Vanguard or TIAA-CREF - Which one for the Little Guy?

By Jonathan Kandell, Contributing Writer

Vanguard is often touted as the fund company of choice for the small, no-nonsense index investor. Vanguard is a terrific company, but it is really set up to favor the investor with over $50,000 who doesn't have to pay the custodial charges and index fees. While these fees are fair in terms of the higher costs of administering small accounts, they still represent a competitive disadvantage. TIAA-CREF, a comparable mutual fund company, offers many funds that can be a better deal for the small investor.[1]

"What our fee structure does is recognize the efficiencies of the larger accounts. Those responsible for efficiencies should be the beneficiaries of them. As it is, it takes the fund years to break even at the lower account levels. The point of our fees is that it's a fairer allocation of cost. You're really subsidizing the smaller investor. If you incur costs, you should have to pay for them. . . Also, in a taxable account, if you intend to switch when you hit the $10,000 threshold, the tax consequences could be significant."                                            -Brian Mattes, Principal, The Vanguard Group

"The significance of low expenses is simple to explain - they result in more money going to work for investors. Therefore, whether talking about small or large investors, TIAA-CREF believes that they appreciate having more money wind up in their accounts, rather than with fund companies. Even for small investors, the impact of expenses can be dramatic, particularly over long periods of time. And, since small investors will have less earnings in terms of actual dollars, they should look to keep as many of them as possible by investing in low-cost funds."                                    -Tom Pinto, Director, Media Relations, TIAA-CREF

Fees and Expense Ratios

Vanguard charges investors a $10 maintenance fee per year on each index fund with less than $10,000 of assets. There is an additional $10 IRA custodial fee for each fund with less than $5,000 unless total assets are more than $50,000. So one's total fees will amount to either $10 or $20 per fund per year depending on the size of one's investments.

While TIAA-CREF does not charge either of these fees, its funds have higher expense ratios (ERs) than Vanguard's across the board. Expense ratio costs come straight out of returns. So in comparing funds the question becomes, "At what point do the expected higher returns resulting from a lower expense ratio make up for the added fees?"

IRA Accounts

Let's use the total stock market funds as an example. Vanguard's Total Stock Market Index Fund has an ER of 20 basis points. TIAA-CREF's equivalent fund, its Equity Index Fund, has an ER of 26 basis points. At what level of total net assets does the 6 basis points difference equal the equivalent of the $10/$20 in fees? Simple arithmetic shows the TIAA-CREF expense ratio will be less than the Vanguard fees until assets in the fund are $10,000 or more (6 basis points x $10,000 = $6).[2] At less than this, you save more by not paying fees than you make in lower expenses, and vice versa. In other words, until your IRA Total Stock Market Fund allocation reaches $10,000 use TIAA-CREF's Equity Index Fund. After that point, roll over to Vanguard.

Let's look at the two short-term bond funds. Vanguard's Short-term Bond Index Fund has an ER of 20 basis points. TIAA-CREF's Short-Term Bond Fund has an ER of 30 basis points. At what point does the 10 basis point difference break even with the $10/$20 fees? 10 basis points is equal to $10 when assets are $10,000.[3] So, again, if your short-term bond allocation is less than $10,000 use TIAA-CREF. After that point roll over to Vanguard.

TIAA-CREF's equity funds, aside from its Equity Index Fund, use a "dual investment strategy." Part of the fund tracks the index and the rest is managed. The fund manager has the flexibility of keeping between 20 and 80% of the fund under enhanced passive management or under active management. While the merits of this strategy are debatable in general terms, it doesn't cost the investor anything at the low expenses TIAA-CREF offers, and may even add value. A TIAA-CREF official noted that most of the equity funds are currently about 50/50 active/passive.

Using the same reasoning, here is a run-down of where various other funds break-even.[4]

Figure 1: Break-even point for various funds
when you should switch from TIAA-CREF to Vanguard

So, in short, with the exception of international, TIAA-CREF is a wiser place to invest for the IRA investor with less than $10,000 per fund. IRA investors should start with TIAA-CREF and switch to Vanguard once their funds get above the figures in the chart above.[5] Depending on how many funds one has, the amount of money saved could be significant.

Taxable Fund Accounts

Because of capital gains, taxable accounts are more complicated than the above straightforward analysis. Most small investors intend to become large investors eventually. If you want to use TIAA-CREF as a small investor and Vanguard as a large investor, then you will have to pay the cost of switching. The loss of compounding capital to taxation incurred in switching funds would almost certainly drown out any of the above savings in fees. This effectively means that with taxable accounts, one should stick with the original company until redemption, and this changes the economics of comparison.

The decision on which company to chose for these funds depends essentially on one's time-horizon. Long-term investors who start with Vanguard will lose out on the fees until the fund reaches $10,000 ($6,667 in the case of the international equity funds), and then start saving from that point on.[6] But because it takes time for the Vanguard ER gains to overcome the accumulated and compounded fee losses, the actual break-even figure will be higher than those in the chart. To be more precise, the actual "break-even" point depends on the size of one's original investment, the rate of return, and the ER spread.[7]

Figure 2: Total Stock Market, one-time investment of $5000
Time-horizon when it pays to start with Vanguard over TIAA-CREF

Figure 3: Bond Funds, one-time investment of $5000
Time-horizon when it pays to start with Vanguard over TIAA-CREF

As can be seen by these charts, the number of years it takes to justify starting with Vanguard is surprisingly large. As we might expect, the higher the rate of expected return, the lower the break-even point. These figures assume even regular returns and that money is not added to the original investment.

Diversification

TIAA-CREF doesn't offer small or value funds, so you need to use Vanguard if you are concerned with those classes (although the International Equity fund is 33% small). TIAA-CREF does not offer various other funds available at Vanguard either. However, I would argue it is hard to justify complex "slice and dice" beyond broad categories for small investors. Frankly, the hypothetical benefits of subdividing into classes more esoteric than the broad asset categories of Long- and Short-term Bond, Cash, Domestic Equity, and International Equity found at TIAA-CREF are dubious at small amounts.

In fact, if you take fund minimums into account, TIAA-CREF allows more meaningful diversification for the beginning investor. TIAA-CREF has rock-bottom minimums on both IRA and non-IRA accounts: $250 per fund (less if you pay in paycheck installments). This is in comparison to Vanguard's $1000 minimums for IRAs and $3000 for regular accounts. So the small investor can divide into many more funds with the same assets at TIAA-CREF in comparison to what they could do at Vanguard, and they can do it without the expense of annual maintenance fees.

Summary

• With funds that are tax-sheltered, use TIAA-CREF until amount gets above $10,000 (listed in Figure 1), then roll over to Vanguard's equivalent fund.
  
  
• With funds in one's taxable accounts, use TIAA-CREF if your time horizon is in the range shown in Figure 2 (although the TIAA-CREF advantage decreases as fund assets get beyond $10,000, and if you plan to regularly add to the accounts, the time horizon will shrink to the time your account reaches $10,000).
  
  
• Do not slice and dice beyond broad asset categories until your accounts get reasonably large.
  
  
• If you have other reasons for preferring one company over another, don't sweat it, since the savings are relatively modest and both companies are respected, no-nonsense, customer-friendly businesses with fierce loyalty from their investors.

1) Vanguard does of course offer its collection of Life Strategy funds, offering fixed mixtures of funds, with low fees. However, this article is aimed at the investor who likes to create their own multi-fund portfolios.

2) 0.06/100 > [($10 if less than $5000 + $10 if less than 10,000) / x] when
x = $10,000.

3) 0.10/100 > [($10 if less than $5000 + $10 if less than 10,000)/x] when x=$10,000

4) Some of TIAA-CREF's funds are not considered in this analysis because of questions of asset comparability. The TIAA-CREF Inflation Protected Securities fund, for instance, is available only to certain investors. The TIAA-CREF REIT fund is also not comparable, since it owns direct real estate rather than being an index of REIT stocks. Both of these TIAA-CREF funds are also annuities and do not function like a traditional mutual fund. Other funds, like the growth and income and managed allocation, cannot necessarily be compared because of differences in allocation strategy between the two companies, and the fact that Vanguard only charges some fees on it's index funds and not its actively managed funds. The break-even point is relatively low on these two funds anyway, so one is probably wiser to use Vanguard.

5) The above analysis makes the following assumptions: (1) The returns of the Russell 3000 is equivalent to the Wilshire 5000, (2) both companies add equal value through their trading strategies, (3) TIAA-CREF's ERs won't go up, (4) TIAA-CREF's "dual investment strategy" doesn't hurt or help returns above what's reflected in the ERs, (5) the fees you save come out of your investment budget, i.e. is invested and not used for a sandwich.

6) Given there is no custodial fee at Vanguard on taxable accounts, it is somewhat surprising that Figure 1 applies identically as it did with IRAs. It turns out that because all the break-even points are above the point where Vanguard charges its custodial fee, the break-even points for taxable investments are identical to the tax-preferenced, despite the different fee structure.

7) These tables were constructed from an Excel spreadsheet which assumed the W5000/R3000 had returns listed. The Vanguard totals were calculated by taking the ER off the top and then subtracting pertinent fees and reinvesting remaining returns. The TIAA-CREF totals were calculated by taking the ER off the top and reinvesting returns. For each year, total assets were compared between the two funds. "Peak difference" represents the number of years at which the difference was at its maximum (when funds reached $10,000). The "break-even" point, the point representing the time-horizon one should use in calculating, represents the number of years where Vanguard's ER advantage finally eats up the savings in fees.

11/15/00