May 19, 2024

Your Money: Why 401(k)’s Should Offer Index Funds

This shouldn’t be a controversial statement. Yet it passes for one in Washington, where regulators and legislators are still mired in a never-ending debate over whether stockbrokers, certain insurance salespeople and others ought to meet that standard, known in legal circles as a fiduciary duty.

It is an important discussion, but there’s an even more essential one you ought to be having right now with your employer. There, the people who pick the mutual funds in your 401(k) plan are also supposed to be acting in your interest as fiduciaries, too, and may be failing to meet the letter, or at least the spirit, of that legal standard.

The task facing these well-meaning people is to construct your menu of investments carefully, while keeping a close eye on costs and risk. But many 401(k) plans do not offer a basic lineup of index mutual funds, which buy every security in a particular market segment rather than try to guess which small collection of individual ones will offer the highest return. These 401(k) plans lack index funds even though their low expenses and breadth make them the very definition of cheap and risk-conscious.

Instead, too many employees must choose among actively managed funds. Those investments tend to have higher costs, which eat away at returns. Active managers often have fewer stocks inside their funds as well, and that can create higher, more concentrated risks than index funds have.

While a judge has apparently never directly addressed whether a lack of index funds in a 401(k) plan may make it illegal, the people who oversee the retirement plans do not need to wait for a lawsuit to give employees the index investing option.

After all, if your plan lacks such funds, it may cost you well into the six figures by the time you retire. That’s because even if the two types of funds have the same return, you have to take the different costs into account. It’s enough to make it well worth your while to examine your own 401(k) or similar plan and request changes if you don’t like what you find.

So how do you make your case? First, a quick review of the research and the terminology.

Index funds buy every stock in a particular market, say all stocks in the Standard Poor’s 500-stock index. Active managers try to eke out a better return than index funds by buying, say, a subset of large United States stocks that they hope will outperform the collection of stocks in an index fund.

For the 20-year period that ended in December, 72 percent of actively managed mutual funds that invest in United States stocks (including those that closed during that time period) did worse than their benchmark index. In United States bond funds, the figure was 81 percent. International stock mutual funds showed similar results over a 15-year period.

These figures come from Vanguard, which may cause index skeptics to snicker, given the company’s close identification with index investing. Vanguard actively manages about 40 percent of the assets it controls, however, so it presumably has an interest in convincing people that those funds are worth choosing, too.

Some actively managed fund managers do outperform their benchmark index over long periods of time. But it’s awfully hard to figure out which ones will do so when they start funds, let alone which ones will continue to over your many decades of investing. Even so, people who pick the funds in your 401(k) menu make this sort of guess all too often. How are those people supposed to be conducting themselves? A law called the Employee Retirement Income Security Act, Erisa for short, offers some guidelines.

According to the law, the people who oversee your 401(k) plan are supposed to defray “reasonable” plan management expenses, minimize the risk of “large” losses and use the “care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

One big reason index funds do better than actively managed ones is that they are much cheaper to run, since active managers spend a lot of money to conduct research and trade securities. So if cost is a consideration, index funds are usually the better choice.

As for the risk of large losses, the lack of big bets on any single security gives index funds an advantage, too. “Wouldn’t you rather, as a plan sponsor, invest with someone who focused on decreasing costs and decreasing risks, which are two factors over which they actually have control?” said W. Scott Simon, a principal with the 401(k) consultant Prudent Investor Advisors.

Things start to get hazier, though, when you try to pick apart this whole “prudent man” business. Such a person must consider “circumstances,” “like capacity” and “an enterprise of a like character.” It is, in short, an invitation to benchmark against other employers.

The problem with benchmarking, though, is that so many of the employers that someone might measure a 401(k) plan against aren’t necessarily giving their workers the best selection of investment options either. According to the Profit Sharing/401k Council of America, 82 percent of all plans offer a United States stock index fund as an option, 47 percent offer an international one and 54 percent offer a United States bond index fund.

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