Low-cost 401(k) plan investment can deliver high gains
Traditional wisdom says you get what you pay for. Therefore, the more expensive an item or service is, the better. But that’s not a universal truth, and the world of 401(k)s demonstrates that sometimes lower costs may lead to better outcomes.
The move toward greater fee transparency and lower fees across the financial services industry has benefited 401(k) plans. Take fund operating expenses, for example — the expense ratios of mutual funds and exchange-traded products have steadily fallen over the past few decades. According to a study from Morningstar, the asset-weighted average expense ratio across funds was 0.61% in 2015, down from 0.64% in 2014 and 0.73% in 2011.
Within today’s defined contribution plans, low-cost investments have the potential to deliver value where it matters: to plan sponsors and participants alike. The fee compression that has driven down the price of investment products more broadly has also ushered in an era of lower 401(k) investment costs for participants. As a result, sponsors are freeing up dollars that previously went towards fund operating expenses, enabling them to consider other ways to help participants while still keeping a keen eye on overall plan costs.
Low-cost investments in 401(k) plans
Low-cost doesn’t necessarily mean investing in the cheapest fund options available. And while passive investing is currently in vogue, a good 401(k) investment lineup can reflect fee-consciousness and still provide a diverse range of options. Ultimately, proper asset allocation may be more helpful to participants than trying to consistently beat the stock market over time, and for many plan sponsors a menu comprised of both active and passive funds is the preferred approach to help meet the needs of their participants.
One approach to cost-efficiency is to include low-cost funds like index mutual funds or exchange-traded funds in the plan’s selection. Not only can participants potentially save on fees, but research shows they may experience better returns. According to data from S&P Dow Jones Indices, 88.3% of large cap fund managers underperformed the S&P 500 Index over the past five years and 93.4% have underperformed the benchmark since 2013 (as of Dec. 31, 2016).
As I’ve observed over the years, the move toward fee transparency and fee compression has also resulted in smaller plans having more access to the same lower-cost share classes as larger plans as investment managers lower or eliminate investment minimums, benefiting even more participants.
While driving down plan costs is a positive trend, sponsors should first and foremost be sure that the plan they offer delivers value for their participants. Plan sponsors can consider a number of ways to allocate money that had gone to paying higher investment fees to work towards this goal. To put it another way, what could sponsors do for their participants if they had 30, 40 or 50 basis points of plan assets to work with?
For one, sponsors can provide managed account services, or personalized advice based on a number of data points about each participant. This can help participants formulate a retirement savings strategy based on their unique situation and financial goals. Today, I see many sponsors directing energy and resources towards personalized advice services and low-cost index investments in their plans rather than toward actively managed funds.
With that in mind, plan sponsors might consider making automatic enrollment or re-enrollment into professional advice/managed account services a Qualified Default Investment Alternative (QDIA) for the plan, so employees can potentially benefit as soon as they start participating. And for those plan sponsors who determine default advice may not be suited for their plan, low-cost target-date funds may also be a good QDIA choice.
In addition, plan sponsors can focus those dollars on ramping up their 401(k) plan engagement efforts to work towards specific plan goals, such as driving plan enrollment, increasing participants’ contribution rates, and improving overall financial wellness. This includes offering educational resources to help with behaviors like saving, budgeting, tax planning and more.
A final strong option to consider is directing savings back to participants. After all, putting fewer dollars towards fees may mean having more available to invest. And thanks to the power of compounding, the more a participant can invest early on and over time, the greater the potential for their 401(k) account to grow.
Low cost, big upside
What this boils down to is that the era of low-cost in the 401(k) universe can be good for all involved. Participants may benefit from putting more dollars towards their plan account balance and fewer towards fees, and, as mentioned earlier, lower-cost index funds have been shown to yield higher returns over the long term. More and more, plan sponsors at smaller companies have access to less expensive share classes, too, enabling them to offer enhanced plan features while keeping overall costs in line. For sponsors of large and small plans alike, low-cost investments deserve close consideration.