Beyond diversification: the pervasive problem of excessive fees and "dominated funds" in 401(k) plans.

AuthorAyres, Ian
PositionIntroduction through III. The Current Legal and Regulatory Regime Is Ill-Equipped to Address Excessive Fees, p. 1476-1514

INTRODUCTION

  1. DEFINED-CONTRIBUTION RETIREMENT PLANS, THEIR REGULATION, AND CRITIQUES OF THE SYSTEM A. Background 1. An Overview of 401(k) Plans 2. The Controversy over Fees B. Plan Sponsor Fiduciary Duties and the 404(c) Safe Harbor C. Judicial Approaches to Reviewing Plan Menus Under Section 404(c) II. FEES, MENU DIVERSITY, AND INVESTOR CHOICE IN 401(k) PLANS A. An Empirical Analysis of Fees and Menus in 401(k) Plans 1. Sources of Reduced Utility in 401(k) Plans 2. Measuring Reduced Utility in 401(k) Plans a. Brief Summary of the Methodology b. Losses in 401(k) Plans B. The Problem of Dominated Funds 1. Measuring the Prevalence of Dominated Funds 2. Why Dominated Funds Are a Problem III. THE CURRENT LEGAL AND REGULATORY REGIME IS ILL-EOUIPPED TO ADDRESS EXCESSIVE FEES A. Toward an Improved Fiduciary Standard 1. 404(c) and Menu Construction 2. The Misdirected Procedural Focus 3. A Coherent New Standard B. Revenue Sharing and Cross-Subsidization of Expenses C. The Limits of a Revised Fiduciary Standard IV. IMPROVING INVESTOR OUTCOMES IN RETIREMENT PLANS A. Strengthen Qualified Default Investment Alternative Regulations B. Freeing Employees from High-Cost Plans 1. High Costs Undermine the Policy Case for Employer-Sponsored Plans 2. Employees Should Be Able To Withdraw from High-Cost Plans a. Determining the Cost Percentage that Triggers the High-Cost Plan Designation b. Distributive Effects C. Strengthening Qualified Defaults To Encourage Low-Cost Investing CONCLUSION APPENDIX: DATA AND METHODOLOGY A. Computing Optimal Portfolios B. Measuring Plan Diversification and Excess Expense Costs C. Regression Results D. Benchmarking Expenses INTRODUCTION

    Participant-directed defined-contribution retirement plans are now the primary private savings vehicle for most Americans' retirement. (1) Defined contribution plans hold more than $4.4 trillion of workers' retirement savings. (2) The bulk of assets in these accounts is invested in professionally managed financial products--mutual funds and similar structures--in which investors pool funds and pay a percentage of invested assets for professional portfolio management services. For many plan participants, welfare in retirement-and even the ability to retire--hinges on the performance of the mutual funds in their retirement portfolios. With the first wave of workers of the 401(k) era now retiring, the success of private retirement plans presents a policy question of enormous economic significance.

    These 401(k) plans have been the subject of heavy criticism on a number of fronts. Some critics have argued that professional pension fund managers have substantial advantages over individual employees in managing investment accounts. (3) Others have pointed to the advantage of the compulsory savings aspect of defined-benefit plans in ensuring that participants save enough to retire. (4) Still others have pointed to the tendency of employees to concentrate holdings in their own company's stock, despite the risk of underdiversification. (5) And 401(k) plans have been criticized for exposing participants to the vicissitudes of the market, (6) especially in the aftermath of the financial crisis.

    The early evidence suggests that some of these criticisms have merit. It appears that most workers have insufficient savings for retirement. (7) An extensive economic literature has revealed that employees make predictable mistakes in allocating retirement portfolios, suggesting that putting untrained workers in charge of managing their retirement portfolios comes at a significant cost. (8) Individual instances of retirement plan disasters, such as the collapse of Enron and the resulting devastation of many employees' 401(k) portfolios, vividly illustrate the risks of employee-directed retirement accounts. (9) Another line of criticism has focused on the costs to employees of managing their 401(k) plans. (10) Critics have noted that many 401(k) plans include mutual funds with relatively high fees. (11) Since investors in retirement plans are limited to choosing from the menu offered by their employers, high-cost funds in the menu can greatly affect the performance of a retirement account. The stakes are high: reforms that reduce fees incurred by investors by only ten basis points on average would save more than $4.4 billion annually, and these savings compound over the course of investors' careers. (12)

    The complex web of statutes and regulations that govern 401 (k) plans, however, does afford employees some protection from these risks. The employer sponsors of plans are held to a fiduciary duty to serve the interests of employees, and suits alleging breaches of this duty are not uncommon. (13) For better or worse, these suits are the primary means by which plan participants can protect themselves against inadequate plan menu offerings by their employers. But this regime of fiduciary duties runs up against an important limit: employers whose menus meet certain requirements have a safe harbor against fiduciary claims when losses result from decisions made by plan participants. (14) Some courts have interpreted this safe harbor broadly, sharply limiting the viability of fiduciary claims against employers who sponsor poor 401(k) menus. (15) As a result, employers are often immunized from liability for investor choices that lead to predictable, adverse investment consequences, notwithstanding the substantive shortcomings of menu construction described in this Article.

    This Article makes four contributions. First, drawing on our proprietary dataset on 401(k) plan menus from the 2010 plan year and mutual fund data from 2003 through 2013, we present empirical findings with implications for the policy debate over 401(k) plans. (16) We show that the primary problem for investors in 401(k) plans is not loss due to lack of diversification, but loss due to excessive fees. On average, 401(k) menus in our sample provide investors sufficient options to diversify, but investors in many plans bear costs well in excess of retail index funds--and these costs are unlikely to be fully mitigated by returns. In addition to the excess fees imposed on investors by high-cost menu options, many investors incur costs by making cost-inefficient choices from the available menu. Overall, we find that investors in an average plan suffer a cost that is seventy-eight basis points higher than the costs associated with retail index funds. We also estimate that fees are so high in 16% of analyzed plans that they consume the tax benefits of investing in a 401(k) for a young employee. Importantly, the observed costs do not appear to be due to economies of scale; we find substantial variation in total costs over plans of similar size. These results put the policy spotlight squarely on the problem of fees in reducing investor returns.

    Second, we show that many plans effectively create traps that set up investors to fail. In particular, we show that many menus include dominated funds. We define dominated funds as choices in the plan menu that have an optimal portfolio weight of less than 1% and that are more than fifty basis points more expensive than either (i) funds in the same style (17) offered in the menu or (ii) an average of similarly styled funds in the marketplace. (18) These funds are unusually expensive, even compared to funds that offer similar investment exposure. The requirement that the funds have low portfolio weight suggests that these costs are not offset by additional diversification, and we demonstrate that dominated funds have substantially underperformed between 2010, the date on which we measure dominance, and 2013. We find that more than half of the plans we studied offer at least one dominated fund. It is well established that some investors naively diversify by spreading their plan investments across all fund offerings. (19) As a result of the naive diversification strategy, unsophisticated investors often invest in dominated funds when they are offered.

    Third, our empirical insights suggest an important deficiency in the current judicial approach to 401(k) plans. Courts have been reluctant to analyze the substantive reasonableness of fees or menu offerings, focusing instead on whether plan sponsors follow certain procedural requirements, such as periodically considering alternative investment advisors or other service providers. Courts' review of the substance of menu offerings is normally limited to evaluating whether the menu contains diverse offerings. So long as a plan provides some attractive options for investors, courts will generally not find the sponsor in breach of fiduciary duties. While this approach to adjudicating menus, known as the "large menu defense," has some statutory support, we argue that it is profoundly flawed as a normative matter. Courts reasonably eschew basing liability on after-the-fact outcomes. But by focusing on process over the substantive reasonableness of the plan's fees or of individual high-cost funds, courts have unwittingly allowed self-interested service providers to construct plan menus with dominated, high-fee options. These options predictably lead to investor decisions that benefit fund managers at investors' expense.

    We suggest adjustments to the jurisprudence of 401(k) fiduciary duties to help address the issue of high costs in plans. Even if the standard for liability were refined as we suggest, however, it is unlikely that fiduciary duties alone could address the problems with 401(k) plans. Enforcement of these fiduciary duties relies on plaintiffs' attorneys, but only the largest and most egregious plans present profitable litigation opportunities (even if the standard were adjusted as we suggest). Nor is public enforcement of fiduciary duties likely to be sufficient to address a problem that is a matter of widespread overcharging, rather than a result of a small number of highly abusive plans. While public and private enforcement can...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT