The lack of low-cost alternatives to brand-name mutual funds is creating a two-tier pricing system in the 401(k) market, according to industry experts.
That two-tier system results in small and midsized plans paying higher investment and administrative costs than larger plans, which are starting to seek more economical investment choices.
Brand-name funds dominate the investment selections of most 401(k) plans, and the retail fees associated with those funds have caused larger plans to turn to institutional alternatives. But institutional mutual funds have relatively high minimum investments, limiting their use to plans with a sizable asset base.
Other alternatives to retail mutual fund investment options, such as unitizing defined benefit management and private-label funds, also are more suited to large plans.
The use of retail mutual funds has led some plan sponsors to issue warnings about fiduciary responsibility for those who blindly use bundled service providers with brand-name funds rather than applying the disciplined approaches used in managing defined benefit plans.
Leading the chorus is William McHugh, treasurer at Novartis Corp., Tarrytown, N.Y., who said some sponsors might be sidestepping their fiduciary responsibility under ERISA in selecting 401(k) managers and not properly establishing appropriate investment guidelines in accordance with pre-established standards (Pensions & Investments, Feb. 17).
Mr. McHugh said 401(k) investment management fees are generally higher than defined benefit management fees, and participants generally pay these costs. He said plan sponsors should reassess the way they manage 401(k) plans and take steps that could include "moving away from bundled approaches" and make sure they buy the best available investment products.
But the bundled approach is still the most popular. According to the latest survey by the Profit Sharing/401(k) Council of America, 30% of plans with 1,000 to 4,999 participants use one family of mutual funds for all plan investments, and 27% of plans with more than 5,000 participants use a single mutual fund family.
"Defined contribution plan assets have grown to huge amounts but the (mutual fund) industry has kept a fee structure from another era, when plans were much smaller," said James P. Klein, principal at Towers Perrin, New York. "The average Morningstar fund expense ratio is close to 115 basis points, and participants are paying at least that.
"And they argue that you are getting record keeping included in the fee, but we can show that record keeping is not worth 80 basis points; we believe it is closer to 20 basis points depending on the size of the account."
Mr. Klein said participants in plans using bundled service providers and a single mutual fund family pay "enormously high fees."
William F. Quinn, president-AMR Investment Services Inc., Fort Worth, Texas, which oversees American Airlines' $2.5 billion in 401(k) plan assets, also said in an interview that plan sponsors should consider their fiduciary duties when selecting 401(k) investments.
"Why pay 125 basis points when you can pay 25 or 50? People who use bundled funds from retail mutual fund families usually are paying 125 to 150 basis points in (annual) fees," said Mr. Quinn. "If you went one of three or four other ways like unitizing, private-label mutual funds like we do, or commingled trust accounts - any one of those will get your costs closer to the 25 to 50 basis points range.
"The reason plans do it (pay retail rates) is that 401(k) plans started relatively small and mutual funds were the simplest and easiest thing to do. And, companies aren't paying, participants are paying. If companies were paying, it would have changed long ago. As the plan gets larger it becomes more of a fiduciary obligation question down the road if you are paying two or three times what you pay for defined benefit plan managers."
Mr. Quinn said bundled mutual fund providers claim to provide record keeping for seven to 25 basis points. "Ours is closer to 10 basis points. So, if we pay 25 or 30 basis points for management and record keeping is seven to 25 basis points and mutual funds are charging 100 basis points, there is a gap there."
The difference, he said, is profit to the mutual fund and, over time, raises fiduciary responsibility concerns because the plan could have obtained the same service for less, which detracts from overall investment returns.
But Mr. Quinn and other critics of the brand-name fund approach say institutional options such as unitization or separate account management might not be appropriate for many small and midsized plans who may be better off using mutual funds.
Several large plans have turned to unitizing their defined benefit plan managers or other less costly institutional funds including Novartis; Chevron Corp., San Francisco; NYNEX Corp., New York; IBM Corp., Stamford, Conn.; Xerox Corp., Stamford; Vulcan Materials, Birmingham, Ala.; U S WEST Inc., Englewood, Colo., and General Mills Inc., Minneapolis.
Peter Starr, consultant at Cerulli Associates Inc., Boston, said most large plans are turning to institutional alternatives to retail funds.
Cerulli recently completed a major report on the state of the defined contribution market with Lipper Analytical Services Inc., New York.)
Although there is no hard data to support the concept, Mr. Starr said after interviews with top service providers, consultants and money managers, and more than 100 plan sponsors, "we feel strongly about the institutionalization of the large plan market."
But, he said, plans with less than $500 million in assets or fewer than 5,000 participants, in general, will continue to face retail fees for some time. But as the market grows, the pricing differential should start working down into the middle market in the next few years as well.
"The same dynamics will ultimately take place in the midmarket as well, as assets continue to increase and buyers become more aware, and finance and treasury people become more involved in the selection process," he said.
For that reason, the Cerulli report anticipates the demand for mutual funds in 401(k) plans is cresting after 10 years of rapid growth.
Meanwhile, said Mr. Starr, "the bundled approach in the large plan market will simply go by the wayside."
He said some mutual fund companies are starting to consider institutional funds with lower expense ratios than traditional retail funds.
According to Cerulli, the average retail expense ratio for a typical actively managed large-capitalization equity fund is 147 basis points compared with 91 basis points for a similar institutional fund.
For an active small-cap fund, the retail expense ratio averages 157 basis points compared with the institutional rate of 101 basis points.
Even though institutional funds are designed to provide a cost break to large plans, that is not always the case, according to P. William McNabb, senior vice president at Vanguard, generally recognized as a low-cost mutual fund provider.
He agrees most plan participants pay retail fees in brand-name funds but said in some cases there is not much difference between institutional and retail fees.
He said one major Wall Street firm that recently launched a series of institutional funds is pricing its growth equity fund at 80 basis points while Vanguard's U.S. Growth Fund carries an expense ratio of 43 basis points.
"It is correct that people are generally paying retail rates in 401(k) plans but they are usually getting more than retail services including record keeping, administration, comprehensive education programs, much more than the stand-alone investor in a mutual fund," said Mr. McNabb. "That doesn't mean that fees aren't important," he said. "Plans should be looking at them at both the plan and participant level. The mix, how much the plan pays and how much the participant pays, is important and it is also significant how you disclose all this," he said.
He said plans using Vanguard funds average 30 basis points or less "and we have some plans (with expense ratios) in the low teens," which use passive investment funds.
Robin Pellish, managing director-consulting at RogersCasey, Darien, Conn., said bundled mutual fund providers include record-keeping services knowing "it is a loss business" for them.
Mutual funds include record-keeping services "knowing that hundreds of millions of dollars will flow into their mutual funds" and are able to recoup those costs through investment management fees.
In addition, she said, mutual fund expense ratios are higher today than five years ago "and not insignificantly. . . . Then look at the tremendous inflows into mutual funds during that time; the economies of scale haven't worked here."
Ms. Pellish countered the argument that mutual fund families are moving toward institutionally priced funds saying, "most funds haven't started institutional funds and in general you are buying retail."
