Gadfly

The Gadfly from Yale Continues to Buzz the 401(k) Industry

Gadfly

Last year, we wrote about the exploits of Professor Ian Ayres of Yale Law School. You may recall him as the fellow who sent letters to 6,000 plan sponsors whom he identified as having especially high expenses. Essentially, he gave them an ultimatum to improve their plan or else face a public shaming in a forthcoming paper. Needless to say, it caused quite the uproar in the 401(k) industry, and Professor Ayres did eventually walk back his threat to name names. Recently, a working paper version of the article was posted on the Social Science Research Network. We found it to be quite interesting.

The title, “Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans”, pretty much tells you where he is going. To clarify, a “dominated fund” is an investment option that is clearly inferior to other investments in the same menu, and no reasonably informed employee would choose to invest in it. Ayres and his co-author (Quinn Curtis) found that 1,842 (52%) of the 3,573 plans in their sample had at least one dominated fund, and the average return on the dominated funds ranged from 0.60% to 1.50% worse than their non-dominated counterparts.

Of course, dominated funds are part of the overall problem of high fees paid by 401(k) plan participants. Ayres and Curtis calculate that excessive fees lead to an average loss of 0.86% compared to low cost index funds. In 16% of the plans analyzed, the excessive fees entirely consumed the tax benefit of investing in a 401(k) plan for a young worker. For the 3,573 plans in their dataset, the total annualized average loss was estimated at 1.56%, of which 0.50% was attributed to the plan sponsor having less than optimal menu choices and the remaining 1.06% was attributed to plan participants making mistakes such as inadequately diversifying and selecting dominated funds.

Over the past few years, we have seen a rash of lawsuits against companies like Wal-Mart, General Dynamics, International Paper, et al. The lawsuits are not just for failing to offer low-cost funds, as they have also been filed in response to practices such as failing to monitor the plan’s internal costs and paying excessive fees by allowing investment companies to receive undisclosed payments from plan investments in addition to their annual record-keeping fee. Ayres and Curtis provide a theoretical justification for the continuation of these lawsuits by arguing that existing fiduciary duty law can be invoked in these situations because (i) excessive fees can be evidence of an imprudent fiduciary process, and (ii) fiduciaries act imprudently if they include dominated funds in the investment menu.

As expected, Ayres and Curtis suggest some structural reforms beyond the Department of Labor’s disclosure requirements to address this problem. In addition to enhancing the requirements for default fund allocations to assure that they are reasonably low cost, they would require that plan participants demonstrate a minimum level of investment knowledge before being allowed to invest in any other funds that do not satisfy the enhanced requirements. They also recommend that the Department of Labor designate certain plans as “high cost” and allow plan participants to roll out of those plans into a managed IRA account. In our opinion, this proposal in particular would meet an overwhelming degree of resistance.

As we said before, we wish Professor Ayres the best in his endeavors to reform the 401(k) industry. Billions of hard-earned retirement dollars hang in the balance. If you beleive that your retirement plan could be improved or you would like to learn more about the benefits of having IFA act as a true fiduciary for your retirement plan, please visit our Retirement Plan website, IFA401k.com or give us a call at 888-643-3133.