It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans

• Published date: 01 August 2016
• Author: CLEMENS SIALM,VERONIKA K. POOL,IRINA STEFANESCU
• DOI: http://doi.org/10.1111/jofi.12411
• Date: 01 August 2016

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 4 •AUGUST 2016

It Pays to Set the Menu: Mutual Fund Investment

Options in 401(k) Plans

VERONIKA K. POOL, CLEMENS SIALM, and IRINA STEFANESCU∗

ABSTRACT

This paper investigates whether mutual fund families acting as service providers

in 401(k) plans display favoritism toward their own affiliated funds. Using a hand-

collected data set on the menu of investment options offered to plan participants,

we show that fund deletions and additions are less sensitive to prior performance for

affiliated than unaffiliated funds. Wefind no evidence that plan participants undo this

affiliation bias through their investment choices. Finally,we find that the subsequent

performance of poorly performing affiliated funds indicates that this favoritism is not

information driven.

EMPLOYER-SPONSORED DEFINED CONTRIBUTION (DC) accounts have gained signif-

icant importance around the world. In the United States, the value of 401(k)

∗Veronika K. Pool is at Indiana University Kelley School of Business, Bloomington; Clemens

Sialm is at the McCombs School of Business, University of Texas at Austin, and at the National

Bureau of Economic Research; and Irina Stefanescu is at the Board of Governors of the Federal

Reserve System. We thank Ken Singleton (the Editor), an Associate Editor, two referees, Pier-

luigi Balduzzi, Keith Brown, Lauren Cohen, Van Harlow, Frank de Jong, Olivia Mitchell, Joshua

Pollet, Jonathan Reuter, Oleg Rytchkov, Paul Schultz, Laura Starks, Steve Utkus, Marno Ver-

beek, Scott Yonker, and seminar participants at Arizona State University, the California State

University Fullerton, DePaul University, Emory University, the Federal Reserve Board, George

Washington University, Indiana University, INSEAD, Loyola University in Chicago, McMaster

University, Securities Exchange Commission, Southern Methodist University, Stanford Univer-

sity, University of Alabama, University of California at Davis, University of Georgia, University

of Kentucky, University of Illinois at Urbana-Champaign, University of Virginia,Vanderbilt Uni-

versity, Yale University,the American Economic Association Meeting in San Diego, the European

Household Finance Conference in Stockholm, the FIRS Conference in Croatia, the Humboldt Uni-

versity Conference on Recent Advances in Research on Mutual Funds, the IU-Notre Dame-Purdue

Summer Symposium, the NBER Conference on Personal Retirement Challenges, the NETSPAR

spring workshop, the Nova Finance Conference on Pensions and Retirement, the Second MSUFCU

Conference on Financial Institutions and Investments at Michigan State University, the Society

for Financial Studies Cavalcade in Miami, and the TIAA-CREF Fellows Symposium for helpful

comments. The research reported herein was performed pursuant to a grant from the TIAA-CREF

Institute through the Pension Research Council/Boettner Center (the PRC) of the Wharton School

of the University of Pennsylvania (PRC). We also acknowledge financial support from Indiana

University,NETSPAR, the Stanford Institute for Economic Policy Research, and the University of

Texas at Austin. The findings and conclusions expressed are solely those of the authors and do not

represent the views of the Board of Governors of the Federal Reserve System, the SSA, any agency

of the federal government, the Boettner Center (the PRC), or TIAA-CREF.

DOI: 10.1111/jofi.12411

1779

1780 The Journal of Finance R

assets reached $4.6 trillion in 2014.1Such growth represents important busi-

ness opportunities for mutual funds as they manage approximately half of the

401(k) investment pool. In addition to asset management, many fund families

also provide administrative services to the plans, and hence may play an active

role in creating the menu of investment options for plans’ participants.

Fund families involved in a plan’s design can face conflicting incentives.

While they work with plan sponsors to create menus that serve the interests of

plan participants, they also have an incentive to promote their own proprietary

funds, even when more suitable options are available from other fund families.2

Surprisingly, however, little is known about whether and how these conflicting

incentives affect 401(k) menus. This is concerning given that DC accounts are

the main source of retirement income for many of the plan beneficiaries.

In this paper, we examine the conflicting incentives of mutual fund compa-

nies in the 401(k) industry. Focusing on menu changes, we argue that service

providers may influence the 401(k) sponsor to include and subsequently keep

their own affiliated funds on the investment menu. We further hypothesize

that, due to this provider influence, fund addition and deletion decisions may

be less sensitive to the prior performance of affiliated funds as mutual fund

families have an incentive to smooth money flows across their funds with dif-

ferential past performance.

To investigate this favoritism hypothesis, we hand collect information on the

menu of mutual fund options offered in a large sample of 401(k) plans for the

period 1998 to 2009 from annual filings of Form 11-K with the U.S. Securities

and Exchange Commission (SEC). Building on Cohen and Schmidt (2009), we

collect information on the identity of the trustee of employer-sponsored 401(k)

plans. Our sample includes plans that are trusteed by a mutual fund family as

well as plans with nonmutual fund trustees. Most 401(k) plans in our sample

adopt an open architecture whereby investment options include not only funds

from the trustee’s family (“affiliated funds”) but also those from other mutual

fund families (“unaffiliated funds”). An interesting feature of our data set is

that a given fund often contemporaneously appears on several 401(k) menus

that are administered by different fund families. This data feature provides

us with a unique identification strategy and allows us to contrast how a given

fund is viewed across menus in which the fund is affiliated with the trustee

and menus in which it is not.

Our results reveal significant favoritism toward affiliated funds. Mutual

funds affiliated with the service provider of a 401(k) plan are significantly

less likely to be removed from the plan’s menu than unaffiliated funds. The

biggest relative difference between how affiliated and unaffiliated funds are

treated arises among the worst-performing funds, which have been shown

1See the 2015 Investment Company Fact Book (http://www.ici.org/pdf/2015_factbook.pdf),

p. 141.

2See the 2011 U.S. Government Accountability Office (GAO) report “Improved Reg-

ulation Could Better Protect Participants from Conflicts of Interest” (http://www.gao.gov/

assets/320/315363.pdf).

ItPaystoSettheMenu 1781

to exhibit significant performance persistence (Carhart (1997)). For example,

mutual funds ranked in the lowest decile based on their prior three-year per-

formance have a deletion rate of 25.5% per year if they are unaffiliated with

the plan’s trustee but a deletion rate of just 13.7% if they are affiliated with

the trustee. In contrast, funds in the top performance decile have a deletion

rate of around 15% for both affiliated and unaffiliated trustees. Similarly, we

find that the propensity to add funds to 401(k) menus is less sensitive to per-

formance for affiliated funds than for unaffiliated funds. These results suggest

that decisions to change the composition of 401(k) menus are driven not simply

by meritocracy, but also by favoritism. Protecting poorly performing funds by

keeping them or adding them to plan menus helps mutual fund families smooth

the money flows into their various offerings.

Although the investment opportunity set of the plan is limited to the available

menu choices, participants can freely allocate their contributions among these

options. If participants are aware of provider biases or are simply sensitive to

poor performance, they can undo favoritism in their own portfolios (at least

in part) by, for instance, not allocating capital to poorly performing affiliated

funds. Therefore, to test whether menu favoritism has an impact on the overall

allocation of plan assets, we examine the sensitivity of participant flows to

the performance of affiliated and unaffiliated funds. Consistent with studies

documenting that DC plan participants are naive and inactive (Benartzi and

Thaler (2001), Madrian and Shea (2001), Agnew,Balduzzi, and Sunden (2003)),

we show that participants are generally not sensitive to poor performance and

do not undo the menu’s bias toward affiliated families. This result indicates

that plan participants are affected by the affiliation bias.

Finally, while our evidence on favoritism is consistent with adverse incen-

tives, plan sponsors and service providers may also have superior information

about the affiliated funds. It is therefore possible that they show a prefer-

ence for these funds not because they are necessarily biased toward them, but

rather due to favorable information that they possess about these funds. To

investigate this possibility, we examine future fund performance. For instance,

if, despite lackluster past performance, the decision to keep poorly performing

affiliated funds on the menu is information-driven, then these funds should

perform better in the future. We find that this is not the case: affiliated funds

that rank poorly based on past performance but are not deleted from the menu

do not perform well in the subsequent year. Weestimate that, on average, they

underperform by approximately 3.96% annually on a risk- and style-adjusted

basis. These results suggest that the menu bias we document in this paper has

important implications for employees’ income in retirement.

Our study belongs to a nascent literature on the effect of business ties in DC

plans. Davis and Kim (2007) and Cohen and Schmidt (2009) study conflicts of

interest in the 401(k) industry and argue that, to protect the valuable business

relation that arises between the sponsoring company and mutual fund service

providers, families cater to the sponsors while compromising their own fidu-

ciary responsibilities. In particular, Cohen and Schmidt (2009) find that trustee

fund families overinvest in the sponsor’s stock. They also show that, when other