Active Management in Defined Contribution Plans

Abstract

We analyze the problem that fiduciaries face when monitoring and selecting from a universe of active mutual funds within a defined contribution (DC) plan. In a DC plan, a fiduciary must recognize that there are two levels of decision makers, namely, the fiduciary, who decides which funds will compose the DC plan, and the individual plan participants, who must decide which funds to invest in and the timing of their investment. Moreover, plan participants, and to some degree the fiduciary, need to be able to make investment decisions without being investment professionals.

We find that due to the general lack of consistency in performance of mutual funds, fiduciaries and plan participants would be better served by selecting passive rather than active funds across the US equity mutual fund space. Moreover, the most consistently outperforming funds tend to have meaningfully higher tracking errors relative to their stated benchmarks, which makes effective asset allocation in a DC plan more difficult.

TOPICS: Wealth management, retirement, mutual fund performance, passive strategies

Key Findings

• • There are two levels of decision makers in defined contribution (DC) plans—fiduciaries and plan participants—and this complicates active fund selection.

• • Most DC fiduciaries would be better served by replacing active US equity mutual funds with low-cost passive alternatives for both wealth aggregation and performance consistency reasons.

• • Consistently outperforming active funds are rare and tend to have higher tracking error, which makes asset allocation more complicated.