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The Two Faces of 403(b) Index Funds
NEA Direct Invest and Schools First CU Offer a Glimpse Into Revenue Sharing Fees
I’ve been reviewing a couple 403(b) vendors for some clients. One is the local program offered by the credit union, Schools First, the other by the national union, NEA Direct. Both products are flawed, but in the scheme of things quite reasonable given how bad most 403(b) products are.
What stood out to me in both of these products was that they offered two different S & P 500 index funds. That’s strange.
In the case of Schools First they offer the Vanguard 500 Index Admiral fund which has an expense ratio of 0.04%, but an add-on fee of 0.44% for a combined fee of 0.48%. The record keeper is Nationwide and Schools First offers another S & P 500 index fund sponsored by Nationwide. This fund charges a whopping 0.60%, but the add-on fee is only 0.04% for a total fee of 0.69%.
The same exact investment option can be had for 0.48%, but some participants are paying 0.69% (yes, both are overpaying for an index option).
Why would Schools First do this?
Before I attempt to answer this question, let’s look at the National Education Association’s 403(b) product, NEA Direct Invest.
Direct Invest also offers Vanguard’s 500 Index Admiral fund which only costs 0.04% and they don’t add a fee (this is a fantastic deal). But then they bizarrely offer BNY Mellon S & P 500 index which costs an absurd 0.50%, 12 times more expensive.
What is going on here?
The answer is revenue sharing. I used to consult for government retirement plans and while I advocated for any plan that I worked with to eschew using mutual funds that contained hidden fees called ‘revenue share’ that would be passed onto the recordkeeper, some plans elected to keep using them.
Hidden revenue share fees are problematic for many reasons, but if you already have an index fund that charges hidden revenue share fees in your plan, if you replace it with an index fund that doesn’t have revenue share, the plan’s recordkeeper loses income (this is why I always advocated for a revenue-neutral plan where fees are explicit and all investment options are free of hidden revenue share fees).
In order to correct for the lost revenue, a plan or product might add another index fund that has no revenue sharing fees, but not move the assets from the old index fund that does charge those fees into the new one (so existing participants would still be in the expensive index fund unless they knowningly made the exchange). This is the likely explanation for why both the Schools First and NEA Direct Invest programs have two index funds that track the same index, but charge different fees.
A fiduciary would not allow for such trickery. A fidcuiary is required to place the interest of the participant first. This means that if there is a lower cost investment option within the plan that is exactly the same, that lower cost option must be utilized. In other words, a fiduciary based plan can’t and never would offer two of the same index funds with varying fee structures. Not only is it wrong, it would lead to potential liability.
While I’m not happy about the above and I neither Schools First or NEA Direct Invest would be my first choice for a 403(b), both products are decent relative to the rest of the 403(b) world. In fact, the NEA Direct Invest is one of the cheapest ways to invest in Vanguard index funds in the United States. I just wish they didn’t do it by taking advantage of other index fund holders within those programs (technically the participatns in the actively managed funds within that program are subsidizing the Vanguard index fund holders).
The problem would be easily solved if both programs went revenue-neutral in their operation (which ironically would raise the cost of some of those who hold the lower cost index funds). This would be a much more fair program. The programs could also simply get rid of the higher cost index option and move those participants to the lower cost one.
Scott Dauenhauer, CFP, MPAS