Since an index represents an unadulterated exposure to undulating markets, any lack of investing discipline can lead to bad decisions.

“Many people think as long as they aren’t coming up on retirement there is no issue taking on full market risk. This is not the case as time goes on,” says Amit Chopra, Managing Partner at Forefront Wealth Planning and Asset Management in Ramsey, New Jersey. “We all face different scenarios that a large amount of capital which necessitates a reduction of risk as that scenario gets closer. From an emotional stand point most people have difficulty with the volatility of just riding the market waves, and steep drops tend to cause panic and a client to exit the market. The classic sell low and buy high scenario.”

Index funds may or may not be an appropriate investment for any individual 401k plan participant. In that respect, they present the same fiduciary issues as actively managed funds.

The 401k plan sponsor is well advised to recognize this.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary Solutions,  Hey! What’s My Number? How to Improve the Odds You Will Retire in ComfortFrom Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

1 Comment

  1. Lyle Himebaugh
    Lyle Himebaugh February 26, 10:35

    Excellent article, could not agree more. There are several sectors if indexed would cause harm to the participant. It’s not about price, it’s about process.

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