Should 401(k) plans offer only index funds?

A number of retirement plan experts believe that 401(k) plan participants should only be allowed to invest in index funds. They say the additional cost that participants pay for actively managed mutual funds is not justified by better performance. Some 401(k) plan sponsors have agreed, offering only index funds in their fund line-ups. Is that a good idea?

Here are arguments for using only index funds:

Less volatility. There is no question that an index-fund-only line-up will be less volatile than a line-up that includes actively managed funds. Generally, less volatile funds are better for 401(k) plan participants, who tend to get emotional when markets are volatile, often selling at market bottoms and buying at market tops.

Lower litigation risk. Because index funds are the lowest cost alternative for any asset class, some experts believe that 401(k) plan sponsors are less likely to get sued by offering them. Given that the majority of lawsuits against plan sponsors have arisen because higher-cost fund options were offered when lower-cost share classes were available, this is probably a valid argument.

In addition, some commentators believe that litigation risk is further reduced when offering an index-fund-only line-up, since this approach eliminates the risk of being sued because a fund is an extremely poor performer relative to its index.

Elimination of adviser conflicts. It would seem that offering an index-fund-only line-up would make it impossible for those advisers working for banks, brokerage firms and insurance companies (who are not fiduciaries) to recommend funds that aren't in participants’ best interests. Since these advisers work for their employers first, and probably themselves second, client interests generally come in third place. Offering an index-fund-only line-up would make it impossible for these conflicted advisers to recommend funds that pay them high commissions or soft dollar payments.

No more poorly performing funds. Index funds will always deliver average market performance. An index-only menu would appear to forever eliminate the risk of offering a bad-performing, or below-average, investment fund.

Simplicity. Many participants have a hard time understanding the goals and objectives of some of the investment funds in their plans. They may have an easier time understanding that a mid-cap index fund mimics a mid-cap index rather than trying to distinguish between mid-cap growth, value and blended funds.

The end of fund changes. If you offer a fund line-up composed of index funds only, will you ever have to make a change to your fund line-up? Maybe not. Many plan sponsors view this as simplification of their plan administration process.

Better performance. We all have seen the data showing that passive management has beaten active for many years. There may be enough data available to conclude that for some asset classes, it is better to choose a passive or indexed approach.

Closet indexers. Unfortunately, there are too many actively managed mutual funds that chart their index way too closely and are in reality index funds charging actively managed fees. These funds (and fund managers) have given active management a bad name and are the primary reason that active management has underperformed passive management so broadly recently. Actively managed fees subtracted from index returns equals an underperforming fund.

Higher level of fiduciary compliance? Is a plan sponsor better complying with its fiduciary responsibilities by offering an index-fund-only line-up? Because the line-up would be less volatile and lower cost compared with an actively managed fund line-up, some experts think so.

Here are arguments for using actively managed funds:

Less than 100% of every market downturn. Index funds are guaranteed to capture 100% of every market downturn. An important feature of actively managed funds is that a good active manager can sell out of positions before capturing an entire market crash. Although not every active manager has been able to accomplish this, many have. This is the strongest argument for the use of actively managed funds.

Inefficiencies still exist. Although it will be hard for active managers to beat their index in a number of asset classes that are highly researched and followed, there still are many asset classes where inefficiencies abound (e.g., international equity). Those investment management firms that have research expertise and managerial talent in these areas can significantly outperform their indexes over a full market cycle.

Misperception of active management. I have never understood why there is the widely held belief that all active managers should outperform their fund's indexes every year. First, an actively managed fund needs to be evaluated over a full market cycle, not just one or two years. Also, some active managers are very good at defending your investment against loss, but not quite as skilled at outperforming the index during a rising market. And finally, in what industry are 100% of participants top performers? Yes, there are some active managers whose approach is bottom-quartile. Don't invest with them. Invest with top-quartile managers in every asset class if you choose active management.

Animal spirits. We live in America, where entrepreneurship and innovation are valued and rewarded. Most of our pysches are not calibrated to be satisfied with average or index returns. We expect to have above-average children, above-average pay raises and above-average returns in our investment portfolios. Index investing guarantees average returns every single year. I talk with very few investors who are happy with average returns. Many feel that if they experience a year of average returns, that is not a good year.

So, what’s the winning formula?

Without question, a winning formula in building a great 401(k) plan investment fund menu is to combine index offerings with actively managed choices for those asset classes where inefficiencies still exist. But for some plan sponsors, an all-index-fund lineup may be the best approach.

Robert C. Lawton, AIF, CRPS is president of Lawton Retirement Plan Consultants, LLC, a RIA firm helping 401(k) plan sponsors with their investment, fiduciary, employee education and compliance responsibilities.

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