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

• Author: Ayres, Ian
• Position: IV. Improving Investor Outcomes in Retirement Plans through Conclusion, with footnotes and appendix, p. 1514-1552

IV. IMPROVING INVESTOR OUTCOMES IN RETIREMENT PLANS

In this Part we develop several policy proposals that go beyond heightened fiduciary duties in addressing fee issues, particularly in small plans that are unlikely to be targets of fiduciary suits. We suggest: (1) extending the existing Qualified Default Investment Alternative framework to encourage low-cost defaults; (2) providing enhanced disclosures that provide all-in fee information, specifically for high-cost plans, combined with rollover rules that permit investors to remove funds from high-cost plans; and (3) requiring investors to pass a sophistication test before they can invest in funds with a substantial risk of underperformance. Some of these proposals could be adopted through relatively simple regulatory changes, (133) while others would require legislative change. The proposals also differ in terms of how radically they would alter the plan landscape and how likely they are to be adopted. While certain aspects of these changes interact, each could also stand on its own with little modification.

1. Strengthen Qualified Default Investment Alternative Regulations

   Research on 401 (k) plans has shown that default options have powerful effects. (134) While a fully rational individual operating free of constraints on time and attention would simply reallocate his investment to reflect an optimal portfolio, real-world investors have a strong tendency to lock in and continue to hold whatever investments they initially purchase. (135) Therefore, it is especially important to adopt policies that promote prudent initial investment choices.

   The current Qualified Default Investment Alternative (QDLA) rule is an important step toward making 401(k) participation and allocation automatic so as to minimize the impact of behavioral biases. The Pension Protection Act of 2006 permits employers to enroll employees in 401(k) plans as a default, and to invest their funds by default into the plan's QDIA. (136) To qualify as a QDIA, an investment fund must, applying "generally accepted investment theories," be either (1) "diversified so as to minimize the risk of large losses" and be "designed to provide ... a mix of equity and fixed income exposures based on the participant's age, target retirement date (such as normal retirement age under the plan) or life expectancy," (137) or (2) "consistent with a target level of risk appropriate for participants of the plan as a whole." (138) Traditional "target-date funds," which decrease stock exposure as the target date nears, or so-called "balanced" funds, which contain relatively fixed proportions of stocks and bonds, are common and desirable QDIAs.

   Notably missing from the requirements for a fund to be a QDIA is any limitation on the fund's cost. This is yet another instance in which concerns about diversification have taken precedence over concerns about costs. (139) A QDIA must be diversified and balanced, but there is no separate requirement that fees in the default fund fall below any threshold, or even be good relative to the market.

   We propose strengthening the current QDIA rules in two ways, in effect creating an Enhanced QDIA standard or EQDIA. First, we would require that EQpiAs, in addition to meeting the qualifications of QDIAs, be low cost as described below. (140) Second, while current rules merely permit plans to designate a default investment fund, we would mandate that plans designate an EQDIA as a default investment choice. (141) This would make E QDIAs a universal feature of 401(k) plans.

   To qualify as an EQDIA, we propose that a fund have expenses that are less than a relatively low regulatory threshold. We suggest fifty basis points as a reasonable cutoff. As is the case with any hard fee cutoff, fifty basis points is somewhat arbitrary, but would permit almost all index funds, including passively managed target date funds, as well as relatively low-cost actively managed funds to function as defaults. A clear threshold would provide plan sponsors with the benefit of certainty. There are hundreds of funds that currently exist in the marketplace and that would qualify as EQDLAs.* 142 Our proposal would not prohibit actively managed funds, of which there are several available to institutional investors at this price point, but, as a practical matter, most EQDIAs will be passively managed. In light of the research on how difficult it is to beat market returns, (143) we regard placing investors by default into low-cost index funds to be an empirically well-supported policy, particularly in small plans without much bargaining power vis-a-vis service providers.

2. Freeing Employees from Fligh-Cost Plans

   l. High Costs Undermine the Policy Case for Employer-Sponsored Plans

   In many ways, the current structure of 401(k) plans is a result of path dependence rather than deliberate design. (144) Employers originally offered pensions to induce loyalty and provide security. (145) As pensions became more regulated, defined-contribution plans, which exposed the employer to less longterm financial risk, gained popularity as a tool for employers to supplement pensions without increasing future liabilities. These defined-contribution plans have gradually come to dominate the retirement savings space as the popularity of defined-benefit plans has declined. (146) Since defined-contribution plans slowly evolved to become a major component of retirement savings, beyond merely a supplement to pensions, they were not originally designed to provide as much of a portion of retirement income as they are currently expected to provide.

   Nevertheless, employer-sponsored, defined-contribution plans have advantages over individual investing. First, pooling employee assets into large investment accounts allows employers to potentially leverage lower investment management fees. (147) Limited plan menus may also encourage better investment decisions by employees. For example, they may encourage investments in diversified mutual funds rather than individual stocks. And at least as a theoretical matter, menu-driven choices give employees greater autonomy than defined-benefit plans to tailor the levels of risk and reward to better fit their "in" individual preferences and circumstances." (148)

   The advantages for employer sponsorship can evaporate in plans that offer menus with dominated choices and high fees. Too many 401(k) menus present a set of selections with pitfalls that employees must carefully avoid--in contrast to a model in which a sophisticated party uses leverage to drive a hard bargain on behalf of all employees. Our empirical evidence indicates that, at least for a subset of plans, employers make many of the same mistakes as individuals in setting up plans. For example, while research suggests that low-cost index funds often outperform actively managed funds, (149) actively managed funds continue to predominate in plan menus. (150) Others have pointed out that funds included in 401(k) menus tend to have a history of strong performance, suggesting that plan sponsors chase returns much like individual investors do. (151) Extensive research has shown that return-chasing behavior in mutual fund investing is unlikely to be a successful investment strategy. (152) In such cases, the question becomes: does the tax code's policy commitment to employer-sponsored retirement accounts make sense?

   The law provides few avenues for escape once money is paid into a 401(k) plan. The money cannot be withdrawn without penalty except under limited circumstances. (153) An early distribution from a 401(k) is treated as income added to the plan holder's taxable income and is taxed at the applicable marginal rate. Additionally, the recipient of the distribution, unless he meets one of the stated exceptions, must pay a penalty of 10% additional tax. (154) The most commonly used exception to the restriction on early withdrawal occurs when employees change jobs and are permitted to roll over their assets from their old employer's plan into their new employer's plan.

   The 401(k) system is predicated on the notion that investing in an employer-sponsored plan is better than saving in another type of account when the 401(k) option is available. The law provides ancillary, tax-favored means of saving for retirement. But for employees whose employers offer a 401(k), this option is likely to be the centerpiece of their personal retirement savings. (155) When economies of scale are not realized and a particular 401(k) plan offers inferior options to what might be available to an individual seeking an outside option, the incentives surrounding 401(k) plans--designed to spur individuals to save and invest responsibly--have the perverse effect of forcing employees to settle for suboptimal options or forgo the incentives to save. (156)

   2. Employees Should Be Able To Withdraw from High-Cost Plans

   There is no policy reason to lock employees into plans that leave them worse off than they would be if they had access to, for example, ordinary retail index funds. If a plan does not realize economies of scale, then one of the primary policy advantages of employer sponsorship is moot. In such cases, the impediments to employees' leaving such plans should also be mooted. Our policy proposal is simple: if the average total percentage costs paid by all investors in a plan exceed a regulatory threshold, then investors should be permitted to roll over their investments in the plan on a continuing basis, without penalty, into an individual retirement account offering qualified, low-cost investments. Employees who leave an employer with expensive 401(k) plans currently have the option of rolling their accounts into the 401(k) of their new employer or an IRA. This rollover option gives former employees the ability to escape being locked into high-fee investments. Our proposal aims to provide employees saddled with demonstrably deficient plans the incidental benefit of...