For DC Plans, Lowest Fees Aren’t a Panacea
January 25, 2017
Plan sponsors are focusing a lot on fees these days. Fees do play a part in sponsors’ fiduciary duties, but just one part. And fiduciary duty is tied to ensuring that fees are reasonable––not simply the lowest.
There’s no question fees are a hot topic for defined contribution (DC) plan sponsors. Fees came into sharper focus with ERISA’s fee-disclosure regulation in 2012. And while DC plan sponsors have always been fiduciaries, recent 401(k) litigation and the new US Department of Labor (DOL) Fiduciary Rule, scheduled to take effect this April, are leading many financial professionals—including plan sponsors—to look even closer at fees.
Putting Fees into Perspective…Not Just Under a Microscope
The trend for plan fiduciaries has been the line of thinking that says investing in funds with the lowest fees will ensure compliance with fiduciary responsibilities. But low fees aren’t a panacea for the numerous fiduciary considerations plan sponsors have to address. It’s fair to say that if a plan sponsor chooses a plan investment solely because it’s the lowest fee option, that plan sponsor hasn’t engaged in a prudent fiduciary process.
Ensuring that fees are reasonable involves a much wider scope of expert responsibility. It’s part of determining what the best investment solutions are for all plan participants.
DOL’s Extensive Fiduciary Road Map
Investments must be appropriate for all participants and beneficiaries, and investing decisions must consider a number of factors.
In determining whether a particular investment is appropriate, the DOL regulations state that a fiduciary must consider, among other things:
- the role the investment plays in the plan’s portfolio
- whether the investment is designed reasonably to further the plan’s purposes
- the risk and return factors of the potential investment
- the portfolio’s composition with regard to diversification
- the liquidity and current return of the total portfolio relative to the anticipated cash-flow needs of the plan
- the projected return of the total portfolio relative to the plan’s funding objectives
- the limitation on the participant’s rights to withdraw or to transfer their interests
In addition, when plan fiduciaries focus on a target-date fund, they should consider plan demographics and the underlying investments within each target-date fund when determining whether the fund is appropriate for the specific age band of participants.
With so many factors to consider when selecting an investment, merely focusing on fees, when put in this context, seems remiss. Likewise, focusing on index or passive funds to the exclusion of other investment options—just because of fees—seems similarly shortsighted.
For example, returns after fees are an important criterion for investments—and can reveal a much different picture of what’s best for a plan’s investment menu. And the lowest cost option may carry hidden risks as participants move toward retirement readiness.
Potholes Near the Finish Line?
For example, exposure to too much market risk can be particularly damaging in the years just before retirement. As we saw in the 2008–2009 market crash, retirees and pre-retirees are highly vulnerable to sharp market losses. They have less time to recover from investment losses, and if participants are near or in retirement, the amounts of those losses can be much higher.
Let’s put that into dollars and sense: A 35-year-old who loses 25% of a $100,000 balance would have lost $25,000, and would have three or more decades to recoup that loss. But a 60-year-old who loses 25% of an $800,000 nest egg would have lost $200,000, and would have very little time to make up for that loss.
So what can a plan sponsor do to limit this risk for participants?
A properly diversified portfolio would allow a participant to limit the impact of investment risks. This could include reducing market volatility exposure gradually and systematically as participants approach and move through retirement via a target-date fund’s glide path. Lifetime income options also provide certainty and can limit exposure to market risk as participants reach retirement age, and beyond.
Too much reliance on passive investment strategies might increase exposure to a big market selloff, a buildup in corporate debt and other market risks. Passive investing can lower fees, but it also keeps participants anchored to an index. Even though the market has come through an extended period in which the rising tide lifted all boats, it’s quite possible that the next five years won’t be the same.
Low-Fee Focus Not Key to Plan Success
While fees are certainly a consideration for plan participants and sponsors, our research shows that plan sponsors place other concerns higher on their list of critical measures of plan success.
In AB’s 2016 survey of more than 1,000 DC plan sponsors, respondents were asked to pick their top two measures of success from among six choices that ranged from improving plan participation and increasing employee retirement confidence to offering investments that outperform their benchmarks and reducing plan fees. Reducing plan fees was cited least often among the top two concerns.
Plan sponsors are keenly aware of potential litigation over excessive fees. But “excessive” is not the same as “reasonable.” It may be better to align fiduciary responsibility with a focus on what plan sponsors see as their participants’ greatest retirement savings issues. In our survey of plan sponsors, participants’ concerns over high fees ranked only fifth of seven possible answers.
Addressing All Concerns
One risk of focusing too tightly on fees is creating a distortion that addresses cost while possibly overlooking other retirement-saving factors. With so many equal or greater concerns, it’s important for plan sponsors to keep a broad perspective and maintain a comprehensive approach to their fiduciary duties.
Remember: While fees matter, they’re just one of many considerations for plan sponsors to monitor.
"Target date" in a fund's name refers to the approximate year when a plan participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as a participant nears retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested—including at the time of the fund's target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.