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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.