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March 06, 2014 at 06:18 AM
Critics of the Department of Labor’s initiative to modernize the 40-year old fiduciary standard under ERISA like to say, despite the mounds of research that suggest the opposite is true, that there’s no need to update the fiduciary standard under ERISA. They assert the proposed rule was/is/will be a “solution in search of a problem.”
A new study by law professors Ian Ayers and Quinn Curtis, Beyond Diversification: The Pervasive Problem of Excessive Fees and “Dominated Funds” in 401(k) Plans, provides fresh additional data to suggest why these critics are wrong.
The study seeks to measure the reduced performance returns due to menu restrictions, excess fees and bad investor choices. Losses are broadly divided into two categories: those resulting from plan menu restrictions (called “fiduciary losses” because these are the result of the plan sponsor decisions) and sub-optimum allocations and excessive expenses from investor choices (investor losses).
The researchers set a baseline by establishing a set of optimal portfolios, using historic performance data and computing “the fraction of the total investment that each fund should receive in order to produce plan portfolios with the maximum risk-adjusted return.”
Its analysis of 3,573 plans with more than $120 billion in assets reveals that 52% of these plans have “Dominated Funds,” funds the authors consider “poor investment choices” because of excess fees—fees that reduce annual returns on average by as much as 150 basis points (bps) compared to the lower cost, same-style fund also available.
It’s important to note that dominated funds are not defined as actively managed funds; they are defined as actively managed funds that carry excess fees, even as compared to other actively managed funds in the same style or in the same plan. If dominated funds were eliminated and assets spread pro rata into other funds in the plan, investors would save 67 bps in management fees on those assets, according to Ayers and Curtis.
Curtis adds, “To be clear, a fund is classified ‘dominated’ because it is much more expensive than funds of the same management type and investing style. Thus, a Large Cap US Actively managed fund is only dominated if it is much more expensive than other Large Cap US Actively managed funds, even if a low cost index fund will almost certainly be a better investment than an average Large Cap US active fund.”
