Beware of Negative Growth

With yields low and fees high, "safe" funds used in deferred compensation plans may eat away at principal.
July 22, 2010 AT 3:00 AM
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

Human-resources directors and finance officers need to look into their 457 and 403b deferred compensation plans. They may be using bond funds and money market funds with fees so high that their participants will likely earn negative returns. With interest rates falling again to historically low levels, the fees on some of the funds used in this industry are so high that employees are doomed to receive a negative return.

With the stock market correcting again, public employees nationwide are climbing back down the risk ladder, much like a frightened kitty that climbed too high in the tree (again). That means they are placing even more money into "safe harbor" and "safe" investments. Like Will Rogers, they are more concerned about the return of their principal than the return on their principal. Except that some of these funds won't even return their principal if their fees eat up all the income.

Here's the problem: The mutual funds used by many plan providers in the deferred compensation industry are often not the lowest-fee products in their market. The plan administrators prefer to offer mid-priced or sometimes even high-priced mutual funds that compensate them (as peddlers and recordkeepers) invisibly. "R" shares, 12b-1 fees and "TPA reimbursements" are common in this sector.

For example, a retirement plan is usually large enough to qualify for low-fee institutional money market funds like Vanguard and Fidelity offer, but many of the plan administrators don't offer those because the mutual funds don't pay them for participant recordkeeping. Instead, they often offer higher-fee money market funds with expense ratios over 40 basis points (0.40 percent). Yet in today's market, six-month U.S. Treasury bills yield only 20 basis points and riskier commercial paper of that maturity yields just a little more. So it doesn't take a genius to figure out that the higher-fee funds are likely to produce negative returns unless the mutual fund waives fees to keep the yield above zero. Even the lowest-fee money market funds struggle today to keep their yields above zero, so the higher-fee funds are an accident waiting to happen.

The same problem affects many bond funds now. Their fees are even higher. Those investing in U.S. government securities are facing a yield curve in which Treasury bonds maturing within 3 years pay less than 1 percent. Most bond funds in these plans have an average maturity not much longer than that. So when we subtract the average retail government bond fund's total expense ratio of 90 basis points (0.90 percent), there is nothing left for investors from the coupon income. They can only make money if interest rates decline further and generate one-time capital gains. Meanwhile, they are doomed to increasingly large losses whenever rates ultimately increase — as would be expected when the economy recovers.

Thus, the only bond funds that make sense in a 457 plan today are either (1) highly diversified low-fee funds (such as bond index funds or full-spectrum total return funds with below-average fees), or (2) riskier junk bond funds that receive enough coupon income to cover their fees as long as the economy doesn't double-dip and send their prices crashing again.

Other alternatives. For savers and investors in deferred compensation plans, there are three alternatives. In today's low-rate world, at least one of these should be considered for inclusion after professional review. The plan can offer what is known as a stable-value fund that is essentially a short-term bond fund, if its portfolio yields are sufficiently strong and stable to consistently cover the fund fees and produce a positive return. Alternatively, some plans use an insurance company's interest contracts, which provide a guaranteed positive return as long as they are held a minimum time period. The third option is FDIC-insured bank CDs, which some plans offer as an alternative.

All three products have their warts. The stable value funds are generally not guaranteed and usually prohibit transfers to competing products like money market funds. Like bond funds, they also face a problem of low yields chewed up by fees, although they are designed to suffer smaller price losses if interest rates rise. Insurance companies still have credit-quality risks and must be professionally evaluated by an independent third party if you want to sleep well at night. A few states have a guarantee fund for general account products that insurance companies offer. These protect small investors in these plans, so that can be explored — but get it in writing. Finally, the FDIC-insured bank CDs can provide a percent or so of income, but at the expense of liquidity. Investors' money is tied up until they mature.

This affects Target-Date funds also. Here's another dirty little secret in the industry: Many of the Target Date funds and Asset Allocation funds now pitched as all-in-one investments for retirement savers contain big chunks of these higher-fee money market and bond funds in their fund-of-funds structure. Although the negative returns on those products will be invisible to the investor, they have the same issues. So investors — especially older investors using conservative funds with high percentages of these underlying products — will suffer the same problem, and not even know what hit them.

We still need better fee disclosure in this industry. Ironically, the U.S. Department of Labor recently announced interim regulations to improve the fee disclosures in private-sector defined contribution plans like 401(k) plans.  However, governments and political subdivisions are exempt from these federal rules and their participants have no federal protection. So plan professionals need to ask "best practices" questions of their plan providers to get to the bottom of their fees. Many of these sales people are trained to be evasive about total fees, so it is wise to insist on a comprehensive fee disclosure that captures all expenses when comparing funds and plan providers.

Consultants. This may be the time to engage a consultant to help. Some plan providers and administrators offer significantly lower-fee funds, so it pays to shop around. If your plan can save 10 or 20 basis points on 30 percent to 40 percent of the total assets — a normal participant asset weighting — and your total plan assets exceed $15 million, you can save enough money to pay the consultant for a fee review over a two or three year period in most cases. For larger plans, the savings will pay the consultant in a year or less.

Endorsers, beware. A final note to the unions and affinity groups that collect endorsement fees and royalties from plan providers — especially those that feign due diligence in overseeing "bundled" arrangements for small employers. You look like sitting ducks for a class-action lawsuit if you have funds in your patron's fund menu that produce negative returns because of unnecessary fees. The smaller plans are typically those with the highest fee structures, and thus the higher likelihood of negative returns under the scenarios I have described. Those who fail to perform diligent oversight and negotiate better deals could face some nasty litigation if participants' statements show red ink on funds promoted for safety and income. Or if the tort attorneys come out of the woodwork once they finish with BP.

Girard Miller
Girard Miller | Finance Columnist |