Due Diligence has New Vanguard “Low-Cost” Product Opening to Mixed Reviews
The Vanguard press release is dated October 11, 2011, but the story broke on Reuters recently. In anticipation of the DOL’s new Fee Disclosure Rule, there’s been a trend among major investment houses to repackage 401k offerings into “low-cost” bundled options. These products generally combine a variety of services under one umbrella fee. “The solutions both Vanguard and Schwab are rolling out are long overdue,” says Jonathan Leidy, a principal at Portico Wealth Advisors in Larkspur, CA.
Now nearly five months old, Vanguard works with Ascensus to offer its service both directly to plans and through 401k advisers. Some advisers like Vanguard’s initiative into this arena because it will draw more attention to fees. Leidy especially likes the Vanguard product, whose target market is the $0-20MM sized plan. “It provides a relatively low-cost, high-quality platform versus the prevalent insurance wrap products,” he says. Leidy feels “that particular market segment is both grossly underserved and oft exploited.” Michele Suriano, President of Castle Rock Investment Company in Castle Rock, CO, serves clients on both Vanguard’s bundled platform and on the Ascensus platform. She says, “I am delighted they are working together to serve the under $20MM market. They have been working together for years developing this product and the internal record keeping credit from the Vanguard investments makes this solution stand out in the small market.”
The fact Vanguard’s press release and the Reuters story headlined a hypothetical example where at $5,000,000 plan with 100 participants would result in an “all-in” fee of “32 basis points” certainly attracted a lot of attention. Leidy, though, analyzed the example in the press released and discovered revenue sharing accounted for 10 basis points. “In actuality the fee is 42bps,” he points out. “If a sponsor/advisor were to select Admiralty/Signal shares, additional ‘out-of-pocket recordkeeping fees’ would apply,” he says. Leidy estimates once you add in fiduciary adviser fees and individual participant adviser fees (he says these to be in the neighborhood of 1% for small 401k plans), total costs are likely to be similar to other non-bundled providers. Still, he feels these fees remain well below the highest bundled service providers.
The larger question is Vanguard’s casual acceptance of revenue sharing to give the impression of lower fees. While Vanguard is certainly not the only major player to use revenue sharing, this disappoints Leidy. He says, “This sales tactic of ‘eliminating’ fees through revenue sharing has dominated industry fee proposals for decades… I have come to expect this sort of brinkmanship from the Hancocks and Prudentials of the world, but it is disheartening to see Vanguard using the same opaque methods.”
The reliance on revenue sharing, a sore subject with those heeding to a strict fiduciary adherence, is ironic given the 2012 John Bogle Legacy Forum, where Bogle himself said “there’s a crying need for a fiduciary standard.” By lauding a “low-cost” product where that “low-cost” is predicated on revenue sharing, Vanguard risks exposing 401k plan sponsors to increased fiduciary liability. The problem, as Dr. Ron Rhoades so aptly puts it, resides in the conflict of interest borne by wearing two hats, a common situation with bundled service providers. In this case we actually have three hats as Vanguard manages the underlying funds, holds custody of the assets and provides the recordkeeping (albeit through a third party contractor).
Harold Evensky, President of Evensky & Katz understands the attraction to revenue sharing but warns plan sponsors – and their participating employees – to enter these relationships with eyes wide open. He says, “Well disclosed revenue sharing may be acceptable but it’s a slippery slope and to suggest ‘it keeps fees low’ is misleading. It only keeps fees low because the participants end up covering some of the costs. Again, if they understand that, it may be acceptable but the total cost is still the same (or, when hidden, typically higher).”
In a pure fiduciary setting, revenue sharing would have no bearing on investment decisions. Janice J. Sackley, CFE of Fiduciary Foresight says, “Selection of fund menus should be done without regard for whether or not an advisory firm shares in revenue. In an ideal world it is best if the advisory personnel who perform the due diligence on funds for selection on a 401k menu have no knowledge of which funds may provide revenue sharing. Their robust vetting process likely includes performance, fees, stability, error rates, administrative capacity, and many other factors, but [revenue sharing] should not be in the equation. If revenue-sharing funds are selected and the advisor chooses to accept compensation or reimbursement for certain shareholder accounting functions, of course that will trigger the disclosure requirements as well as sign-off by another plan fiduciary. This firewall between the ‘fund selectors’ and the personnel who administer revenue sharing is very difficult to maintain in small firms.”
And revenue sharing does appear to come with a long term cost. Academic research shows “broker-sold” funds – mutual funds that offer commissions, 12b-1 fees and other revenue sharing arrangement – lag “direct-buy” funds on average about 1% per year. One of the authors of the original research, Jonathan Reuter, Assistant Professor of Finance at Boston College’s Carroll School of has a new paper coming out later this year that revisits the data. He’s told FiduciaryNews.com “Our conclusion about actively-managed direct-sold funds outperforming actively managed broker-sold funds is unchanged.” In the face of this research, and the fact uneven revenue sharing among different plan options may have some participants subsidize other participants, 401k plan sponsors will need to examine whether any value associated with revenue sharing will offset the increase in fiduciary liability.
“A 401K plan can certainly avoid the problem by insisting on no sharing with all of the savings being passed on to the participants,” says Evensky.
Vanguard defends its use of revenue sharing. Linda Wolohan, a Vanguard public relations official, says “Any revenue-sharing payments Vanguard may receive from third-party mutual funds are credited back to the plan and can be used to pay for certain eligible ERISA expenses. Any remaining amounts would be distributed to plan participants at year-end.”
At the very least Vanguard’s product and other similar products espousing to be “low-cost” brings the issue to the forefront, and just in time for the implementation of the DOL’s new Fee Disclosure Rule. Many won’t be surprised if plan participants suffer “sticker shock” once they see the fees they’re paying.
Suriano provides a good summary. She says, “During this time of fee compression and disclosures it seems reasonable that all consultants and plan sponsors in the small market should take time to research this solution. It’s important for fiduciaries to have fact based answers when participants start asking how their fees compare to the marketplace and the value provided by their current provider. There will never be a one-size-fits-all solution but it’s our responsibility to align solutions with employer needs so I would encourage fiduciaries to do their research on this product.”