Fiduciary Fears Still Adding to Passive Product Tailwind

Cerulli Associates finds “fiduciary fears” are supporting flows into lower-cost, passive products, but many plan sponsors overestimate their ability to mitigate fiduciary liability through indexed investments.

Passive funds can be compelling from a cost-of-investing perspective for Employee Retirement Income Security Act (ERISA) fiduciaries, according to new research from Cerulli Associates, but this does not mean they come without market and fiduciary risk.

“An unfortunate misconception” exists among defined contribution (DC) plan fiduciaries that low cost is equivalent to low risk from either a market or a fiduciary perspective, says Jessica Sclafani, associate director at Cerulli. This misconception is benefitting index fund providers in terms of inflows, Cerulli data shows, but could lead to some serious plan sponsor confusion and even increased litigation down the road.

Those with investment experience know indexed products are generally as risky, or even riskier, than active products for a given asset class. Index funds as a rule seek exposure to whole markets or portions of markets—the idea being to give investors full access to the upside, which inevitably brings exposure to the downside. When markets do well for extended periods of time (like in the last four or five years in particular) it is easy to overlook this full embrace of the downside present in passive investing, tipping the balance in the perennial active versus passive debate.

This happens both inside and outside the DC industry, Cerulli explains. “What is unique to the DC industry is that demand for passive strategies is [also] being driven by the misunderstanding of many plan fiduciaries that choosing passive is a way to offload or mitigate their fiduciary liability,” Sclafani explains. “Countering the demand for passively managed funds has been a difficult task in the face of strong domestic equity returns and is not a challenge unique to the DC industry.”

Cerulli finds asset managers, especially those depending on profits from actively managed products, “are keenly aware of the ongoing fee compression in the DC industry, with nearly one-quarter citing cost concerns and fund expenses as a major challenge to their DC business.”

NEXT: Regulatory attention drives indexing 

Cerulli says, in light of a shifting regulatory agenda and plan sponsors’ “hyper-focus on plan costs and fees, and more frequent examples of DC fee-related litigation,” it should not surprise readers that many plan sponsors describe feelings of fear and general unease regarding DC plan management. Indeed, investment and administrative cost concerns are continuously cited as the top worries for plan sponsors when making DC plan decisions.

“While the Department of Labor explicitly directs plan fiduciaries to determine whether plan fees and expenses are reasonable, many plan sponsors cite a lack of clarity regarding the definition of “reasonable” as a source of unease, Cerulli warns.

“Fiduciary liability ranks as the second-most important factor for plan sponsors when making DC plan decisions,” Cerulli finds. “This is undoubtedly a reflection of the nearly 40 lawsuits levied against ERISA plan sponsors during the past decade. According to Cerulli survey data, more than half of plan sponsors cite the potential for lawsuits as a ‘very important’ factor when making DC plan decisions.”

In a related trend, Cerulli reminds plan sponsors that they “have a fiduciary responsibility to be aware of their purchasing power because the inefficiencies across investment vehicle and share classes can be material.” By both regulators and service providers, plan sponsors are being urged at every opportunity “to ask whether they are large enough (by plan assets) to qualify for an institutional share class or alternative vehicles that carry lower costs,” such as collective investment trusts (CITs).

These findings are from the October 2015 issue of The Cerulli Edge – U.S. Edition. Information on obtaining Cerulli reports is here