The Price of Everything and the Value of Nothing

By Fred Reish

There is a criticism of the newly rich-the nouveau riche-that they know the price of everything, but the value of nothing. In other words, they buy the priciest, flashiest items, but they don’t understand enduring quality. If that criticism were accurate, the nouveau riche would make lousy 401(k) fiduciaries.

That’s because, in 401(k)-land, quality and cost often move in opposite directions. That is counterintuitive, but true.

ERISA requires that plan sponsors and their fiduciaries, like 401(k) committee members, know the costs that are charged to the plan (and its investments) and understand the value that is received in return. The duty is explicit in the statute; ERISA Section 404(a)(1)(A) mandates that a fiduciary manage the plan assets for the “exclusive purpose” of providing retirement benefits and paying reasonable expenses of the plan. The fiduciaries must decide that the expenses are reasonable, which means that they must know what the costs are and what they are buying for the plan. The regulations are of little help in determining reasonableness; they say that it “depends on the particular facts and circumstances of each case.”

However, there is no need to dive into the law books; the answer is obvious. The expenditure must support the needs of the plan and the cost must be reasonable relative to the value. As the DoL brochure, “A Look at 401(k) Plan Fees...for Employees,” explains, fiduciaries must “insure that fees...and other expenses of the plan are reasonable in light of the level and quality of services provided.” Of course, those costs also must be in line with the price of similar services in the marketplace.

The largest expense is the cost of managing the plan’s investments. Typically, more than 80% of the expenses are investment-related. Focusing on investment expenses, it seems intuitive that, in order to provide the best-performing investments for the participants, the plan will need to spend more to hire superior managers. Is that true? No. The relationship between investment expenses and performance is counterintuitive. We have grown up in a world that tells us that we cannot expect to have Fifth Avenue luxury at Main Street prices; yet, in the investment world, below-average expenses can equate with above-average performance. That is true for several reasons.

Those include:

• The expenses are deducted from the investment return of a mutual fund and, the higher the expenses, the more the return is reduced.

• To overcome the effect of higher expenses, some investment managers will take on additional risk; while, in the short term, that risk may be offset by higher gains, most managers do not have the skill to produce a return that consistently offsets the higher risk and the higher expenses.

• Mutual funds that have below-average expenses also tend to have above-average performance; as a result, they attract additional assets that enable them to reduce their expenses further.

The performance advantages of low-cost funds have been documented by Morningstar, Standard & Poor’s, and John Bogle (of Vanguard mutual funds). All these studies concluded that, with only a few exceptions, funds with lower expenses outperform those with higher costs. As Morningstar reported:

“Our findings conclusively demonstrate the importance of avoiding the highest-cost funds in each category. In eight of the nine domestic Morningstar style boxes, we found that the lowest-cost 25% of funds in a category (ranked by 1996 expense ratios) had a significant edge over the 25% of funds that landed in the highest-cost bucket.”

The importance of costs-low costs-to mutual fund performance is well-documented. It is now part of the body of knowledge available to diligent plan sponsors and investment fiduciaries. In fulfilling ERISA’s mandate to act for the exclusive purpose of providing benefits and paying only reasonable expenses, fiduciaries must consider the costs of the investments. Unlike the nouveau riche, fiduciaries usually should shop at the bargain bin. If the expense of an investment option is high, compared to its peers, the fiduciaries must be prepared to justify the additional cost.

© 2003 Article was reprinted, with permission, from Plan Sponsor magazine (Sept. 2003). Copyright 2003 Asset International, Inc. All rights reserved.

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