How index and active can work together in DC plans

Nov 12, 2015
By BlackRock

Index strategies are gaining momentum in defined contribution (DC) plans. The reasons seem clear enough: renewed scrutiny on fees and the demand for transparency have plan fiduciaries taking a closer look at how they are using index and active strategies to cover major asset classes and within multi-asset solutions such as target date funds.

What should plan sponsors be aware of when evaluating their investment menu line-up? We spoke to BlackRock's Sean Murray, head of Advisor Sold and Platform Distribution for the US Defined Contribution Group, and Sean Lewis, Investment Strategist, to find out their views on how to use index and active strategies together in DC plans.


Can you give us a sense of the momentum for index strategies within DC plans?

Sean Murray: Indexing is well established in DC and the trend remains strong. As of 2014, 89% of plans were offering some type of index investment option, most frequently within a line-up incorporating active and index funds. And the growth has been dramatic for target date funds (TDFs) as well. In fact, TDFs with underlying index exposures now make up 42% of all TDF assets—up from just 4% 12 years ago.1

Could this be seen as a decisive move way from active management?

Sean Lewis: I don’t think so. In fact, while index strategies have seen inflows, there are still dollars going toward active strategies, especially in categories such as fixed income and international equities.2 More and more, we are seeing plans looking to offer an investment menu with a blend of both—active strategies and index strategies. We are also seeing plans combine both within a TDF. So the question becomes: how to make active and index work together for a specific plan?

Are plan sponsors motivated by the scrutiny on fees?

Murray: The regulatory environment has certainly played a role in the growth of index investing in the DC market. There’s a lot of focus right now on fees. At BlackRock, we believe it’s important to serve participants well with affordable plans. But keeping costs low is only one part of a plan sponsor’s fiduciary responsibility. The Department of Labor, in their Target Date Retirement Funds—Tips for ERISA Plan Fiduciaries, has made it clear that fees are not the only consideration when it comes to target date fund selection, for example.

The first consideration for any investment should be the objective you are seeking—both at the plan level and at the fund level. There are specific outcomes, such as reducing market volatility, that may require something different than what a traditional index may deliver—whether through active management, smart beta or data-driven approaches.

Second, you need to look at the value plans are getting from that investment. Whether an investment is actively managed, tracking an index, or something in between, the cost should be commensurate with the value.

So while fees are extremely important, providing investments designed to help build better retirement outcomes is an equally important part of the mission. We think many DC plans will choose to offer both lower-cost index strategies and alpha-oriented funds to deliver different outcomes.

How can a plan sponsor go about combining index and active strategies in their line up?

Lewis: It’s important that plans and the advisors who serve them have the tools and insights to consider their investment menu holistically. This goes beyond evaluating strategies based on a specific investment’s fees or performance.

Consider what the participants are getting in return from an investment manager. For example, if an active manager is delivering valuable, consistent diversification and results beyond what’s available through indexing, that manager may be worth paying more. But a manager whose returns tend to track an index, yet still charges a higher fee, might be replaced with a lower cost index vehicle.

It’s also important to incorporate index and active thoughtfully into the investment menu. Typically, plans start with a qualified default investment alternative (QDIA), such as a TDF. If they combine index and active strategies within the TDF, it’s important to be very clear on what the intended benefit is for the active component. Is it designed to limit losses or to seek additional returns opportunistically? Define the goal first and foremost.

Beyond the QDIA, many plans provide a second tier of broad-based building blocks for participants who want to manage their own asset allocation. A range of index funds across major categories, such as large cap stocks, may make sense. Also, if the plan sponsor has a conviction that active management can generate alpha in certain sectors or asset classes, such as fixed income, the plan may include actively managed funds as well. And the third tier could have more specialized funds for more sophisticated participants.

How can plans implement their choices?

Murray: That really depends on the needs of the plan. Many larger plans use collectively managed fund structures to increase efficiency. For many mid-sized to smaller plans, traditional mutual funds may make more sense. As plan sponsors and advisors look to partner with an investment manager, they may consider partners who offer the full range—not just the basic low-cost index options. That way, plans get flexibility in the way they can build their menu going forward, from TDFs to index mutual funds in major asset classes and a wide range of actively managed choices as well.