We blog frequently about high 401k costs—and with all the other problems (and ready solutions) in these failing plans, I sometimes worry that we talk about cost too much! But then I'm reminded of yet another way that actively-managed funds over-charge and conceal what they are charging, or I analyze another plan, and my outrage (and sanity) returns. If you think we overdo our rant on cost, please, please, take a closer look! You and your participants are getting fleeced and there is no redeeming value for your overpayment.
When we do a cost analysis of plans and calculate what can be saved, we try to keep it simple and not overstate. The easiest way to calculate the cost of a plan is to take the "total expense ratio" on each fund in the plan and then "weight" that cost based on how much money is in each fund. Add to that any other costs that are billed to the plan sponsor or participants and you have a reasonable estimate of what the plan costs. I can promise you this—this "reasonable" estimate is far more than you should be willing to pay.
But this calculation leaves out a very significant cost component. The disclosed expense ratio does not include trading costs—the costs for buying and selling shares within an actively-managed fund. The more active a manager is in trading the underlying portfolio, the higher these costs will be.
I guess that plan sponsors with actively-managed funds in their plan would view some extra cost here as reasonable: after all, you would be seething if your manager just sat on his butt all year! But the irony is that for all that extra managing, studies prove that there is no correlating improvement in return. In fact, the more managing and trading, the worse the return.
How much additional cost does trading expense add? Generally between .09 and 1 percent. On the high end, that nearly doubles the cost of the average actively-managed fund. And keep in mind, active funds hardly ever beat their index! All this trading and cost–and literally nothing to show for it.
Not moved by an extra 1% of cost? Here's how it impacts savings:
A $7,200 investment growing by 7% each year will reach $14,163 after 10 years, before charges. A fund levying an annual charge of 1.55% would be worth $12,240 after 10 years, but a fund with an annual charge of 2.25% would be worth be $788 less, at $11,452, according to Lipper, the fund analysts. Over 30 years, a 1% expense load depletes appreciation by roughly 28%.
Critics like to say that simplistic comparisons between the charges levied by actively-managed funds and index-tracking or passive funds miss the point. That the two investment approaches incur different levels of cost, so the question is not whether stock-picking funds should be more expensive than index funds (they obviously are) but whether their higher charges are transparent and a fair reflection of the extra resources and effort involved. This is nonsense.
The costs are not only non-transparent, they are hardly discoverable. And what would "a fair reflection of the extra resources and effort" be? The simple reality is that actively-managed funds cost much more than index funds 100% of the time and they lose to their index more than 80% of the time. That is a fair reflection. Why would anyone knowingly pay that cost? Why would any advisor instruct them to do so?
What's your definition of a successful plan? Great participation? Low cost? Helping employees maximize their retirement savings? Preventing harmful participant decision-making? Compliance? Fiduciary excellence?
The questions we pose in this blog are designed to get you thinking about where your plan is today, and where it might fall short of your own definition of success.
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