Recent developments in the marketplace, as well as with passed and pending regulation from the U.S. Department of Labor, are making a strong case for the substantial use of index mutual funds and ETFs in investment lineups of corporate retirement plans. This is in sharp contrast to the traditional practice of primarily (if not exclusively) including only actively managed mutual funds in these plans. Actively managed funds, however, have come under increased scrutiny as concerns regarding cost, diversification, performance, and fiduciary risk have come to the forefront. With these issues in mind, one can make a substantial case for the inclusion of index funds in corporate 401(k) plans, and even a case for using index funds exclusively.
A substantial part of the argument in favor of index funds is that their performance does not deviate from that of the underlying index. In stark contrast to this, actively managed funds not only deviate from their benchmark, but routinely miss the mark on the low side, underperforming their underlying indexes over time. Of the major equity categories, only large cap value fund managers beat their benchmarks at least 40% of the time. Mid-cap and small-cap fund managers, on average, beat their index at a rate of less than 10%. With knowledge of this consistent under-performance, a new concern arises: Are actively managed funds really worth the cost?
The recurring investment management fees of actively managed funds are higher than those of index tracking funds. These costs account for a substantial amount of total costs levied on plan participants and eat away at returns. If the actively managed funds are already routinely under-performing their index, what value are plan participants getting by paying higher fees for these funds? Even if an actively managed fund beats its benchmark, its management fees may be as much as an entire percent higher than a related index funds, meaning that it would have to beat its benchmark by more than one percent to match the performance of the index-based fund after fees.
Another aspect of 401(k) plans that has slowed the transition to including index options is the practice of ‘revenue sharing’, which involves fund companies making payments to plan administrators. In revenue sharing arrangements, plan administrative costs are ‘bundled’ into the expenses of funds offered in the plan. For example, suppose XYZ Growth Fund is offered in the investment lineup of a given 401(k) plan, and that the management fee for this fund is normally 80 basis points (.8%). Now suppose that to cover administrative costs of the plan, the provider adds a 60 basis point (.6%) ‘wrapper arrangement’ on top of the normal management fees. The fee to be invested in this fund through the plan will now be 140 basis points, or 1.4 percent! This is a common occurrence in plans established through large providers, primarily insurance companies, and drastically reduces participant balances over time because, as the costs are in percentage terms, participants pay more as their plan balances increase.
Based on the above arguments, the U.S. Department of Labor (DOL) is going to continue pushing for greater fiduciary standards, a major aspect of which will be an emphasis on the use of index funds. In the eyes of the DOL, the reasoning is quite simple – while stock markets are often unpredictable, cost can be controlled. With defined contribution plans often being the largest financial asset heading into retirement for most participants, an emphasis on seeking market returns at the lowest cost possible should be the new norm for corporate retirement plans.
The rigidly entrenched 401(k) providers will not change their ways overnight; and fund companies won’t easily relinquish their active management fees, which tend to be significantly higher than those charged on index-based products, especially with recent volatility pinching profits. However, we believe that beginning in April 2012 when 401(k) plans are required to disclose fees broken out into separate categories for administrative, investment management, transaction, fiduciary investment advice, and other expenses, then employees and employers will discover that index funds are the very definition of low cost diversification.
The 401(k) plans of the future will consist of a menu largely consisting of low cost index funds or ETFs (exchange traded funds), resulting in lower fees for plan participants and less fiduciary liability for plan sponsors. Ideally these plans would be set up through an independent fiduciary investment advisor, and will use a state-of-the-art unbundled fee structure (investment advice, custodial, administrative fee, etc. all separate). These changes will go a long way in improving the performance of 401(k) plans, resulting in higher retirement balances for plan participants.