In parts 1 and 3 of this series we discussed 401-k retirement plan fees and how important it is – for both employer and participant – to keep them reasonable.
Generally there are two types of retirement plan fees and expenses.
1. Recordkeeping and Administration
2. Investment expenses
Let’s explore #2 . When it comes to evaluating investments, it’s critical to remember: markets are unpredictable… while expenses are forever.
In the end, the lower your costs, the greater your share of the investment return. And research suggests that lower cost investments have tended to out perform its higher cost alternatives.
There are two ways to improve participants returns. The first is to earn higher returns than the average investor by finding a winning manager or a winning investment strategy (an “alpha” or “skill-based” approach). Unfortunately, research shows that this is easier said than done . The second way is to minimize expenses. And study after study reveals a common thread: higher costs lead to worse performance for the investor.
The illustration below compares the ten-year records of the median funds in two groups: the 25% of funds that had the lowest expense ratios as of year-end 2012 and the 25% that had the highest, based on Morningstar data. In every category we evaluated, the low-cost fund outperformed the high-cost fund.
Average annual returns over the ten years through 2012
Notes: All mutual funds in each Morningstar category were ranked by their expense ratios as of December 31, 2012. They were then divided into four equal groups, from the lowest-cost to the highest-cost funds. The chart shows the ten-year annualized returns for the median funds in the lowest-cost and highest-cost quartiles. Returns are net of expenses, excluding loads and taxes. Both actively managed and indexed funds are included, as are all share classes with at least ten years of returns. Source: Vanguard calculations using data from Morningstar.
Indexing can help minimize costs
If—all things being equal—low costs are associated with better performance, then costs should play a large role in the choice of investments. As the chart below shows, index funds and indexed exchange-traded funds (ETFs) tend to have costs among the lowest in the mutual fund industry. As a result, indexed investment strategies can actually give investors the opportunity to outperform higher-cost active managers—even though an index fund simply seeks to track a market benchmark, not to exceed it. Although some actively managed funds have low costs, as a group they tend to have higher expenses. This is because of the research required to select securities for purchase and the generally higher portfolio turnover associated with trying to beat a benchmark.
Asset-weighted expense ratios of active and indexed investments
Notes: “Asset-weighted” means that the averages are based on the expenses incurred by each invested dollar. Thus, a fund with sizable assets will have a greater impact on the average than a smaller fund. ETF expenses reflect indexed ETFs only. We excluded “active ETFs” because they have a different investment objective from indexed ETFs. Source: Vanguard calculations, using data from Morningstar Inc.
Look: Employers that offer 401-k plans have more choice today than ever. “Open architecture” platforms give plan participants endless investment choices. And since we can’t control the markets - and it makes sense to focus on things we can control – reducing costs via ETFs and index funds is a worthwhile endeavor for anyone who sponsors or participates in 401-k plans today.