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The Battle Over 401(k) Advice

A teacher of mine used to say that when the feathers started flying, you knew you hit your target. If that's true, the Department of Labor's recently proposed rules regarding 401(k) plans were right on the mark.

The proposal, in part, concerns the delivery of advice to 401(k) participants. Worried that the advice might be slanted in favor of asset managers, the Department of Labor will require that the recommendations be provided by unbiased computer models.

But the questions the Department is asking as it establishes the basis for those computer models have many in the brokerage industry up in arms. The questions, they fear, indicate that the guidelines for 401(k) advice will favor -- if not exclusively require -- the use of index funds.

Following are some of the questions the Department of Labor seeks comment on in its proposal:

  • "What investment theories are generally accepted ... and what investment practices are consistent ... with such theories?"
  • "On what bases can a fund's superior past performance be demonstrated to derive not from chance but from factors that are likely to persist?"
  • "Under what if any conditions would it be consistent with generally accepted investment theories ... to recommend a fund with superior past performance over an alternative fund in the same asset class with average performance but lower fees?"
  • "Should a model ascribe different levels of risk to passively and actively managed investment options?"
It would seem that advocates of active management are right to be concerned, for honest answers to each of the above would favor a passive approach. But the Department of Labor is right to conduct a thorough examination of the intellectual arguments that underlie both active and passive management.

The logic of passive management is well-established, and grounded in decades worth of academic study and real world experience.

The intellectual justification for active management pales by comparison. It's not a stretch, in fact, to say that there is no argument in favor of active management that can withstand a rigorous and unbiased examination. When pressed, most proponents of active management end up saying, in effect, "trust me, I can add value." At best, they can point to a record of past success. But, as any mutual fund ad or prospectus is required to disclose, past performance has nothing to do with future returns.

The fact that active management has a difficult time surviving such scrutiny is likely why so many in the investment industry are beside themselves at the idea that the Department of Labor is asking such questions. Some fine examples of their outrage were on display in a recent article in Investment News.

"I was absolutely shocked that they were asking questions about whether historical performance should be a factor," one broker said. "It's like saying that you should buy a Volkswagen over a Rolls Royce just because it's cheaper."

The government shouldn't be "dabbling over investment theories," said the chief executive of the American Society of Pension Professionals and Actuaries.

And, in my favorite defense of active management, Investment News reports that a UBS executive said that "while index funds may perform well over the long term, it's often the ups and downs of actively managed funds that keep plan participants paying attention."

What's a little underperformance, in other words, in return being engaged along the way?

You don't really need to scratch the surface very much before the arguments in favor of active management go beyond ridiculous, do you?

But the investment industry is not going quietly in the face of an attack on their raison d'etre. An editorial in following issue of Investment News, which carried the headline "Advisers Should Sound Off on 401(k) Plan Advice," rallied the troops to action. In it, they said that a policy of excluding index funds depended upon "how efficient the stock market really is," pondered "whether the Labor Department should be endorsing constrained models (i.e. those limited to index funds)," and called on their readership to "make their expert opinions known."

Please. First, a passive approach depends not a whit on whether or not markets are efficient. Minimizing your expenses maximizes your share of the market's return, regardless of how efficient or inefficient that market is. Second, if you haven't been paying attention, our nation's retirement system is in pretty poor shape. An argument that attempts to rectify that should ignore the undeniable arithmetic that underlies a passive approach could only be made by someone with a vested interest in maintaining the status quo.

Retirement plan participants would be far better served if the Department of Labor followed the lead of the Massachusetts Institute of Technology, which just undertook a "thorough review" of their 401(k) plan, aiming to "improve the plan's investment options."

The result? "More emphasis on passive index funds with lower fees."

If such an approach is good enough for some of the world's foremost experts in science, technology and finance, it should be good enough for the average American worker as well.

If you agree, and wish to add your own opinion to the debate, I encourage you to submit a comment on the Department of Labor's proposal, and make your feelings known.

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