Strongly associated with indexing as a core investment philosophy, Vanguard looks at the evolution of indexing within Vanguard-administered DC plans in “Indexing in Defined Contribution Plans 2004-2012.” Although the research is specific to Vanguard, the paper states the firm’s belief that an analysis of the Vanguard experience is a useful benchmark for assessing the relationship of target-date funds (TDFs) and indexing in DC plans over time.
By the end of the eight-year period, nearly half of Vanguard DC plan assets were invested in index funds, and $1 of every $6 was invested in index target-date options. As recently as 2008, the fraction of actively managed assets exceeded the fraction of indexed assets within Vanguard DC plans. By year-end 2012, 45% of Vanguard DC plan assets were invested in indexed or passively managed options, 31% were invested in actively managed options, and the remaining 24% were invested in “non-indexable” assets—money market, stable value and company stock options.
Several trends are reshaping the composition of DC plan assets, according to Vanguard’s paper. As noted in earlier Vanguard research, the growth of TDFs is transforming participant investment allocations, whether through default or voluntary choice mechanisms. (See “More Participants Seeking Managed Investments.”)
At the same time, sponsor scrutiny of recordkeeping and investment fees in DC plans has spiked. Sponsors have been considering how to use passive investment strategies to reduce investment costs, as well as reduce active management risk exposure and improve diversification.
Menu composition has changed during the eight years Vanguard examined. The average number of options offered increased, from 18 to 27, because of the addition of index target-date options to plan menus. Plan sponsors adding index target-date options to plan menus replaced actively managed funds. With the introduction of index TDFs within Vanguard-administered DC plans, the fraction of indexed assets has increased sharply.
TDFs Transform DC Menus
This change underscores the fact that the composition of DC plan menus is being changed by the rapid adoption of target-date strategies. Moreover, the choice of active versus passive TDFs is driving changes in the composition of a DC plan’s active/passive mix and its investment cost structure. Sponsors seeking to lower aggregate plan costs and reduce participants’ active risk exposure should consider choosing a passive target-date series. Sponsors choosing active target-date strategies should weigh the long- term effect of that decision on aggregate plan investment costs and aggregate active risk exposure among participants.
Passive TDFs were introduced on Vanguard’s recordkeeping system in late 2003. As a result, the absolute level of indexing among clients choosing Vanguard as a recordkeeper is higher than industry averages. For example, in 2011, an estimated 20% of all assets within DC plans were passively managed, compared with 41% of all DC plan assets at Vanguard.
Since the study evaluates aggregate plan allocations at the end of each calendar year, the sample gives a snapshot of plans over time. The year-end 2012 sample included approximately 2,000 DC plans covering nearly 3.4 million participants, including both active and deferred participants. The study begins with an analysis of the allocation of plan assets among active and index investment choices, and how this allocation has changed over time. Vanguard considers the changing composition of DC plan menus and highlights the strong relationship between menu lineups and plan asset allocation.
“Indexing in Defined Contribution Plans 2004-2012” can be downloaded here.