Do you know how your 401(k) plan picks its funds?
The answer may be less straightforward than you think. A forthcoming study in the Journal of Finance found that when 401(k) plan administrators also offer mutual funds—and many do—they “often face conflicting incentives. While they are pressured by plan sponsors to create menus that serve the interests of plan participants, they also have an incentive to include their own proprietary funds on the menu, even when more suitable options are available from other fund families.”
If the fund companies’ funds and all others performed equally, there would be no issue. But a summary of the study from the Boston College Center for Retirement Research said that “mutual fund company involvement in 401(k) menu decisions appears to favor the company’s own funds, with potential adverse effects on the retirement savings of plan participants.”
Overall, 401(k) plans held about $4.6 trillion in assets at the end of 2014, according to Investment Company Institute data, and for many Americans their 401(k) holdings are a critical part of their retirement savings. But over the years, critics have voiced concerns about the fees embedded in the plan offerings and the fund choices themselves.
The new research indicates that some fund choices follow interesting patterns. For example, plans with administrators that offer mutual funds are more likely to have disproportionate additions of affiliated funds, and that is particularly true when funds with subpar performance are added.
“Performance becomes a bigger factor in determining additions for unaffiliated funds than for affiliated funds,” said Clemens Sialm, a finance professor at the McCombs School of Business at the University of Texas at Austin and a co-author of the study.
That propensity is not necessarily surprising, he added. The employer offering the 401(k) might like the fund company and its offerings, “and that might be a reason” they were chosen as an administrator.
Another reassuring point: The researchers looked at affiliated and unaffiliated funds’ performance overall, and found that when they compared the two groups to a passive portfolio of indexes, the affiliated funds outperformed, though only to a statistically insignificant degree.
Unfortunately, the study found that that pattern did not hold for all the funds. In fact, the lowest performing affiliated funds had significantly worse performance than the lowest performing unaffiliated funds. And while unaffiliated funds performing in the lowest tenth of offerings had a 25.5 percent deletion rate per year, the deletion rate for affiliated funds at that performance level was just 13.7 percent. (Tweet This.)
“These results suggest that decisions to change the composition of 401(k) menus are not simply driven by meritocracy, but also by favoritism,” the researchers wrote.
The study is appearing at a time when the Labor Department is mulling an expansion of the so-called fiduciary rule to require all financial advisors to act in the best interest of investors. The proposed rule is not specifically focused on 401(k) plans and their administrators, but it does suggest that the Labor Department has concerns about the quality of investment advice that retirement savers may receive.
David Certner, legislative policy director for government affairs at AARP, which favors the proposed rules, said 401(k) plan sponsors and administrators fall under plenty of regulations, like those within the Employee Retirement Income Security Act (ERISA), that require them to act in plan participants’ best interests. However, he said, if the new study raises questions about what goes on within the 401(k) plans, “you can imagine how it is outside the realm” of those rules.
In fact, a study by the White House Council of Economic Advisors that focused on IRAs found that retirement savers who receive conflicted advice generally earn annual returns that are a full percentage point lower than those who don’t.
However, securities industry groups like the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) are strongly opposed to the proposed expansion of the fiduciary rule, arguing among other things that it would add an unnecessary layer of regulation.
“The clear consequence of the Department’s heavy hand is the explicit and implicit limitation on the types of investments individuals may choose to utilize with their retirement funds, as well as how they choose to pay for the services they seek,” SIFMA CEO Kenneth E. Bentsen Jr. said in written testimony. “We question whether it is appropriate for the government to effectively substitute its judgment for that of every IRA owner, every plan fiduciary and every plan participant, and whether that is what Congress intended when it enacted ERISA.”
As for the new research, Matthew Beck, a spokesman for the Investment Company Institute, said plan sponsors, not administrators, have ultimate responsibility for the offerings in a 401(k). (The sponsor is typically the employer that sets up the retirement plan, while the administrator manages it.)
“The plan’s fiduciary, usually the sponsor, selects the plan’s menu of investments. The fiduciary makes those choices based on numerous factors, including each fund’s investment objectives, risks, performance and fees,” he said. “The fiduciary has a duty to weigh these factors to ensure that the menu meets, in its judgment, the best interests of that plan’s participants.”
Sialm agreed that the ultimate responsibility for which funds to include in a 401(k) falls to the plan’s sponsor, though the sponsor may have an incentive to emphasize the administrator’s funds. “The plan sponsor might allow favoritism toward affiliated options because this might reduce the fees they have to pay to the various service providers,” he said.
Still, he said, “we document that affiliated funds in 401(k) plans are treated very differently than unaffiliated funds. Affiliated funds are significantly less likely to be deleted and they are significantly more likely to be added. In addition, the prior performance levels play a smaller role for affiliated funds than for unaffiliated funds.”