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Money Never Sleeps - Why Mutual Funds May Be Hurting Your Employee 401k Returns...

Think all funds in 401k's are created equal?  Think again.  Under the premise that HR people are a lot like the general population, I've been meaning to get out a post to encourage all my HR peers who have anything to do with a 401k to push for more Index Funds and less Actively Managed funds.  You don't have to be Gordon Gecko to have a firm grasp of the impact.  First up, let's get a definition of what these types of mutual funds are:

Index Fund - A passively managed mutual fund that tries to mirror the performance of a specificGecko index, such as the S&P 500. Since portfolio decisions are automatic and transactions are infrequent, expenses tend to be lower than those of actively managed funds.

Actively Managed Fund -Most mutual funds are "actively managed," meaning the mutual fund shareholders, through a yearly fee, pay a mutual fund manager to actively buy and sell stocks or bonds within the fund. Though you would think that mutual funds provide benefits to shareholders by hiring alleged "expert" stock pickers, the sad truth of the matter is that the vast majority of mutual funds under perform the average return of the stock market. Over time, because of their costs, approximately 80% of mutual funds will under perform the stock market's returns. Currently, most mutual funds do not make their fees very easy for shareholders to understand.

Expense Ratio - A mutual fund's total annual operating expenses (including management fees, distribution fees, and other expenses) revealed as a percentage of the fund's average net assets. High expense ratios decrease investors' returns. An example would be two funds that both earned an 10% return before fees. If the first fund has an expense ratio that is 2 percent higher than second fund, you lose an extra 20 percent of your expected returns each year when your money is in the first fund. High expense ratios doesn't mean better results.

So, with those definitions in mind, if your mutual fund selection doesn't include multiple index funds with expense ratios of .50% and below, you can likely do better for your employees.  The average expense ratio for mutual funds in company 401K is said to be in the 1.50% range.

How's that hurt employees?  Over time and with the magic of compounding, that seemingly small difference in expense ratios can end up hurting overall returns.  Here's a calculation I ran at Moneychip.com:

Scenario - Investing $100,000 for 20 years, Expected Annual Rate of Return - 10%

Fund A - Expense Ratio of .4%, Transaction Costs of .1
Fund B - Expense Ratio of 1.5%, Transaction Costs of .8

Results

Cost-Adjusted Return Rate - Fund A, 9.0%.  Fund B, 6.2%
Final Balance - Fund A - $560,441.  Fund B - $333,035
Difference - Index Fund outperforms Actively Managed Fund by $227,406 over 20 years...

All the more reason to rethink your 401k.  If you don't have at least 4 index funds in your 401K, you aren't providing all the tools available to enable employees to maximize their returns.

Like Gecko says - Money Never Sleeps.....

Legal Considerations - Before you start swapping funds in your plan, make sure you get full disclosure on expenses associated with employees moving money out of a fund with a high expense ratio.  Sales fees associated with funds with high expense ratios are common and a type of poison pill designed to discourage change...

Comments

Grant

You've painted some broad strokes here...The scenario for the active v. passive manager assumes bullish activity. One cannot discount having a fiduciary on the side of the EE when the chips are down. Sound advice might be to seek professional wisdom from someone who is willing to take on the fiduciary responsibility for the side of the EE as well as the ER.

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