Participant-directed, defined-contribution retirement plans are now the primary private savings vehicle for many, if not most, Americans' retirement, now holding more than $4.5 trillion. The majority of these accounts are invested in mutual funds or exchange-traded funds (ETFs) in which investors pool their money and pay a percentage of invested assets for professional portfolio management services.
For many plan participants, their ability to retire, as well as how they'll fare in retirement, depends heavily on how the investments in their retirement account performs.
Unfortunately, problems can arise with plan design, including the lack of a menu of funds that allow an investor to prudently diversify across asset classes and geographic regions. And, most important, there's the potential for conflicts of interests that create problems manifested in excessive fees that lead to poor investment performance.
A conflict of interest
Because of the expenses of providing and maintaining a plan, a conflict of interest can arise between what's best for the employer (least cost) and what's best for the employee (access to the best investment vehicles). Unfortunately, for employees, this conflict is often decided in favor of the employer.
The employer can save large sums by not having to pay for the administration of the employee benefit. Therefore, management might be interested when a fund family that provides high-cost (and typically actively managed) funds proposes to the employer that it'll pick up all of the plan's administrative expenses if the employer makes this fund family the exclusive (or at least dominant) provider of investment alternatives.
While the employer wins by saving money, employees lose as they accumulate fewer dollars in their retirement accounts. If your plan is run by some insurance company or other financial institution, this is the type of plan you're likely to be investing through.It would be better for both employers and employees to choose a plan that has low-cost, passive investment vehicles, such as index funds that aim to simply mirror the performance of a certain index, such as the S&P 500. If the employer can't afford the administrative cost of such a plan, the expense could be unbundled and passed on to each employee appropriately.
Now, without proper education, employees may then think they're being charged for a service that in the past was "free." However, through education employees will learn that they've been paying for administration services all long -- they just weren't being billed directly for them. The cost showed up not in a bill but through lower portfolio returns due to the mutual funds' higher internal expenses.
In the long term, charging employees directly for administrative costs is significantly less expensive for them than paying the management fees of high-cost mutual fund companies while also incurring the extra (and nonproductive) trading costs of active management. A simple way to address this particular problem is to ban all revenue-sharing practices.
Ian Ayres and Quinn Curtis, authors of the February 2014 study "Beyond Diversification: The Pervasive Problem of Excessive Fees and 'Dominated Funds' in 401(k) Plans," examined over 3,500 plans. Here's a summary of their findings:
- On average, 401(k) menus provide investors sufficient options to diversify.
- Investors in many plans bear costs well in excess of retail-, let alone institutional-class index funds that are unlikely to be mitigated by returns.
- On average, investors pay 0.86 percent in fees in excess of low-cost index funds.
- The average excess menu expenses in the highest-fee decile are 1.46 percent.
- The total excess expenses paid in the top decile were "a whopping" 1.84 percent, or about nine times the fees on lowest-cost plans.
- In 16 percent of analyzed plans, fees are so high that, for a young employee, they consume the tax benefits of investing in a 401(k)!
- Higher costs aren't a function of economies of scale -- they exist across large and small plans alike.
Among the authors' important findings was that in addition to the excess fees imposed by high-cost menu options, many investors incur costs by making inefficient choices over the available menu. Unfortunately, many investors lack the knowledge to make optimal choices. And many plans effectively create traps that set investors up to fail, including investment options that are clearly inferior to other investments in the same menu.
The researchers termed these inferior investments "dominated" funds. A dominated fund is a menu option in which no reasonably informed employee would invest. They found that more than half of plans offer at least one dominated fund.
It's well known that many investors naively diversify by spreading their plan investments across all fund offerings. This naive diversification strategy will tend to cause unsophisticated investors to hold some dominated funds when they're offered. And that's exactly what Avres and Curtis found: In the plans that offer dominated funds, 15 percent of the offered funds are dominated, and dominated funds hold 11.5 percent of plan assets.
The authors also found that more than half of the negative impact of high fees comes from choices investors make by deviating from the optimal, low-fee portfolio. Thus, investors could avoid these excess costs -- if they were more knowledgeable.
Sadly, our education system fall short here. Unless you have an MBA in finance, you've likely never taken a single course in financial theory or investments. It's hard to make good decisions without being informed.
The authors did find that expensive plans have lower contributions per employee (the high fees did discourage some investors), and employees in expensive plans allocate their portfolios less effectively, even before accounting for fees.
Unfortunately, the courts have taken a very lenient position in analyzing the reasonableness of offerings. Sadly, as long as a plan provides at least some attractive options, the courts will generally find the sponsor not in breach of fiduciary duties. The authors concluded: "These results put the policy spotlight squarely on the problem of fees in reducing investor returns."
Addressing the issues
To address the problem, Avres and Curtis offered two simple, yet elegant, suggestions.
First, the current "Qualified Default Investment Alternative" regulations, which permit plans to default investors into diversified funds, should be modified to ensure that a low-cost, passively managed default fund is made a universal feature. Because many investors never opt out of the default, ensuring that default options are low-cost is critical.
Second, investors in high-cost plans should have a way out without incurring substantial tax penalties for early withdrawal. Whenever participants' investment management costs exceed a regulatory threshold, such plans should be officially designated as "high-cost plans." Investors in high-cost plans would be eligible to roll over their investments on an ongoing basis into an individual retirement account.
The authors note that the mere labeling of certain plans as "high-cost" is likely to alter fiduciary and advisor behavior, by signaling to plan sponsors that their plan is likely to be materially deficient. And the rollover option would provide employees previously trapped in high-cost plans the opportunity to invest in low-cost IRA accounts.
Their third suggestion was more radical. Avres and Curtis propose creating surmountable barriers to investors who wish to opt out of the low-cost default allocation. Those who want o allocate more than a specified percentage of their portfolio away from the default fund would need to demonstrate financial competence. They'd have to either pass a test designed to assure some acquaintance with the core concerns of retirement investing, or act under the advice of a financial professional.
This proposal would give "sophisticated" investors some flexibility, while protecting the unsophisticated via a vetted, low-cost default option. The researchers note that "while imposing obstacles to reallocation may strike some as paternalistic, our barriers are tailored to reduce the probability of mistaken allocative choices and hence foster informed autonomy. Moreover, our educated-choice proposal is -- of course -- far less paternalistic than the traditional defined-benefit pension, which prohibits any alternative investment choices."I would add two more suggestions. First and most important, require service providers to provide a fiduciary standard of care. Most retirement plan providers (such as many of the leading insurance companies) won't serve in a fiduciary capacity because they would then be legally required to act solely in the participants' best interests. The insurance industry, in particular, and the financial services industry in general, would fight this tooth and nail because while it's good for investors, it would be bad for their bottom lines.
The same is true of my second suggestion -- ban all revenue sharing arrangements. The only ones paying fees to service providers should be the plan sponsor (the employer) or the plan participants. Revenue sharing arrangements allow providers to have platforms that show an appearance of independence because they may offer a menu of funds from many different fund companies.
However, in many circumstances, those funds are on the menu because they are willing to share revenue with the provider to help cover recordkeeping expenses. This model of revenue sharing is one of the biggest flaws preventing participants from receiving the best possible solutions.