Morningstar may have given the right answer, but they asked the wrong question.
In its recent report, the 2017 Health Savings Account Landscape, Morningstar focused heavily on fund fees in its evaluation of HSA providers. This emphasis on fees echoes concerns I’ve heard from advisors when I’ve spoken at recent fi360 and PSCA conferences, among others.
Sensitivity to fees is understandable given the litigious environment and the DOL fiduciary rule. However, as advisors increasingly turn their focus towards the fast-growing HSA sector, they should take care not to view HSA fees through the same lens as 401(k) fees. Doing so could adversely affect how they guide their clients, not to mention their clients’ outcomes.
When it comes to investment choices, cheaper is not always better. For example, too much emphasis on fees can distort the judgment of whether a participant should allocate money to a 401(k) or an HSA.
If fees were equal, I believe virtually all advisors would buy into allocating participant benefit dollars first towards a 401(k) plan, but only in an amount sufficient to maximize any employer match; next towards an HSA up to the allowable maximum, to maximize long-term tax advantages; and finally, allocate remaining dollars to the 401(k) plan.
In real life, of course, fees are often not equal between 401(k) and HSAs, and this has introduced some controversy to that second-stage allocation decision, the switch of dollars from 401(k)s to HSAs after the employer match has been maxed.
I’ve heard some advisors express concern about recommending this when fees on HSA investment options are higher, especially when those funds might be used for non-qualified medical expenses during retirement.
This is often the case because of share class differences between HSA and 401(k) plans. Doesn’t this give 401(k) plans an inherent advantage? Only for those participants who don’t mind paying more taxes.
Let’s take what I think is a reasonable example of the fee differential. Suppose an investment option in an HSA was 50 basis points higher than a comparable 401(k) option. “That’s outrageous,” you say. “Allocate the money to the 401(k) instead.” Well, not so fast.
Beyond the “triple tax advantage” of HSAs—money goes in pre-tax, grows free of tax, and can be withdrawn without income tax as long as it’s used for qualified medical expenses—there’s the fourth tax advantage, which is that money going into HSAs is excluded from Social Security and Medicare taxes. 401(k) contributions enjoy no such exemption.
This means that money going into an HSA saves 7.65 percent compared to money going into a 401(k). Even if that participant then paid 50 basis points per year less in a 401(k) for investment options, it would still take over 15 years to recoup that initial 7.65 percent tax differential—and that doesn’t count the potential other advantages the HSA money would enjoy, such as no RMDs.
While the fiduciary rule has made advisors sensitive to fees, that legal standard is also not likely to look kindly on advisors who cause participants to pay excess taxes. Achieving a fraction of a percent in fee savings by allocating to a 401(k) rather than an HSA might not be in the best interest of investors if the tax consequences are much greater.
Furthermore, there is little doubt that over time HSA fees will come down. 401(k) plans are much larger and enjoy greater bargaining power, but HSAs are growing fast. Already, some platforms are offering HSA investment options at fees comparable to those of 401(k) menus, and other firms are bound to follow suit.
My issue with the Morningstar report is that an over-simplistic emphasis on fees could distort participant-level and plan-level decisions about HSAs. For one thing, comparisons with 401(k) offerings might steer participants away from the superior tax benefits of HSAs.
Also, HSA fees are structured differently from one platform to another, making the know-your-client fiduciary obligations more nuanced than a simple comparison of mutual fund fees.
For example, the trade-off between fixed-dollar platform charges and basis-point fund fees has different impacts on investors depending on their balances. Advisors may need to consider those details when making recommendations about HSA investments.
Finally, I am concerned that using 401(k) evaluation criteria as a standard for HSA plans could inhibit the evolution of HSA menu design. The implicit long-term liabilities of HSA investment programs are quite distinct from the general retirement liabilities funded by 401(k) plans, and menu design should reflect that. This relationship between liabilities and menu design is something I want to take up in a future column because the industry is going to have to take it up in a meaningful way if HSAs are to fulfill their potential.