Green+ Vendors Fidelity and Vanguard
December 12, 2023
By Barbara O'Neill, CFP®, AFC®
Several years ago, 403(b)wise instituted a vendor rating service using a “traffic light” system: green means “go” (i.e., proceed to use a vendor), yellow means “proceed with caution,” and red means stop (i.e., avoid using a vendor). There is also more detail about vendor quality through the use of plus (+) and minus (-) signs. Thus, the highest rated 403(b) plan vendors are Green + and the lowest rated ones are Red -.
As shown below, only two 403(b) plan vendors have a Green + rating: the investment companies Fidelity and Vanguard. These can be considered the “holy grail” of vendors. Other high-ranking Green vendors include Aspire (non-advisor option), CalSTRS Pension 2, and T. Rowe Price. When plan participants select Fidelity and Vanguard, they have the ability to invest in mutual funds instead of high-expense annuities.
This post describes mutual fund basics including fund types, fees, risk reduction strategies, and selection criteria well as a profile of funds offered by Fidelity and Vanguard. It also summarizes research about the impact of fees on retirement plans as well as three “need to know” facts and six take-away action steps.
Mutual Fund Basics
To understand the products offered by Fidelity and Vanguard, 403(b) plan participants must first understand mutual funds. A mutual fund is a portfolio of securities (e.g., stocks and/or bonds) that is managed by an investment company on an ongoing basis. Advantages of mutual funds in 403(b) plans include professional management and diversification. Disadvantages are no guaranteed return and the risk of loss of principal.
Net asset value (NAV) is the price that mutual fund shares are bought and sold at. It is available online and in newspaper listings of mutual fund share prices. NAV is calculated by first adding up the value of all securities held in a mutual fund’s portfolio and subtracting applicable liabilities at the end of each trading day. The value of net assets is divided by the number of fund shares to arrive at a mutual fund’s NAV.
Types of Mutual Funds
Listed below are some common types of mutual funds:
Money Market Mutual Funds contain high-quality, short-term investments with lower risk and returns vs. stock or bond funds. They aim to keep NAV stable at $1 per share and are best suited for short-term goals.
Bond/Fixed Income Funds vary in risk and reward depending on bonds held within the fund. Their market value can rise (interest rate decrease) or fall (interest rate increase). Therefore, investors can lose money.
Equity/Stock Funds offer the highest risk and potential return. A fund’s value can rise or fall rapidly over short time periods, but, historically, stocks have outperformed other types of investments over the long term.
Balanced Funds contain a mixture of stocks and bonds (e.g., 60% stocks and 40% bonds). Balanced funds can be a good beginning investment because they diversify their portfolio with two different types of assets.
Asset-Allocation Funds blend stocks, bonds, and cash assets and typically contain different portfolios (e.g., aggressive growth, growth, moderate growth, and income), with varying proportions of each asset class.
Target-Date Funds also hold a mix of stocks, bonds, and cash and gradually and automatically become more conservative (read: less stock in fund portfolio) as the “target date” (e.g., 2050) approaches.
Sector Funds specialize in certain industry sectors, such as health care or technology. They are considered riskier than growth funds in general because they are less diversified.
Index Funds hold the same securities contained within major stock and bond indexes such as the Standard and Poor’s (S&P) 500 and Wilshire 5000. They are designed to track market performance trends.
International/Global Mutual Funds provide overseas equity exposure and invest in securities from companies outside the United States and in both foreign country and United States stocks, respectively.
Mutual Fund Fees
Mutual funds can charge fees for the purchase and sale of shares. Front-end load funds charge a fee to investors upon the purchase of shares, called Class-A shares. Class B shares have back-end loads; i.e., a fee for the sale of fund shares. Typically, back-end loads gradually decrease on a sliding scale (e.g., 5%, 4%, 3%, etc.) until they disappear after five or six years. No-load mutual funds have no front- or back-end loads.
All mutual funds have management fees to compensate those making portfolio management decisions. Index funds tend to have very low management fees because their portfolio is pre-determined by securities within the index that a fund is following. A 12b-1 fee is an additional fee that can be charged for fund marketing expenses. Not all funds have a 12b-1 fee and it should be avoided because it adds another layer of expenses.
A mutual fund’s expense ratio consists of the management fee plus a 12b-1 fee (if any) plus fund operating expenses. The lower the ratio (e.g., 0.25% vs. 1.5%), the better the return because fewer fund expenses are being charged to shareholders, which lowers investment performance. Over time, there can be a difference of tens- even hundreds- of thousands of dollars in earnings between funds with high and low expense ratios.
How Mutual Fund Investors Make Money
- Dividends and Interest- A fund may receive income from dividends and interest on its portfolio. Bonds pay interest and some stocks pay dividends. This income is distributed proportionately to shareholders.
- Capital Gains/Losses on Securities in a Fund- Prices of securities in a fund may increase. When a fund makes a profit on the sale of a security, it incurs a capital gain which is also distributed to shareholders.
- Increased Net Asset Value (NAV) of a Mutual Fund- If a company does not sell, but, rather, holds securities that have increased in value, the NAV of shares of the mutual fund will increase.
Mutual Fund Selection Criteria
Four key factors should be considered in the selection of a 403(b) plan mutual fund.
- Fund should match an investor’s objectives
- Have below-average expenses for its category (e.g., growth)
- Offer sustained above-average performance compared to peer funds and/or relevant market indices (e.g., the S&P 500 for large U.S company stock funds),
- Feature investment policies aligned with personal investment risk tolerance.
Funds to avoid include those with front- or back-end loads, 12b-1fees, high expense ratios, a short history of operation, and a history of under-performing peer funds and/or market index benchmarks.
Mutual fund prospectuses are a vital screening tool to make a “side by side” comparison of similar mutual funds (e.g., three different stock index funds). Key sections to review in a prospectus are a fund’s objective, fees, expense ratio, historical performance, and investment policies (e.g., use of derivative securities). Prospectuses must include an illustration of the expenses for a hypothetical $10,000 investment over one, three, five, and ten years. This standardized format allows investors to easily compare different funds.
Diversification and Dollar-Cost Averaging
Two recommended investment risk reduction strategies are diversification and dollar-cost averaging. Diversification means spreading money among different securities to reduce the risk of loss from a decline in any one. Most mutual funds are well diversified. Dollar-cost averaging is the practice of investing regular amounts of money at a regular time intervals, regardless of whether the value of investments is going up or down. A common example is the fixed amount that workers contribute to their 403(b) plan each pay period.
A simple illustration of dollar-cost averaging can be found in the table below. The average cost per share is $8.09 ($800 divided by 98.91 shares). Note that investors buy the most shares when the share price drops.
$800/98.91 shares = $8.09 average cost per share
A Profile of Vanguard Mutual Funds
Vanguard is the world’s largest mutual fund company. Unlike other investment companies that are owned by shareholders, Vanguard is uniquely owned by its investors and is known for offering mutual funds with very low expenses. There are two Vanguard investment classes: investor shares and admiral shares.
Admiral shares have slightly lower expense ratios but require higher minimum investments for taxable accounts. However, Vanguard 403(b) Services offers access to the admiral share class without a minimum investment requirement. Available 403(b) mutual funds are grouped into three tiers: 1. all-in-one target-date funds, 2. core funds: four index funds and a money market fund, and 3. supplemental (actively managed) funds in eight subcategories (e.g., balanced, domestic small-cap stock, and international).
Examples of Vanguard mutual funds with razor-thin low expense ratios include Total Stock Market Fund Admiral Shares (VTSAX) and Vanguard 500 Index Fund Admiral Shares (VFIAX) with a 0.04% expense ratio (which equates to $4 annually for every $10,000 invested) and Total International Stock Index Fund Admiral Shares (VTIAX) with a 0.11% expense ratio ($11 annually for every $10,000 invested).
A Profile of Fidelity Mutual Funds
Fidelity is the world’s third largest mutual fund company (after Vanguard and BlackRock Inc.). Like Vanguard, it offers a wide selection of investments for non-profit organization 403(b) plans. Investment choices include government money market, index, balanced, international and regional (e.g., Europe, China Region), small- and mid-capitalization (cap) stock, target-date, gold, bond, and sector funds.
Expenses on Fidelity funds vary. For example, the Fidelity 500 Index Fund (FXAIX) that tracks the S&P 500 index has a 0.15% expense ratio ($15 annually for every $10,000 invested) while the Emerging Markets Discovery Fund (FEDDX) has an expense ratio of 1.19% ($119 annually for every $10,000 invested).
A complete snapshot of each mutual fund can be found by clicking the link for a fund name on the Investment Choices webpage. Average annual returns for the past 1, 3, 5, and 10 years and year to date performance are also provided.
Research Results
A 2022 study investigated the impact that fees have on retirement accounts and how public school employees are affected by fees. Common mutual funds found in retirement accounts were compared against the Vanguard S&P 500 index fund. Findings confirmed that a majority of employees are unaware of the fees that they are currently paying and the effect that these fees have on their investments over time.
A blog post by 403bwise Executive Director, Dan Otter, further quantified the impact of high fees as shown in the illustration below that compares two teachers, age 22, who contribute $5,000 to a 403(b) plan each year until age 60 and earn a 7% annual return. One invests in Equitable's Target 2045 fund (2.3% fee) and the other invests in Vanguard Retirement 2045 fund (0.08% fee).
High expense ratios erode investment returns over time. The difference in accumulated value between the two scenarios after 38 years is an astounding $379,371!
Three (More) Things
- Understanding a mutual fund’s risk profile involves assessing its volatility and historical performance during different market conditions.
- There are two types of mutual fund prospectuses: a dense 40-50 page traditional prospectus and a shorter 8-12 page summary (profile) prospectus.
- Sources of information about mutual funds include prospectuses, personal finance publications, library references (e.g., Morningstar and Value Line), and mutual fund trade associations.
Six Smart Strategies
No. 1: Assess Your Risk Tolerance — Use this tool from the University of Missouri to evaluate how comfortable you are with market fluctuations so you can select mutual funds that match your ability to withstand volatility.
No. 2: Check Expense Ratios — Take the time to compare mutual fund choices, including expenses of different funds within the same category (e.g., target-date funds).
No. 3: Monitor Historical Performance — Evaluate mutual funds’ long-term and recent performance against relevant benchmarks to gauge their consistency and ability to weather market downturns.
No. 4: Review and Adjust Asset Allocation — Periodically review and revise percentage allocations in your 403(b) in stocks, bonds, cash equivalents, and other asset classes.
No. 5: Be Focused and Disciplined — Stick to your investment plan during periods of market volatility (especially downturns) and avoid making decisions based on short-term market movements.
No. 6: Stay Informed — Keep abreast of market trends, economic indicators, and any changes (e.g., new fund manager) in mutual funds you’ve invested in to make informed decisions.
In Summary
Vanguard and Fidelity are reputable companies with a long history of success in the financial services industry. Both offer 403(b) participants a wide variety of mutual fund investment options, many with very low expenses. Those without direct access to these investment companies, or indirect access via Aspire, should lobby their employer to get them added to their list of approved vendors.
This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.
...
Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.