‘Best’ Doesn’t Always Mean ‘Cheapest’

50628995_sI talk a lot about retirement planning. To clients, to my class attendees, to you Cutter Family Finance readers, to Jill and my girls, even to my dog, Max, when I can’t sleep at night. After listening to my ramblings for years, everybody listed above can probably name over a dozen investment vehicles that pre-retirees can utilize when saving for their future. But many Americans think of only one thing when it comes to their retirement planning, and that is their employer-sponsored retirement plan. Thirty years ago, most would have only thought about their pension, their employer-sponsored defined benefit plan. Now, most career-long employees rely on their 401(k), their employer-sponsored defined contribution plan.
It comes as no surprise then, that because 401(k)s are the primary saving mechanism for so many people, they receive the lion’s share of the attention and speculation from regulators.
The Employee Retirement Income Security Act of 1974 (ERISA) holds 401(k) plan sponsors to a fiduciary duty. I’ve spoken before about the difference between the suitability standard and the fiduciary standard. Many brokers and investment managers are held only to a standard of suitability, which means that their recommendations need only be “suitable” for their clients, not necessarily what is best for them. The fiduciary standard, on the other hand, requires an advisor to take their clients’ best interests into consideration before making any recommendations. Since ERISA imposes a fiduciary duty on employer-sponsored retirement plans such as a 401(k), the question is, what is in a participant’s best interest?
Last summer, I wrote about a US Supreme Court ruling that defined the duties of employers with respect to their company’s 401(k) plan. In that specific case, a group of workers in California argued that their employer breached its fiduciary duty by choosing more expensive retail-class mutual funds when nearly identical and cheaper institutional-class funds were available. The ruling stressed that employers must choose investments that they believe are the best possible selections for the plan and they must be prepared to defend those decisions. Furthermore, they are obligated to actively monitor the performance of those investments to ensure that they continue to be the best selections.
In another lawsuit regarding 401(k) management, Bell et al. v. Anthem Inc. et al., the fiduciaries of the Anthem 401(k) plan are being accused of breaching the fiduciary standard by subjecting its participants to excessive Vanguard Group fund fees, specifically the revenue-sharing portion of those fees (12b-1 fees). This is just another example of participants in a 401(k) plan attempting to argue that “best” means “cheapest.” But I could make a case that anyone who bought a Pinto back in the ‘70s knows that the cheapest choice may not always the best choice.
Fees must be “reasonable” rather than the cheapest; the fees must be reasonable for the level of service provided to the plan. In other words, the value of the services provided must be worth any additional cost. A plan fiduciary, as defined by ERISA, must be able to justify that the services provided are worth the fees charged.
This debate is causing many within the industry to point to actively managed institutional strategies as the greatest example of value. With these strategies, managers rely on analytical research, forecasts, trends and momentum, quantitative data, and their own judgment and experience in making investment decisions for a retirement plan.
Think about it this way: since about the middle of last year, small cap stocks are down about -22 percent, international stocks about the same, mid cap stocks are down about -20 percent, large caps are down about -12 percent, commodities are at a whopping -55.2 percent, and global bonds -15 percent. Low cost index funds have performed similarly. Not a very rosy picture to date.
Active management, as one could assume by the name, typically has higher fees than passively managed (or indexed) funds. But what if a slight increase in fees could give a plan participant an actively managed strategy that will move a portfolio to safety during a major market downturn? Cheaper funds, on the other hand, will often simply “ride out the storm.” The cheaper approach could leave a portfolio in a fiery mess, just like those cheap Pintos in the ‘70s.
You see, a fiduciary’s role isn’t necessarily meant to find the most possible ways to cut costs. In my opinion, that is folly. A plan fiduciary meets its standard in managing those employer-sponsored plans, by relying on making the best investment decisions for its participants and beneficiaries based on ALL of the relevant factors. The cost associated with the fees is an obvious consideration; I get it. But it is not the only one. Be vigilant, stay alert, and make sure your plan fiduciary is doing what is best for you by looking at the big picture of your investment choices, and not just the short-term bottom line. Have a great week!