I recently attended a session at an industry conference on the topic of lowering costs in 401(k) plans. This intrigued me, as I have a vested interest in making the plans that I advise as cost effective as possible. With all of the opportunities to add value to retirement plans by focusing on ideas like fee transparency and share class analysis, I was surprised to find this session solely focused on the use of an index strategy as a way to cut cost. The pitch to the broker community was that this is a good way to make your imbedded fee look more reasonable.
As the presenter honestly admitted, the main reason these index funds are being pitched to plans are the low cost feature, not the net value. In fact, net investment return as a benefit to the investor was never mentioned in the hour-long session. The focus of the argument was how to win business with a “low-cost plan”.
Since that session, I have read many articles and pitch sheets on using low-cost index strategies in 401(k) plans to lower overall participant costs. While it is true that cutting management fees for equity mutual funds from an average of 1.00% to 0.25% will lower the cost burden for participants, what happens to the performance net of these fees? A goal of a fiduciary is to provide plan participants with the best opportunity to invest wisely and successfully. Often, index funds do not accomplish this goal.
Most mutual funds present historical return data net of fees. This helps make the decision easier when selecting a strategy. If you are presented with large-cap domestic stock fund that out-performed it’s best fit index consistently over time, net of fees, how could you exclude it from your lineup? If the index fund out-performed most actively managed funds in its category, net of fees, you would be compelled to make it available to participants. What you need is the skill to examine the active and passive alternatives for each investment category.
Morningstar, the leading mutual fund reporting agency, shows 75% of actively managed domestic large cap stock funds are currently under-performing the large-cap index for the 5-year annual return. On the other hand, 70% of actively managed domestic small-cap stock mutual funds are out-performing their best fit index. The results of this study do not necessarily mean you should index large cap and choose active funds for small cap. Within each investment style there are different strategies and levels of risk. Understanding how to determine net of cost value by including risk and return metrics is critical in the practice of building an effective 401(k) plan lineup.
Another consideration is the investment knowledge level of your employee base. One benefit of many actively managed funds is they have a skilled manager that can evaluate ever-changing economic, geo-political and market environments and use this knowledge to the benefit of the investor. The passive strategy simply invests in the entire market without regard to any of the data mentioned above. Do your participants have the knowledge themselves or the expert support to adjust their investment allocation amongst market cap and investment style?
Controlling plan costs should be a top priority for you, as a plan fiduciary, and there could be opportunities to reduce costs of plan investments without sacrificing the benefits of an active strategy. Many funds offer lower cost share class, depending on plan size and other considerations. Your investment choices could also include fees that are used to offset service provider costs or pay your broker, called 12b-1 fees. You should work with your service provider and advisor to evaluate these fees to determine if they are truly necessary.
I believe this trend to make a sweeping change in 401(k) lineups to include only index funds for cost reduction is misguided. Index funds may have a place in your plan lineup, and the fact that they cost less is attractive, but it is only the start of the analysis. If your goal is to provide your plan participants with investment choices that will give them the best chance to retire on time and financially secure, you must consider returns net of fees, risk compared to the index, and the ability of the manager to make sound investment decisions in changing environments.