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Home > Library > Stable Times > Volume 5, Issue 1  The quarterly publication of the Stable Value Investment Association First Quarter 2001 • Volume 5 Issue 1 Back to Basis Point BasicsJust a few can make a huge difference over a lifetime of investing, which is why institutionally priced funds are becoming a hot 401(k) topic By Timothy Middleton A basis point is such a small thing that the Wall Street Journal has to explain, every time it uses the phrase, that it means one-hundredth of a percentage point. But those teensy numbers can get awfully large when they're compounded over years and years of investing. At 11%, the historical average return of domestic equities, a defined contribution plan with a present value of $50,000 would grow to $403,230 in 20 years. But that historical average doesn't take fees into account. If they were 147 basis points, the Morningstar average for large-cap growth funds, that hypothetical kitty would shrink to only $308,845. "You can easily make a difference of 10% to 30% in someone's retirement assets by paying a higher percent than they should have paid in fees," says Don Butt, vice president of the 56,000- participant defined contribution plan of Qwest Communications International in Denver. Only 1.2% of the plan's $6 billion of assets are invested in retail mutual funds. The Department of Labor is so concerned about 401(k) fees that it posts bulletins for employers and employees alike on its website (www.dol.gov/dol/pwba), explaining its rules. It also offers a form that sponsors can use to determine if the fees charged their participants are reasonable. "Expenses eat up rates of return and fiduciaries, in their role of prudently selecting plan investments, should be examining these expense ratios," says Louis Campagna, chief of the division of fiduciary interpretations of DOL's Pension & Welfare Benefits Administration. DOL rules leave latitude for sponsors to select investment options, even if they are relatively expensive. The sponsor cannot personally benefit from them. "Plan sponsors don't have to pick the fund that is getting the highest return, and they don't have to pick the fund that's charging the lowest fees. They have to act in a reasonable manner," says Donald Myers, an ERISA specialist with the Washington law firm of Reed Smith, and himself a former DOL official. Fees have to be "within a range of reasonableness," he says. Beyond reasonableness, however, is participants' bottom line, and some sponsors feel passionately that fees can help make or break a participant's future. Butt says his plan stresses the advantages of low-cost investments, and participants have gotten the message. "The vast majority of our participants are happy with institutionally managed funds," he says. Bottom Line: They're Cheaper Institutional investment portfolios typically have lower expenses than those designed for retail investors because their administrative costs are less. High minimums – they are $5 million for PIMCO Total Return Institutional, compared with $2,500 on that fund's Class A shares – mean they have a lower ratio of shareholders to assets than retail funds, and therefore lower administrative costs. The PIMCO institutional fund, widely offered in 401(k) plans, has an expense ratio of 43 basis points, less than half the 90 points charged on the A shares. Institutional funds also tend to have less cashflow volatility than retail funds, meaning fewer assets have to be reserved for possible redemptions, and trading costs are lower. And separate account fees, which can be utilized by many large plans are even lower! Institutional funds have become increasingly popular. Of the 5,650 distinct mutual fund portfolios in the database of Morningstar Inc. as of Feb. 28, some 1,045, or nearly one in five, was institutional. Within defined contribution plans, however, institutional portfolios are far from ubiquitous. A 1998 study by Fidelity Investments found that only 15% of large plans – those with 2,500 participants or more – and less than 3% of small ones offered institutionally priced investment options. "There has been very little increase in the percent of plans offering domestic equity pools and separate accounts since 1995," the report concluded. Indeed, the trend may be the other way. The most recent annual survey of defined contribution plans by the 401(k)/Profit Sharing Council reports that mutual fund companies are by far the most popular investment managers utilized by plans of all sizes, accounting for 36.7% of aggregate assets. The next most popular managers are banks and insurance companies, with 18.3% and 16.8% of assets, respectively. The survey doesn't even report statistics on institutional vs. retail pricing. DuPont, the chemical giant, offers a few institutional funds to the 60,000 participants in its $10 billion plan, says Michael Wyatt, a director at DuPont Capital Management, which manages money institutionally as well as overseeing the 401(k) plan. Of the 30 investment options available, nearly 20 are brand-name mutual funds from such complexes as Merrill Lynch and Fidelity. Only six are institutionally priced funds – three equity index portfolios, and three asset-allocation funds that use the index funds and a stable value fund in conservative, moderate and aggressive mixes. "We sought to satisfy most participants' needs," Wyatt says. About half the plan's total assets are invested in the stable value option. For the balance, "We wanted to offer a range of investment vehicles, including institutionally priced funds and, for those who feel most comfortable with them, brand-name mutual funds." Some plans push them Plans that do believe in institutional funds, however, tend to use them extensively. Of the 26 investment options available to participants in the 401(k) plan of American Airlines, more than half are institutionally priced. Bill Quinn, president of AMR Investment Services, which both manages the plan and the American AAdvantage group of mutual funds, says 13 core options are managed by the same external managers that manage the company's defined benefit plan assets. "Our belief is that to the extent we can provide enough investment options of the institutional variety, coming out of our defined benefit plan, that's the preferential way," he says. "We get lower costs, better diversification and professional oversight of the investments." Myra Drucker, chief investment officer of Xerox Corp., also believes strongly in institutionally priced funds, and continually stresses the importance of low fees in the plan's quarterly and annual reports. The Xerox 401(k) plan has 50,000 participants and assets of $3.5 billion. It offers nine core options and a mutual fund window to 49 others. The core options are mainly unitized versions of the company's defined benefits plan portfolios, which provide the benefits of lower fees and strong performance. "We're a great believer that fees clearly have an impact," she says, "and that's one of the reasons we felt that using our buying power and creating our own institutional funds was so important to our plan participants – because we could bring them expense ratios that were significantly lower." The international stock fund available to Xerox participants has an expense ratio of 80 basis points. The average for Morningstar's foreign-stock category is 170 points. The small-company domestic stock fund charges 68 points, compared with 138 points for Morningstar's small-blend category. A fund called Balanced Fund/More Stocks (70%, rather than the usual 60% equity allocation) charges 47 basis points, compared with Morningstar's 127 points for the balanced objective. Xerox's core funds attract 92% of the 401(k) plans assets, Drucker says. "Our single most popular option is the Balanced Fund/More Stocks, with 35% of defined contribution assets," she says. The most popular option in the mutual fund window is a money-market fund; Xerox doesn't offer a stable value portfolio. In the heady days of the late 1990s, when equities were delivering double-digit returns, the toll fees take on investment performance were scarcely apparent to defined contribution plan participants. Since the Nasdaq Composite Index peaked March 10 of last year, however, returns have been negative, meaning high fees aggravate the economic pain already administered by lower market values. Reed Smith's Myers notes that no participants have yet sued their sponsors alleging that high fees ate into their retirement balances. Lower returns will make participants more sensitive to the eroding impact of fees on the accumulation of their pension savings over time. If return expectations are significantly lower, fees will stand out sharply, and could become a much hotter topic among regulators and plaintiff's lawyers alike.
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