Active or Index Funds – More Perspective on Your Plan’s 401(k) Fees

March 15, 2021

Monday, March 15, 2021

 

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401(k) fees have been a hot topic in the news for many years now and, more often than not, the focus is on the evils of these fees. Much of the coverage, however, doesn’t tell the whole story. It’s time to dispel yet another myth about fees within 401(k) plans: the difference between actively-managed mutual funds and passively-managed funds, otherwise known as index funds.

Let’s start by repeating the ground rules for 401(k)s. When looking at ERISA (Employee Retirement Income Security Act of 1974), which governs 401(k) plans, it clearly states that 401(k) fees shall be REASONABLE for the products and services delivered. Nowhere in ERISA does it say that a plan must have the lowest fees. 

 

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The Difference Between Active and Index Funds

Before we get into a fee discussion, we’ll look at the basic differences between the two types of funds:

Active funds: Fund managers research various companies or holdings and make strategic decisions on which ones to buy and sell as well as when to buy and sell them. They are looking to provide “alpha,” which is a fancy way of saying they are trying to maximize returns for shareholders.
Index funds: Fund managers simply invest in the companies that make up the particular index, or benchmark, that the fund is tracking. For example, an S&P 500 fund buys the 500 companies that make up the Standard & Poor’s 500 index, which is the largest 500 publicly traded companies in the United States.

In other words, think of the active fund as the sports car on the highway weaving in and out of traffic, attempting to “get ahead” of everyone else, while the index fund is the bread truck in the middle lane, going along with the flow of traffic.

 

Comparing Costs

Based on how the funds operate, you can see why index funds would have lower costs of operation: they don’t incur the cost of research and strategy that is present in an active fund. But it’s not necessarily prudent to compare an active fund that costs, for example, 0.50%, with an index fund in the same category that only costs 0.10% since they’re apples and oranges.  While index funds are almost always lower cost than their active counterparts, this is not to say that one is better than the other, or that active funds cannot be also considered “low-cost.” 

 

There’s More to Funds Than Their Fees

Costs alone should not be the basis for selecting one type of fund over the other. However, there are many who blindly select an index fund just because it is cheaper. This would be like going out to dinner, dismissing the menu and asking the server to simply bring you the cheapest glass of wine, appetizer, entrée, and dessert.  You would certainly keep the bill down, but you might not enjoy the experience.

We often see 401(k) lineups consisting of only index funds, and many employers have a false sense of security that this approach provides some insulation from fiduciary liability. Again, costs are one piece of the puzzle when it comes to a prudent process. In fact, it could be argued that by only offering index funds, which are designed to track a particular benchmark, you are only guaranteeing that your employees will never achieve above-market returns!

A prudent fiduciary process should take costs of funds under consideration along with many other factors such as:

long-term performance
risk measurements
stability of the fund manager

 

Considering that performance measurements are almost always shown as net of all fees, it is important to look at the big picture and not judge a fund on just one factor in a vacuum.  The overall merits of a fund should be the reason for its selection.

 

The Solution? The Full Menu

All employers who sponsor a plan have probably been “pitched” by someone that they can “lower their fees.” While that sounds attractive, it would be wise to second-guess the methodology if the answer is simply selecting all index funds. Instead, it would be prudent to offer both active and index funds in your company’s plan to allow employees to make their own choice as to which is more appropriate. Think of it like providing a well-rounded menu so your employees can order what they want.

 

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Jim Sampson is the Director of Retirement Advisory Services at Hilb Group Retirement Services in Warwick, supporting retirement plans for companies and their employees for the last 24 years, and is the co-author of the book Save Like a Champion Today, A Winning Game Plan for Retirement.

 

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