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.”
Interestingly, perhaps, this particular finding parallels a central finding of researcher Ken French in his 2008 seminal paper, The Cost of Active Investing. Comparing active management, generally, to passive management, French concludes, “Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980 to 2006 period if he switched to a passive market portfolio.” (Note: French’s analysis includes all active funds; Ayers and Curtis include only those active funds they define as carrying excess fees. One upshot is that the average spread between active and passive fund fees is narrowing.)
Overall, the researchers find that the mean “total loss” investors suffer is 156 bps, of which 85 bps is derived from excess fees and 71 bps from sub-optimum asset allocations. In terms of attributing the responsibility for these losses, the researchers find investor decisions account for 106 bps, and plan sponsor fiduciary menu decisions account for 50 bps.
According to Curtis, “One baseline we use for the total loss number is that it’s about 18% of the total risk premium if investors held the optimal portfolio. So an investor is giving up about a fifth of the expected return on the optimal portfolio. If an investor incurred that loss for the course of an entire career (ages 25-65) and saved $500/month throughout, they would end up with about 30% less at retirement vs. the optimum.”
The researchers also address the issue of the scope and quality of plan services as they relate to plan costs. While acknowledging the quality of plan services “cannot be observed from our data” the researchers suggest that looking at participation rates, contributions per account and, importantly, the quality of portfolio allocations are reasonable.
Their conclusions will certainly be controversial in some quarters: More expensive plans have “significantly lower employee participation,” “lower contributions per employee,” and, interestingly, “employees in expensive plans allocate their portfolios less effectively even before accounting for fees.”
Ayers and Curtis raise important policy issues pertaining to their research, plan sponsor fiduciary responsibilities and the DOL’s expected re proposal of a rule to modernize the fiduciary standard under ERISA. These will be discussed in an upcoming ‘In Search of a Problem’ part two posting.