How 401(k) Plans Stack the Deck to Get Chump Investors to Sign Up for Doggy Sponsor Funds

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Yves here. The Harvard Law School Forum on Corporate Governance and Financial Regulation flagged an important recent paper that describes yet another way that 401(k) plans fleece investors. This new ruse it exposes should give members of the public cause for pause as Wall Street denizens like Blackstone’s Tony James, who is a leading adviser of Hillary Clinton, prepare to insert a big tube directly in veins of all American workers to suck money into mandatory retirement accounts. As we discussed in a post earlier this week, this scheme is a two-fer: a stealthy way to displace Social Security over time, and immediately enrich the purveyors of high-fee strategies with poor recent performance and/or dubious prospects, namely hedge and private equity funds.

We’ve embedded the paper, It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans, at the end of this post. It looks into whether 401 (k) plans engage in an abuse that occurs on a widespread basis at brokerage firms: having salesmen (induced by bonus sales credits) put customers into inferior in-house mutual funds over better performing outside products or index funds. Bear in mind that the rise of “wrap accounts” was to prevent retail broker churning of accounts that invested in individual securities, and for mutual fund accounts, to reward the firm well enough to as to remove the incentive to taking advantage of their discretionary authority. But the howling from brokers and other purveyors of retail investment services over the Administration’s plan to impose a fiduciary duty on brokers managing retirement assets says that there is still a yawning chasm between retail firms’ claims about how they put customer interests first versus reality.

This is why the article by Veronika Pool, Clemens Sialm, and Irina Stefanescu shows yet another way that financial firms prey on unsophisticated investors.

Mutual funds manage nearly half of 401 (k) assets. Many operators of fund families (think Fidelity) are in a conflict-of-interest position by being the plan administrator. That means they are in the catbird seat of determining which funds are on the menu presented to plan participants. The author created a large custom data set to investigate whether plan investors were stuffees by virtue of being presented with inferior choices, specifically, adding funds from the administrator’s in-house roster and not removing them even when they proved to be dogs.

The study focused on “open architecture” plans that included offerings from both the administrator’s fund family and outside products. The authors found the administrators stacked the deck in favor of their own funds:

Our results reveal significant favoritism toward affiliated funds. Mutual funds affiliated with the service provider of a 401(k) plan are significantly less likely to be removed from the plan menu than unaffiliated funds. The biggest relative difference between how affiliated and unaffiliated funds are treated occurs for the worst-performing funds, which have been shown to exhibit significant performance persistence (Carhart, 1997). For example, mutual funds ranked in the lowest decile based on their prior three-year performance have a deletion rate of 25.5% per year if they are unaffiliated with the plan’s trustee and a deletion rate of just 13.7% if they are affiliated with the trustee. On the other hand, funds in the top performance decile have a deletion rate of around 15% for both affiliated and unaffiliated trustees. Similarly, we find that the propensity to add funds to 401(k) menus is less sensitive to performance for affiliated funds than for unaffiliated funds.

Now in theory, investors might be vigilant enough to recognize that their interests are not being well served and will avoid the lousy funds from the administrator’s fund families. But not surprisingly, these fund operators persist in these bad practices because they work. Again from the article:

Consistent with studies documenting that DC plan participants are naive and inactive (Benartzi and Thaler, 2001; Madrian and Shea, 2001; Agnew, Balduzzi, and Sunden, 2003), we show that participants are generally not sensitive to poor performance and do not undo the menu’s bias toward affiliated families. This in turn indicates that plan participants are affected by the affiliation bias.

Oh, but maybe the fund administrators are not evil! Maybe they have inside information that the doggy funds’ performance is on the verge of being turned around, say by appointing a better fund manager. Nope:

…affiliated funds that rank poorly based on past performance but are not deleted from the menu do not perform well in the subsequent year. We estimate that, on average, they underperform by approximately 3.96% annually on a risk- and style-adjusted basis. These results suggest that the menu bias we document in this paper has important implications for the employees’ income in retirement.

Now admittedly, affiliated funds in these 401 (k) plans in toto perform better on some important measures, such as overall fees, asset turnover, and volatility of returns. But that appears to be due in large measure to the fact that the administrator includes more in-house index funds than third-party ones.

Needless to say, we’ve inveighed regularly about 401 (k) plans as an inferior retirement vehicle due to their high and regularly non-transparent fees, abuse of float (they take their sweet time to move funds from one fund to another), and sometimes unduly limited options (for instance, restricted choices on international funds and REITS, which offer an element of asset class diversification). This paper provides further confirmation that 401 (k)s need far more scrutiny and oversight.


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  1. Cocomaan

    Thanks for this analysis. I have a 403b through my institution of higher Ed, specifically Tiaa. Their funds are kind of lousy (compared, say, to a vanguard index) and there’s little choice in which funds seem to be available from one institution to another.

    The idea that workers will somehow sit down and process the numbers surrounding badly performing funds, and then redistribute, is a fantasy. Who has the financial literacy to do that? Like healthcare,it’s another area of personal finance where people are expected to take on time consuming and complex administrative duties.

    Mandatory 401s sounds just great. Can’t wait. “You give me your money, you tell me where to put it among crappy options, wait forty years, and you may or may not ever see it again, based on the quality of your choices. Pleasure doing business with you.”

  2. Larry

    I love the last line, because it applies to almost everything in our society today: far more scrutiny and oversight. Thanks to Naked Capitalism for turning up the scrutiny.

  3. Mark John

    We are going to have a fight on our hands if and when HRC gets elected. The fact that our politicians have gotten away with weakening New Deal programs that actually worked well is all the evidence I need to believe they are not finished with their attack.

  4. Scott

    When I signed up for a 401k at my previous job, I wanted to invest in the S&P index fund, as it was the lowest cost option. Given that Putnam used their own fund, it charged 0.35% at a time when Vanguard was at 0.07% and Fidelity at 0.10%.

    1. James

      If you put $10k into the fund at 35 bps, you’d have $136k at the end of 10 years (assuming 7% gross return). if you got it at 7 bps, you’d have $137k. Now, if you’d bought a loaded A share American Fund with a 5.75% sales load and a 65 bps expense ratio, you’d have $126k.

      The principle of low fees is important, but you’re effectively there with the 35 bps fund.

  5. KYrocky

    “…investors might be vigilant enough to recognize that their interests are not being well served…”

    Come on. Really. I would wager that the percentage of people knowledgeable and sophisticated enough to do so at well under 0.1% of the population. The entire system of 401 retirement plans has been constructed for the purpose of fleecing undisclosed fees from us suckers forced into these plans.

    Washington has proven itself incapable of managing its money (our taxes) prudently and efficiently because of our corrupt representatives putting their electoral and personal interests first. The 401K experiment has failed. Very few individuals will be able to rely on them for retirement security, and of those most hail from the higher income brackets. They do virtually nothing for retirement security for the vast, vast majority of the country.

    Social Security is a proven, cost effective, and reliable deliverer of retirement income for our entire population. 401K’s will never come close, and in fact aren’t worth shit to most people. But that is not what matters in Washington.

  6. James

    Given that asset allocation (not fund selection) determines about 90% of your portfolio’s over- or under-performance, this article sorta focuses on the wrong thing. IE whether you use Fidelity’s SP500 index fund or the comparable ETF matters much less than the asset allocation (between bonds, stocks, other strategies) in your portfolio. Given that we’re seeing the slow death of high fee, active mutual funds and the consequent growth of ETFs and passive funds, we need to focus much more on the advice provided to investors and a little bit less on the fees (given the scale of the decline in fees we’ve seen already…IE we’re talking basis points between an internally managed index fund and an ETF).

    Fees matter a lot. But given that we’ve taken 75% of the fees out of mutual funds already, its no longer the #1 issue.

  7. cdub

    I see this as akin to a Board of Driectors governance issue.

    The Plan administrator has a fiduciary obligation to manage the options. The administrator can put pressure to make non-Sponsor funds available. With a total company 401k of only about $5mm, I was able to pressure our 401K plan Sponsor to provide access to lower cost equivalent portfolios for investment options such as S&P 500, Russell 2000 and a long-term bond yield (via Vanguard and Fidelity).

    All it required was performing the minimums of being a 401k plan administrator. Quarterly monitoring of fund performance versus peers via a service like Morningstar (took 4 hours to prebuild screens that displayed QonQ, YonY and 3Yon3Y), pressing the Sponsor for alternatives and then refusing the steak dinner to discuss with the Sponsor. I mean for crying out loud this is really simple. And of course if your plan administrator isn’t doing this minimum I’m sure they have fiduciary insurance so there are alternatives.

    Of course many people aren’t willing to ask/press these questions of their employer/HR. I’ve seen plans administered exceptionally well (utility with a union for about 1/3 of employees and small family energy firm) and poorly (some larger energy companies). Why somebody doesn’t provides this administrator function as an outsource is beyond me. The real liability can be quite high and pushing off to a 3rd party who does just that would seem worth the $.

  8. P Fitzsimon

    My 401K was administered by Fidelity and I believe there were no restrictions whatsoever. I could invest in any Fidelity fund or actually any fund through a brokerage account. If you didn’t use a Fidelity brokerage account offered by the plan as an option your choices were restricted.

    1. Vatch

      Yes, thank you. I was going to comment on that, but you’re way ahead of me.

      Doggy funds belong in the Antidote du jour.

      1. Mattie

        They are often dodgy too. Great-west/Empower does a real bait and switch on the options offered for certain 401A funds were there is deeply buried disclosure about proprietary versions charging much higher fees, than the term sheet prominently displayed as “this is what you’re buying if you select this fund”. This is a real racket

  9. Arizona Slim

    I’m of the mind that people should be investors because they *want* to, not because they *have* to. Even then, investing is not easy.

    Can’t help agreeing with Joe Nocera, who said that investing is a talent that most people will never have.

  10. oceaniris

    Yves, article and analysis insightful, thanks again. “Doggy” in title makes sense, but “dodgy” may apply as well to Fidelity specifically, read on. Stumbled on to Reuters write up by Tim McLaughlin about Fidelity this month and began a search for a new money management firm with a “fiduciary” bone in it’s body:
    Though the article indicates Fidelity’s behavior is not “illegal nor unethical” – Yale University law professor John Morley said Fidelity runs the risk of losing investors by competing with the funds that serve them.

    “What they’re doing is not illegal, not even unethical,” Morley said. “But it’s entirely appropriate for mutual fund investors to take their money elsewhere because Fidelity has made a decision to take away some of their potential returns.”

    Many of us are trapped in the DC funds our employers establish for us. As cdub referenced, pressuring plan administrators is one way to change options or broaden offerings – but one needs to understand what pressure to apply.

    Morely said it best and I will move on…..

  11. Chauncey Gardiner

    Difficult to reconcile this with the Department of Labor’s new fiduciary rule, which reportedly requires financial advisers to place the interests of clients with retirement-saving accounts ahead of their own. I have read that it will be implemented sometime next year, assuming there are no additional delays. (hat tip Barry Ritholtz)

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