By Jack Dyer
Responsibility for accumulating retirement assets is shifting to individuals, but plan fiduciaries still make important decisions affecting participants' investment results. Fiduciaries select the vendors and investment options, and negotiate the costs of services. Fiduciaries have a duty to manage those services and costs in the best interests of their participants. Failure to do so can subject the company and the individual fiduciaries to litigation risks.
While there are prudent steps a fiduciary can take in selecting investments, none provides fiduciaries a crystal ball. However, knowing what services cost does not require a crystal ball. Fiduciaries must ensure that participants do not overpay for investments or other services.
Overpaying for investments is likely to directly affect participants' ultimate account balances. Generally, for every 25-basis-point decrease in net return, a participant loses between 5%BD;% and 6% of the ending account balance over a 40-year working lifetime. Using ballpark assumptions regarding contribution and matching rates, future investment returns and wage growth, the shortfall would be about $50,000 for an employee hired today at $40,000 per year. For a company with 1,000 participants, that is collectively a $50 million shortfall. The Department of Labor is increasing its review of fees paid from plan assets, and litigious participants could make writing a check for that shortfall a reality. Understanding and managing the plan's cost is a fiduciary responsibility.
Because most plans invest in mutual funds and costs are largely related to the mutual funds' expense ratios, this analysis focuses on providing a framework for evaluating mutual fund costs. Mutual funds report investment returns net of expenses. As a result, many observers assume that the level of expenses is not relevant and net performance is the only important metric. However, in the long-term there is a direct correlation between low expenses and higher returns. This is particularly true for the most efficient investment asset classes, in which there is limited opportunity to outperform benchmarks. All other things being equal, a fund with a lower expense ratio would be expected to produce higher returns over time.
Looking at 85 actively managed large-cap core equity funds in the Morningstar Inc. database over the 15-year period ended March 31 and ranking them by quintile in terms of annualized performance, the quintile with the highest average performance, at 12.71%, had the lowest average expense ratio, at 0.86%. In each successive quintile, average fees rose and average performance decreased, down to the lowest quintile, which had the highest average expense ratio, at 1.32%, and lowest average return, at 7.4%.
For the 15 years, the S&P 500 stock index returned 11%, ranking in the second quintile. Only 23 of the funds evaluated outperformed the S&P 500, net of fees. The current expense ratio might not have been the fund's historical expense ratio, but the results support the intuitive notion that expenses matter. In any efficient market, we suspect expenses are inversely correlated to returns in the long run.
So, what is the right price? Analysis of large-cap core funds found that the dollar-weighted average expense is 0.79% and that 50% of the funds evaluated have a share class available for an investment of $1 million or more that charges 1% or less. Assume a plan has $10 million invested in the large-cap core option and, based on the data in the analysis, the fiduciaries have concluded that 80 basis points is a fair price for the investment of a large-cap core portfolio. If the fee were actually 100 basis points, participants would pay $20,000 per year more than fair market. This higher fee may or may not be a problem. If the vendor, in addition to investment management, is providing services that have a value of $20,000 per year, then the fee is justified. Therefore, to determine if the extra $20,000 is reasonable, the fiduciaries must also determine the value of the non-investment services provided by the vendor.
Of course, fiduciaries cannot look at just one fund in their lineup and conclude whether participants are paying too much or too little. Fiduciaries can do a detailed fund-by-fund analysis along these lines using this study's data and draw reasonable conclusions about a plan's aggregate costs. Also, to fully analyze the cost of a plan, fiduciaries must include all of the charges a vendor may levy, either on the plan sponsor or participants. The fund expense ratios do not necessarily represent the only costs.
Plan fiduciaries should also note that, as assets grow, the vendor's revenue grows. In the 100 basis points scenario, if assets double, then the $20,000 difference becomes $40,000. Absent other changes, it seems unlikely the vendor's cost of providing record-keeping and other services would also double. The right cost today might not be the right one tomorrow, and fiduciaries must regularly review their plan's costs.
For larger asset pools, mutual funds might not be the most cost-effective way to deliver investment management to plan participants. Some investment organizations are beginning to offer daily-valued commingled funds, which could be suitable investment options for defined contribution plans and offer a lower cost. It is also possible for a trustee to value a separate account daily and provide the record keeper with daily net asset values.
Alternatively, the mutual fund industry could move away from its retail roots and begin offering truly institutionally priced share classes. Comparing just five large, well-known investment management firms' large-cap core separate account fee schedules published in the eVestment Alliance database shows an average of 17 basis points more being charged to their mutual funds. This was not a robust study, but it does suggest mutual fund directors, with a little hard negotiation, could certainly offer institutional investors cheaper investment options and still more than adequately cover their investment costs.
Whatever the solutions, it is clear fiduciaries must take the lead in managing participant-directed plan expenses to ensure participants enjoy the living standards in retirement that their significant contributions should support.
Jack Dyer is a vice president at Aon Investment Consulting in Somerset, N.J. His commentary is based on a more extensive analysis of expenses across multiple mutual fund strategies. The study is available upon request by e-mailing [email protected]
