Consumers frequently pay too much for retirement plans by choosing more expensive funds for their investments, University of Virginia law professor Quinn Curtis and Yale law professor Ian Ayres reveal in a new paper that will be published in the Yale Law Journal.
In “Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans,” the professors analyzed more than 3,000 401(k) plans with more than $120 billion in assets. Their research revealed that, for many investors, costs associated with the most expensive funds eat up returns. Their paper explores potential reforms that could help consumers make better choices.
Curtis’ research focuses on empirical law and finance and includes work on mutual funds, corporate governance and mortgages. He holds a Ph.D. in finance and a J.D. from Yale.
Q. Can you tell me about the genesis of this paper?
A. The costs of savings in 401(k) plans have been drawing a lot of attention from policymakers the last several years. I’ve written before on the regulation of mutual fund fees, and so this is a natural extension of that work, since part of the cost of investing in a 401(k) plan is paying the fees on the funds in the plan menu.
The goals of this project are to provide some data on what investors are paying to participate in 401(k) plans, how the design of plan menus affects investor choices and how the legal standards and regulatory environment surrounding these plans could be changed to improve outcomes for investors.
What we find is that, for a lot of plans, and particularly for smaller plans, the costs can be quite high. Moreover, a lot of the costs that investors incur are due to choices that investors make. In a lot of cases, investors have lower-cost options, but pass them up. To some degree, it is likely that this is a result of the way these plans are structured. Employers are charged with constructing the plan menus, and they may rely for advice on how to do so from advisers who manage the funds and have a stake in the fees. The law doesn’t do enough to mitigate this conflict of interest.
Q. What are “dominated” funds, and what is the consequence of including them in plan menus?
A. We define “dominated funds” as funds that are substantially more expensive than either similar funds in the plan menu or similar funds in the marketplace and that don’t contribute substantially to diversifying the plan menu. Investors can get the risk exposure they want by holding other options in the plan menu at lower cost, and the large fee differential suggests that the dominated funds are a poor option.
The problem is that we know that investors tend to invest in the options they are offered, even when they’d be better off passing on some, so including a dominated fund in the menu means that some investors are going to take that choice and end up worse off.
Q. In the paper you suggest that the Department of Labor and the courts could do more to improve consumers’ choices. How?
A. The biggest problem is that the law doesn’t do enough to encourage well-designed menus. Plan sponsors have a fiduciary duty to plan participants, but that duty is limited when investors are harmed by their own choices. This means that plan sponsors must give their investors some good choices, but so long as they do that, many courts will find that they’ve done their job, and if investors are harmed because they select high-cost funds, then that’s the responsibility of the investor.
Our argument is that this is a pernicious approach. Plan sponsors shouldn’t be on the hook for every decision investors make, but they should have a duty to assemble a menu that doesn’t contain pitfalls. Each choice should be defensible as reasonable.
There are other changes that we should consider as well: Many plans currently offer investors default options, but there is no legal requirement that these default options be low-cost. That’s a reasonable change. It would also be helpful for the Department of Labor to set a cost threshold to identify plans that have high costs. Our view is that investors shouldn’t be stuck in those plans and should have an option to easily roll over into other accounts where they would have access to lower-cost options. Finally, we should consider whether unrestricted choice over the menu is desirable. We suggest that investors could be required to demonstrate some financial sophistication before opting into high-cost choices.
Q. What might plan administrators themselves do to improve choices for consumers?
A. There are a couple of ways that plans could improve. The obvious one is to add more low-cost options. The less obvious way is to eliminate dominated options from plan menus. It’s not enough just to give investors some good choices; each choice should be included in the menu for a reason.
Q. Consumers make choices with downsides all the time – getting the double-cheeseburger with fries instead of a salad at a fast-food restaurant, for example. Why should it be different when it comes to choosing retirement plans?
A. It’s an interesting analogy, because there have been efforts to help consumers make better fast-food choices by putting calorie counts on the menu, for example. So even in that context, there seems to be some recognition that people might make different choices with better information.
But there’s an important difference between the choice of a burger or salad and the choice between high- and low-cost funds. In the fast-food analogy, people are choosing between choices with real tradeoffs: flavor versus calories. That’s a choice that turns on their personal preferences. When we look at dominated funds in a plan menu, there’s not a real tradeoff: It’s a choice between an option that costs more and will, in all likelihood, deliver worse performance, and a choice that costs less and will offer better performance. To run with the analogy, a high-cost fund, on a menu with low-cost options in the same investing style, is like a burger with more calories than a salad. And, what’s more, some people probably would prefer a salad to a burger, even if they had the same calories, but people saving for retirement are all looking to get the best return for the level of risk they are willing to tolerate. It’s a context much more amenable to intervention.
Finally, more and more people are relying on 401(k) savings as their primary source of retirement income. That means the stakes are high, both for individuals and for society.
Q. You found that in 16 percent of the 401(k) plans you analyzed, for young workers, the fees charged in excess of an index fund entirely consume the tax benefit of investing in the plan.
A. Yes, we found that there are plans where, even if you minimized fees, you could avoid enough fees in a low-cost, tax-efficient exchange-traded fund to offset the loss of the tax-favored treatment of 401(k) plans if you are far from retirement, so that the fee savings compound for a long time. In these plans, even if you are quite sophisticated, there are not enough good choices to avoid paying a lot in fees.
Q. What information should consumers be using to evaluate what to invest in?
A. Well, allocating a 401(k) portfolio is challenging for a lot of investors. They have to understand the types of funds, how risky the funds are and how to balance risk across funds. But a lot of investors pay too much attention to past returns and not enough attention to fees. There’s little evidence that eye-popping mutual fund performance persists from year-to-year, but fees are usually pretty stable and are a constant drag on a portfolio.