Interpreting Investment Fee Research Is An Art

Nearly all retirement plan industry professionals would agree in principle that improved access to investment fee data has helped plan sponsors and participants shift towards more cost-effective products and providers.

Particularly since the introduction of 408(b)2 and 404(a)(5) fee disclosure regulations and the online availability of Form 5500 data, the ecosystem of fee and service benchmarking information for defined contribution (DC) plan sponsors and participants has expanded dramatically. The individual fee disclosures may still be difficult for the average participant to read and fully understand—steeped as they are in insider jargon and technical language—but the information is out there, and this is a good thing.

Perhaps even more helpful to plan sponsors and participants than the massive amounts of raw data on their own product choices is the increased prevalence of third-party fee comparison studies, which aggregate and benchmark information from broad pools of retirement plans and investment providers. One of the most recent examples shared with PLANADVISER comes from RiXtrema. The in-depth new report is impressive, billed by the firm as the “largest study of its kind ever conducted.” According  to RiXtrema, the underlying analysis “took 17 days of non-stop calculation on powerful 32 CPU Core computers.”

The conclusion of the study is summarized by its subhead: “Record Study of Retirement Plan Investment Expense Finds Over $17 Billion of Annual Waste.” RiXtrema says the analysis “went beyond fees, also focusing on quality measures to ensure that fee savings would not come at the expense of performance for participants.”  

“We have been researching the defined contribution plan market for more than two years and have been surprised to find that even many of the largest plans do not use the available leverage to obtain the best deal for plan participants,” observes RiXtrema President Daniel Satchkov. He explains that RiXtrema analyzed 52,529 retirement plans from the Department of Labor EFAST database, an all-electronic processing system of Forms 5500 and 5500-SF.

Satchkov notes the research leverages “a strict criterion that allowed the consideration of only high-quality funds as low-fee alternatives to the universe of expensive incumbent funds.”

“In the current study, only funds with a better ten-year track record than the incumbent funds were allowed to be used as replacements to obtain the savings,” Satchkov explains. “We also reran the analysis removing index funds and ETFs. The plan savings remained extremely high, in spite of the additional criteria.” 

NEXT: What fee data reveals  

Those who read a lot of retirement industry research can probably predict where the analysis moves next: “Based on a conservative analysis, it is estimated that plan participants could save on average 25 basis points per year by switching to lower cost investments that are quantitatively very similar to those they already hold, but with a better track record. Similarity is defined as a combination of category filters, together with historical and forward looking predicted-correlation based on a multi-factor model.”

With total defined contribution plan assets of $6.8 trillion (as of March 2015), RiXtrema argues the actual potential savings is at least $17 billion annually. It is not exactly easy to argue that retirement plan sponsors should not do all they can to achieve cost savings for their participants, but some readers of PLANADVISER have increasingly taken issue with this type of a conclusion.

Part of the issue is that recent examples of retirement plan fee litigation have cited this type of research as evidence that sponsors and providers are, broadly speaking, not living up to their fiduciary duties. And from a purely analytical point of view, there is the fact that these types of results, while enlightening, take full advantage of hindsight to enable the projected savings. In other words, it is one matter for dispassionate researchers to demonstrate, after the fact, that plan sponsors could have made different choices about what investments to offer, and quite another matter entirely to make investment decisions and comparisons in real time as a working plan sponsor.

RiXtrema responds to this criticism by observing that its own research approach was developed in relation to “a previous, independent study,” which indicated that menu restrictions in an average plan led to 78 basis points of additional cost relative to a low index fund basket. That study, RiXtrema admits, “could be challenged based on the argument that high fee funds held by participants should not be directly compared to low cost funds due to the unique return and correlation profile.”

RiXtrema's research objective, on the other hand, was to “find low fee replacements for high fee funds, but only where it could be proven that 1) the replacement does not materially change the risk/return profile offered to participants in their current menu and 2) that the track record of that fund is actually better on a ten- year basis, than the track record of the incumbent fund.”

“Our study overcomes the difficulty by making sure that the low fee alternatives are chosen to resemble the active fund being replaced,” RiXtrema says, “both qualitatively in terms of fund category and quantitatively in terms of past and holdings based behavior.”

Whether or not one accepts this picture, it must also be admitted that the overall quality and long-term net performance of funds is paramount to consider as plan sponsors and participants make their decisions in real time. Fees are crucial, clearly, but they are only one element of a spectrum of considerations made by plan sponsors in the management of the investment menu, and indeed of the whole plan.  

NEXT: Fee research obscuring value of active investing? 

One of the clearest ways expanded fee data is impacting the way retirement plan sponsors and participants go about picking investment options has to do with the perennial “active versus passive debate.” In short, sponsors and participants have clearly shifted in the passive direction as more fee information has become available. 

Whether this is a good thing will take some time to pan out. A recent Natixis Global Asset Management survey, in the meantime, warns that many investors have expectations that “don’t reflect a full understanding of the risks of low-cost index funds versus the potential benefits of more expensive active management.”

In a nutshell, providers are concerned that a laser focus on lower fees will wholly obscure the additional value potentially delivered by active management. It is true that active management often fails to outperform its respective benchmark over the long term, but this does not mean there are not any prudent active investment funds that would serve plan populations well.  

Other ways knowledge around investing fees and structures falls short include that more than three-quarters of investors agree that index funds and exchange-traded funds are usually a cheaper way to invest compared with active equity mutual funds, but the same number also believes they are less risky as a category. In reality, advisers will know, the simple labels of “index fund” or “exchange-traded” tell one essentially nothing about the underlying investment risk or strategy. According to Natixis, 64% of investors “think using index funds will help minimize investment losses.”

Similarly, nearly seven in 10 investors “believe index funds offer better diversification” compared with active management, and nearly the same number (61%) believe index funds “provide access to the best investment opportunities in the market.”

Natixis finds many investors who were expecting lower risk via low-cost indexed investments “were surprised at the start of 2016 when the Standard & Poor’s 500 had its worst opening since 1928.” The index bottomed out on February 11, having fallen 10.5% since trading began in January, Natixis explains. “The market did rebound, finishing the quarter 0.7% ahead, but tracking the index would have resulted in a hair-raising ride. And while the first quarter might be seen as an anomaly, volatility in markets is not.”

Taking this all together, Natixis urges financial services providers to ensure their clients understand up front what the real definitive characteristics of “active versus passive” actually are—and that investment fee statistics only tell part of the story.