Retail investors’ growing interest in index funds has been well documented, and the trend is also apparent in defined contribution (DC) plans. A May 2017 report from Vanguard Research, “Indexing in Defined Contribution Plans 2006 to 2016,” reports that index target-date funds (TDFs) accounted for 32 percent of Vanguard’s DC plan investment allocations as of year-end 2016, excluding non-indexable assets like money market funds and stable value accounts. That figure has been moving steadily higher from the 4 percent level in 2006. The total percentage for index funds at Vanguard in plans is 63 percent (not including non-indexables), roughly the same level for the past three years, but still up from 43 percent in 2006.
Behind the Numbers
Admittedly, plans working with Vanguard could be predisposed to using index funds, and the study notes that in 2015, an estimated 37 percent of DC plan assets were passively managed versus 51 percent for Vanguard at that time. Still, the allocation gains in index TDFs is impressive and not showing any signs of peaking. So, what’s driving the growth?
Kevin Jestice, head of Vanguard Institutional Investor Services in Valley Forge, Pennsylvania, cites two trends. The first is plan sponsors’ recognition of the increased scrutiny of plan fees and the resulting need to offer participants low-cost investment choices. The second driver is the ongoing shift to TDFs. Jestice reports that over 90 percent of Vanguard’s plan sponsors have TDFs in the lineups, and the clear majority of them are using the funds as the plan’s qualified default investment alternative (QDIA). About 72 percent of participants are using TDFs with 49 percent of their contributions are going into the funds.
Auto-enrollment’s cumulative impact in recent is driving TDFs’ growth, he explains: “You’ve seen a wave over the last five to 10 years of participants being auto-enrolled in the plan and defaulted into the target date fund. And, then as they grow income, savings rates continue to grow and the dollar base on which they’re saving is growing. So, you’re seeing increasing contributions year over year going into the target date funds.”
Plan Design Trends
David O’Meara, CFA, senior investment consultant with Willis Towers Watson in New York City, cites a similar experience with TDFs. Among his client-plans that offer TDFs, over 80 percent are offering only passive funds. At the same time, more plans are using a tiered approach to their plan’s fund offerings so participants have a wider selection of options. One tier will have passive funds while another will have actively managed funds with similar asset class characteristics.
Felicia Bennett, managing director with Wilshire Associates in Pittsburgh, says that her firm has been advocating inclusion of low cost, passive options as part of plans’ core menus for years. While those funds were readily available for U.S. equities, index funds’ expansion into more asset classes now allows plans to create an active/passive mirror for the broad asset classes in the core lineup. At the same time, Bennett adds, many sponsors are streamlining their core investment options and moving to fewer but broader and more diversified funds. “(On) the passive side there might be just one total U.S. equity market fund or an S&P 500 and a small-cap passive fund,” she explains. “There would not be a passive option for every style box if the sponsor was still choosing to have an allocation to active funds in a large cap, growth, value, core, mid cap, small cap, etc.”
Business Implications
The shift to indexed TDFs could have an unintended consequence, says O’Meara. As a greater percentage of a plan’s assets shifts to passive funds from active funds, there is a risk that plans might be forced into more expensive share classes of their active funds due to reduced buying power. That would make those active funds even less attractive over time, he notes.
Another possible outcome is that consultants who viewed actively managed fund research and selection as a central element of their value propositions might see that aspect of their businesses diminished. Jestice downplays that potential problem, however, noting that Vanguard is seeing increased use of consultants by plan sponsors. “For most plans, most options are still the actively managed options and those require, regardless of the assets in them, they require constant ongoing due diligence by the plan sponsor and fiduciaries of the plan,” he says. “And, so, as long as that is true, I believe many plan sponsors will appreciate counsel and advice on the funds in their plans. I also think that there are a lot of other factors that consultants support their clients with in the 401(k) space, including record keepers and best practices and things like purchasing communication and a whole host of other things beyond just the investment menu lineup and the due diligence on those funds.”