Cover | Published in August 2002

What You Don't Know Can Hurt You

Unreasonably high expense ratios can get you into trouble

By Nevin Adams | August 2002
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Far fetched? Not according to a growing number of experts, who point to suits by participants at First Union (now Wachovia) and NY Life, and certainly not in the wake of suits by participants at Enron, Lucent, and WorldCom, concerned that employers hid information that affected their investment decisions in the 401(k) plans.


Granted, the First Union suits (now settled) and NY Life suit (still pending) both involved allegations of employers who limited participant choice to proprietary funds—that is, funds that benefited the employer directly on a financial basis by requiring an investment in those funds. However, what about the employers that are not in the business of offering investment services? Surely, they are insulated from such actions.


Not necessarily. However, even plan sponsors who are not worried about participant litigation (there must be one or two) might want to consider the following. The program and/or fund choices you offer to your participants can make a significant difference in their retirement security.




Equal Impact?


The reason is as simple as this. All funds are not created equal. Prudent plan sponsors routinely examine the risk/return characteristics of the funds in their defined contribution programs. Generally speaking, those returns are, in fact, net of expenses. However, that does not mean that the comparisons yield a true apples-to-apples comparison. Among actively managed large-cap funds with at least three years of history, mutual fund fees range from 0.31% to 2.90% (average 1.10%). Hewitt Associates consultant Pam Hess notes that even indexed mutual funds (with at least three years of history on Morningstar's Principia) have fees that range from 0.03% to 2.95%, with an average of 0.51%.


How much difference might that make to a participant? Well, if you are a participant with $50,000 invested, and you assume an annual growth of 8% per year, Hewitt's Hess notes that investing in a fund with 0.50% fund expenses would yield $263,000 at the end of 30 years. However, if your investment were in a fund that had 1.25% in fund expenses, the ending wealth value would be just $228,000. That 0.75% difference in fund expenses adds up to a 15% difference in return for the participant. These days, it is not hard to imagine a scenario where some enterprising attorney appears in court alongside a participant who will argue that his retirement has been diluted by fees taken from his account—fees that his employer, either deliberately or through some fiduciary oversight, sanctioned.


That is where fiduciary concerns should kick in. A surprising number of plan sponsors are not aware of what they are paying for the services they receive, despite volumes of disclosures. One cannot even imagine a request for proposal that does not call on the bidding vendor to offer a detailed schedule of fees for services bid upon, for example. Moreover,   there is no shortage of mutual fund prospecti in which the various and sundry fees and expenses netted against fund returns are displayed in excruciating detail.


Still, many plan sponsors remain ignorant of what Hewitt has termed their "Total Plan Cost," the aggregation of costs related to investment management, recordkeeping, and trusteeship that comprise about 95% of the total costs, according to Hewitt consultant Tim Murphy.