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What Color Is Your Salamander?

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I used to love the old L.A. Law TV series (which aired 1986 to ‘94) because it humanized lawyers and showed that even though people can be deeply flawed, we can, on occasion, still be heart-wrenchingly kind. It also included one of my favorite scenes in all of television.

Attorney Ann Kelsey (played by Jill Eikenberry) was representing an actor who had played a superhero called The Salamander on TV but was fired by the network. Network execs claimed he was unstable and therefore hurt the brand of their superhero.

Eikenberry put him on the stand and led him through his story as a down-and-out actor who had been unfairly fired, and now the network was even refusing to let him eke out a meager living posing as The Salamander at public events such as sci-fi conventions. He sounded reasonable and sad. The judge looked sympathetic, the jury looked sympathetic, even the network execs looked sorry—it seemed the case was won.

Then the defense counsel stood up and asked the witness: “Why do you think it’s unfair that you were fired from the show?” At which, the actor screamed: “Because I AM THE SALAMANDER” and ripped off his suit revealing the Salamander costume underneath, and using suction cups on his shoes and gloves, started to climb the courtroom wall. The final shot is of Eikenberry putting her head down on the plaintiff’s table.

I was reminded of the Salamander scene the other day when I finally got around to reading a 401(k) study released in February by Ian Ayres of Yale Law School and Yale School of Management and Quinn Curtis of the University of Virginia School of Law titled: “Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans.”

At first, I was encouraged that Ayres and Curtis had improved upon an earlier, somewhat flawed study of 401(k) fees, with a broader look at the myriad costs associated with 401(k) plans and an analysis of the real benefits of expanded investment options that have been the focus of regulators and lawmakers of late. Indeed, their study goes a long way to dispelling the myth that broader menus benefit retirement plan participants. But then I got to the fee section, where the professors tear off their caps and gowns to reveal their Salamander suits and start climbing the walls, with a renewed diatribe against managed mutual funds. Like Jill Eikenberry, I found myself with my head on my desk, wrestling with the question of how to assess a study that gets some things so right while it gets others so wrong.

First, the good stuff. Using a database of 3,500 401(k) plans, the authors use historic market data from 2002 to 2008 to compare the impact of restricted fund menus in plans, called “menu diversification losses,” with “investor diversification losses,” which compare the “returns that investors could receive on the optimal portfolio for their plan and the returns investors are actually expected to receive based on the actual portfolio held by plan investors.”

The answer is that the average 401(k) investor loses a mere 0.06% or 6 bps a year due to restricted plan fund choices. As the authors conclude: “Menu diversity is a non-problem […]. We find that employer-imposed menu limitations generally succeed at giving employees the substantial ability to diversify.”

This means that all the current hoopla about restrictive plan menus is misplaced, and the resulting fixes will help plan participants not at all. That raises the question of whether these efforts are simply misguided or the result of intentional misdirection.

The study also concluded that due to their own poor allocation choices, plan investors lose on average 0.65%, a not insignificant amount, particularly when compounded over decades. The authors don’t draw much of a conclusion from this data, but to my mind, one might reasonably conclude that retail retirement plan investors need the help of professional financial advisors—and lawmakers’ efforts might be better spent on requiring access to qualified advice.

Now for the bad news. As they did in their earlier paper, Ayres and Curtis once again demonstrate a profound lack of understanding about investments and investment advice. This ignorance is demonstrated throughout the paper, but most apparent in their assumptions about portfolio costs. While it’s certainly true that all else being equal, an investment alternative with lower fees is probably better, even the most junior advisors know that investment alternatives are rarely equal.

This erroneous assumption is demonstrated in the authors’ analysis of the costs of 401(k) plans. The paper tells us that the additional expenses paid by participants on their investments and for administration of their plan average 0.43% annually. By making “bad” (read: higher cost) choices in their investment selections, participants add another 0.49% to their expenses.

These computations are based on “excess expenses,” which are calculated in comparison to “retail index fund fees” and, in an improvement over their earlier paper, to “low-cost plan administration fees.” Yet the benchmark admin fees are not disclosed, nor are they broken out from the excess asset management fees. Consequently, we have no way to know whether the “low-cost” plan fees are reasonable or merely less ridiculous.

Then there are the assumptions regarding investment management. The authors make three troubling assumptions here. First, based on their analysis of the six years of performance from 2002 to 2008, they concluded that active fund management adds no value to an investment portfolio. Yes, I’m aware that Ken French came to the same conclusion (on more comprehensive data) in his 2008 paper, “The Cost of Active Investing.” But the fact is that the science on active management versus passive investing is far from settled, as evidenced by the fact that many fee-only RIAs still use actively managed funds in their client portfolios without any financial incentive to do so.

Second, the authors maintain that if two funds are found on a plan’s menu that offer effectively the same assets and the same investment style, if one has fees that are 50 bps higher, they are deemed “excessive.” They write, “These [funds] are so clearly inferior to other funds or groups of funds offered in the same plan menu that investors are clearly better off avoiding the option.” A bit harsh, don’t you think? More disturbing is the exclusion of the possibility that the higher priced fund might have a better manager with historically better returns. Apparently, great managers don’t have a place in the Ayres-Curtis worldview.

And third: Regardless of the data, some investors (and advisors) find comfort in having a human hand at the controls of their portfolios. I’m not saying this is right or wrong, only that some folks are willing to pay extra for this level of comfort. (I like to wear a helmet when I ride my Harley. If I never have an accident, I still won’t consider it a bad investment.)

Consequently, the conclusion that when plan participants choose managed funds it’s out of blind ignorance, and therefore the higher fees are excessive and should be considered portfolio losses, is naive at best. Should 401(k) plans offer index funds? Absolutely. Should they only offer index funds? We’re not quite there yet. But, according to the authors, “The problem of excess fees […] is so severe that for 16% of plans in our sample, the excess menu fees when compared to fees on an index fund consume more than the tax benefits conferred by ERISA.”

If they are truly interested in helping retirement investors, why don’t they itemize the real costs in 401(k) plans—administration, sales and other expenses—that take hundreds of basis points off portfolio returns? Conversely, if the authors are trying to stack the deck to find evidence of excessive management fees in 401(k)s, why don’t they go all the way and compare all funds to the zero costs investors would have if they picked the stocks and bonds themselves? How hard can it be to mirror an index anyway?

Finally, a note to independent advisors: Studies like this one that blindly deem “low” costs “good” and “high” costs “bad” are a disservice to retail investors (the institutional guys can fend for themselves) and to folks who provide high-quality investment management and advice. If Ayres and Curtis are using only costs to compare investment funds, how long do you think it will be before they start comparing advisors the same way—can you say robo-advice at $120 per year? Who will be wearing the Salamander suit then?