managing retirement plans: why cfos can’t be passive … · 4 i managing retirement plans: why...

1 I Managing Retirement Plans: Why CFOs Can’t Be Passive About Investing

MANAGING RETIREMENT PLANS: WHY CFOs CAN’T BE PASSIVE ABOUT INVESTINGMany fiduciaries view index funds as a safe option, but are they?

INTRODUCTION

When it comes to managing a company’s re-tirement plans, among the biggest concerns of finance chiefs is meeting their fiduciary responsi-bilities. CFOs are charged with mitigating risk and protecting capital, and they take those responsi-bilities seriously when handling retirement assets. Failure can have consequences for the company from a legal liability perspective, as well as for plan participants in certain circumstances.

Some plan sponsors may reflexively choose passive investment strategies — index funds — for retire-ment plans because they believe them to be the more prudent option to avoid litigation. But this is not necessarily the case. Fiduciaries are held to the same standard whether they select an active or passive investment strategy.

While lawsuits related to the Employee Retirement Income Security Act (ERISA) have increased over the past several years, there is no evidence from

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity so they may lose value.


the Department of Labor (DOL) that actively man-aged retirement assets face increased scrutiny or that one type of investment strategy is favored over the other.

Fiduciaries should bear in mind that even if they choose an index fund, as many plan sponsors do, it is important to understand the complexities of how the fund is managed, how it tracks the index and how adjustments are made to keep it in close proximity to the returns of the tracked index.

In addition, it is important for the CFO to under-stand fee structures and securities lending risks as well as how they can impact returns over time.

This guide details some key issues CFOs need to be familiar with to effectively manage their retire-ment plans — whether they be defined contribu-tion (DC) or defined benefit (DB) — including:

� Why passive investments may not necessarily be the safest choice;

� What CFOs need to ask about how specific

index funds and the index to which they are managed;

� Understanding securities lending and fee structures of active and passive funds; and

� The importance of effective communication with employees/participants.

PASSIVE INVESTING IS NOT NECESSARILY A SAFE HAVEN

In late 2015, the Tibble v. Edison U.S. Supreme Court decision concluded that fiduciaries have an “ongoing duty to monitor” investments, which is separate and distinct from the duty to exercise prudence in selecting investments for a defined contribution plan investment menu. This has sparked a number of lawsuits challeng-ing not only excessive fees, but also the administration, investment selection and types of investments.

“There’s so much money in passively managed funds that it has become a target of the plaintiffs’ bar,” said Jason Bortz, Senior Vice President and Senior Counsel


at Capital Group, a leading investment management firm and home of American Funds.

Plan fiduciaries who prudently select and monitor an investment fund are not liable for any loss or

underperformance of the fund, according to a report by Stephen M. Saxon and Jason H. Lee, Principals, Groom Law Group.1 This holds true of any retirement plan, whether the plan is managed actively or pas-sively, the report noted.

The mindset that actively managed funds are more susceptible to litigation runs counter to statutory

and regulatory authority on the issue. Legal experts point out that neither the courts, DOL, nor any regulatory agencies have stated a preference for passively managed funds over those that are active-ly managed. “Regardless of the management ap-proach, fiduciaries are held to the same standards,” according to the Groom report.

In fact, lawyers contend that companies could run the risk of being sued by restricting offerings to passively managed funds. Lawsuits have been filed against plan fiduciaries for their alleged breach of fiduciary re-sponsibility in not offering a stable-value fund in their plan (i.e., preventing participants from protecting their returns using this type of fund). This same argument could potentially apply to companies that only offer passively managed options. FIDUCIARIES NEED TO UNDERSTAND HOW INDEX FUNDS ARE MANAGED

All index funds are not created equal. While many plan fiduciaries believe that offering an index fund signifi-cantly reduces liability, indexing is complex — and

1 ”Actively Managed Funds Remain Appropriate Investment Options For 401(k) Plans,” Stephen M. Saxon and Jason H. Lee, Principals, Groom Law Group, 2018, Investments & Wealth Institute, formerly IMCA.

“THERE’S SO MUCH MONEY IN PASSIVELY MANAGED FUNDS THAT IT HAS BECOME A TARGET OF THE PLAINTIFFS’ BAR.”

— Jason Bortz, Senior Vice President and Senior Counsel, Capital Group


fiduciaries need to perform due diligence to protect their organization and plan participants.

A key factor for fiduciaries to consider is how well the fund tracks against the index. “Conceptually it sounds simple, but not all index funds are the same, and there is a lot of work that goes into ensuring that the fund closely hews to the index it is tracking,” said Bradford P. Campbell, Partner at Drinker Biddle & Reath LLP and former Assistant Secretary of Labor for Employee Benefits.

While no index fund is going to track the index exactly over the long term (and after fees), it is important to engage with a fund manager that is familiar with the complexities of the index against which the fund is tracking. “You want to choose a fund manager that can anticipate changes, knows the schedule of when the index will be recalibrated and is prepared to make adjustments,” said Chris Anast, CFA, Senior Retirement Strategist, Capital Group.

It is important for fiduciaries to examine how the index, as well as the index-tracking fund, is con-structed. Historically, even indexes from various providers that track similar market segments have varied significantly. Attention must be paid to securi-ty selection and weighting, calculation of returns and ongoing maintenance of the index. The importance of the underlying index increases in categories such as small cap, emerging markets and fixed income.

Fees are also a consideration when choosing an index fund, Campbell noted. Rather than default-ing to a lower cost share class, fiduciaries should examine whether higher fee share classes will generate revenue to offset recordkeeping expens-es, he added.

“CONCEPTUALLY IT SOUNDS SIMPLE, BUT NOT ALL INDEX FUNDS ARE THE SAME, AND THERE IS A LOT OF WORK THAT GOES INTO ENSURING THAT THE FUND CLOSELY HEWS TO THE INDEX IT IS TRACKING.”

— Bradford P. Campbell, Partner, Drinker Biddle & Reath LLP


Understanding the index and the nuances of manag-ing to an index is part of a fiduciary’s responsibility. Therefore, other key questions for fiduciaries to ask when evaluating an index fund include:

� Does the manager use a full replication approach, optimization, or a sampling approach?

� If sampling is used, how many securities are utilized and what characteristics/buckets are targeted for replication?

� How is the underlying index constructed? How are securities, countries, sectors determined? Does the index composition represent the asset class adequately?

� How are changes to the underlying index managed?

� When index reconstitutions occur, how are trades managed?

� How are large cash flows into the fund managed to minimize disruption?

� To what extent are futures or other derivatives used?

� Is securities lending permitted, and how is it managed?

� For international managers, how is fair value pricing managed? What countries are included/excluded, and why?

WHY SECURITIES LENDING MATTERS TO FIDUCIARIES

While lawsuits are a risk, regardless of the man-agement strategy of the fund, fiduciaries need to be aware of other potential risks when managing retirement amounts. A common practice for gener-ating revenue — particularly for index funds — is for an investment fund to lend the securities held in its

portfolio to third parties.

Passive funds typically hold securities that are highly lendable, explained Toni Brown, CFA, Senior Vice President, Retirement Strategy Group, Capital Group. “The money they are raising through lending offsets the fees, so their results are closer to the index than they would be without securities lending.”

Securities borrowing is largely done by asset man-agement firms, primarily hedge funds. While the practice occurs for several reasons, it is predomi-nantly used to create a short position. The borrower sells the stock without owning it and replaces it later, creating a short.

The other primary reason for securities lending is that some stocks attempt to avoid treatment of cer-tain dividends by moving stock between tax regimes.

While securities lending has the potential to generate revenue, it also introduces additional risk to the fund. What happens if the counterparty doesn’t return the se-curity? And who profits from the earnings component?

There are essentially two risks in engaging in securi-ties lending, according to Simon Mendelson, Senior Vice President, Capital Group. “The first is that the counterparty fails to return the stock they borrowed. What mitigates that risk is the loan being fully collat-eralized. Also, lending agents often offer indemnity against this risk.”

“BEFORE DECIDING ON A PASSIVE MANAGEMENT STRATEGY, IT IS CRITICAL TO UNDERSTAND WHAT THE FUND’S LENDING STRATEGIES ARE AND WHETHER THERE’VE BEEN PREVIOUS ISSUES.”

— Toni Brown, CFA, Senior Vice President, Retirement Strategy Group, Capital Group


The second, bigger risk of security lending — which became apparent after the 2008 financial crisis — is greed. You can raise the returns on securities lending by increasing the risk you take with the cash collater-al. Even in the depths of the financial crisis, if you in-vested your collateral in money market instruments you were fine, Mendelson noted. “But if you took all that money and reached for additional yield, you had a big problem.”

In the vast majority of cases, securities lending is not a cause for concern, Brown said. “But before deciding on a passive management strategy, it is critical to un-derstand what the fund’s lending strategies are and whether there’ve been previous issues.”

FIGURING OUT THE FEES

While fiduciaries need to be familiar with various plan management strategies and securities lending policies as part of their responsibilities, fees are an-other area of potential risk.

“The duty of fiduciaries isn’t to pick the lowest or cheapest fee, it is to ensure a reasonable fee,” said Campbell. “You wouldn’t just pick the lowest bid from a contractor to renovate your kitchen.”

Fees for actively managed funds are typically higher than those of passive funds, given that they incur higher research and management costs and, conse-quently, are more expensive to run.

Because passively managed funds take a mar-ket-driven approach based on widely available infor-mation, fees are typically lower. Even at lower levels, index funds may face scrutiny regarding fees, as there may be other less expensive options that are easily accessible and track the same index.

“S&P 500 index funds are perceived commodities, so it’s tough to rationalize one or the other except on the basis of fees,” Bortz said. Most of the lawsuits

“S&P 500 INDEX FUNDS ARE PERCEIVED COMMODITIES, SO IT’S TOUGH TO RATIONALIZE ONE OR THE OTHER EXCEPT ON THE BASIS OF FEES.

— Jason Bortz, Senior Vice President and Senior Counsel, Capital Group


regarding fees involve small differences, sometimes as little as a few basis points.

In addition, many passive funds charge different pric-es within the same family of funds based on the size of the assets managed for a specific plan sponsor. Fiduciaries have to pay attention to variances in asset levels as they relate to the fees being charged. Fee adjustments are not automatic, so fiduciaries must be proactive in monitoring costs.

Regardless of a fund’s investment approach, fees should be competitive, transparent and predictable. Below are some specific questions fiduciaries should ask about fees:

� What are the different levels of fees?

� Are there any additional administrative fees?

� What is the impact of securities lending on fees?

� For target date funds:

» Are the fees for all the underlying components competitive?

» Is there an overlay fee in addition to the investment management fee?

COMMUNICATING WITH PARTICIPANTS AND MEASURING SUCCESS

We’ve discussed why it is important for fiduciaries to be familiar with the intricacies of managing a retirement plan, including the risks of litigation, securities lending and fees. However, they also need to be able to clearly communicate to plan participants the value of investing for retirement and details on the funds being offered.

An investment policy statement should include the plan’s purpose, objective and overriding philoso-phy. The policy should cover investment structure, options, monitoring, and for plan sponsor directed plans, asset allocation.

As plan participants can feel overwhelmed by invest-ment options, it can be helpful to offer participants a shorter list of carefully selected options to help them reach their retirement goals. An investment structure that includes a target date series, capital preserva-tion, global fixed income and global equity can assist


participants in developing a strategy for their retire-ment investing.

Participants that understand their options and the paths for reaching their retirement goals are more likely to participate in their company’s plan. Partici-pation level is an indicator of success, and it is a key metric to track. Contribution level is also important, and companies should strive to have participants contributing 15% of their compensation.

In addition, there should be a quarterly review of the investment options being offered, with fees and per-

formance being analyzed and compared to industry benchmarks. Underperforming funds can be mon-itored and placed under further scrutiny to ensure that they are properly helping participants pursue investment goals.

CONCLUSION: PASSIVE FUNDS REQUIRE CAREFUL ATTENTION FROM FIDUCIARIES

Many companies have defaulted to passive man-agement of retirement options because they are operating under the misconception that avoiding higher fee, actively managed investments will help them avoid scrutiny and litigation. With the number of lawsuits from plan participants on the rise, the response is understandable, if misguided.

In reality, offering passively managed, lower cost options will not help fiduciaries avoid costly litigation.

In fact, by not offering actively managed options, fiduciaries may deprive participants of potentially higher returns.

Thus far, courts and regulatory authorities don’t come down on either side of the passive vs. active manage-ment debate, but it is clear that fiduciaries are expected to employ a prudent decision-making process.

Fiduciaries must be familiar with the features of the plans they are offering. Developing a clear investment policy statement, and understanding the fees and secu-rities lending policies of investment funds, are key com-ponents of protecting the company and participants.

Finally, the ability to clearly communicate plan ben-efits to participants who are seeking to achieve a comfortable retirement is the hallmark of success.

Key takeaways from this guide include:

� Relying on index funds may feel like a less risky approach, but it doesn’t mitigate the possibility of litigation and may not offer the best returns for participants. Simply put, there is no safe harbor from litigation regardless of investment strategy.

� It is critical for fiduciaries to understand how index funds are managed. Plan fiduciaries should consider a savvy manager who knows the index, anticipates changes and can make quick adjustments.

� While securities lending can boost revenue and help funds increase returns, the strategy carries a risk that plan sponsors should understand.

� Fees can be complicated, so fiduciaries must stay abreast of any changes and closely monitor fees.

PARTICIPANTS THAT UNDERSTAND THEIR OPTIONS AND THE PATHS FOR REACHING THEIR RETIREMENT GOALS ARE MORE LIKELY TO PARTICIPATE IN THEIR COMPANY’S PLAN.


About Capital GroupFor over 85 years, Capital Group, home of the American Funds, has helped millions of investors grow and maintain their retirement savings. Capital Group bases investment decisions on a long-term perspective, which they believe aligns their goals with the interests of clients. Achieving superior, long-term returns is their focus, so managers are rewarded for their results, not the level of assets they manage.

Capital Group’s array of equity, bond and multi-asset strategies serve as the bedrock of the company’s target date retirement fund series, which is among the industry’s largest. Combining the right mix of underlying funds — at the correct time based on the number of years to retirement — helps the target date series to pursue enhanced returns and improved risk management.

Content contained herein is not intended to serve as impartial investment or fiduciary advice. The content has been developed by Capital Group which receives fees for managing, distributing and/or servicing its investments.

Securities offered through American Funds Distributors, Inc.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not to be comprehensive or to provide advice.

https://www.capitalgroup.com/us/

managing retirement plans: why cfos can’t be passive … · 4 i managing retirement plans: why...

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