Beyond Diversification: The Pervasive Problem of Excessive Fees and 'Dominated Funds' in 401(k) Plans
Yale University - Yale Law School; Yale University - Yale School of Management
University of Virginia School of Law
February 21, 2014
Yale Law & Economics Research Paper # 493
Notwithstanding ERISA’s fiduciary requirements, a wide range of plan administrators establish investment menus with options that predictably lead to substantial underperformance of retirement portfolios. Utilizing data from more than 3,000 401(k) plans with more than $120 billion in assets, we provide evidence that fees lead to an average loss of 86 basis points in excess of low cost index funds. In 16% of analyzed plans, we find that, for a young worker, the fees charged in excess of an index fund entirely consume the tax benefit of investing in a 401(k) plan. We also document a wide-array of “dominated” menu fund options where the costs of fees in holding the fund so outweigh the benefits of additional diversification that rational investors would not invest in these assets. We find that approximately 52% of plans have menus offering at least one dominated fund. In the plans that offer dominated funds, dominated funds hold 11.5% of plan assets and these dominated investments tend to be outperformed annually by their low-cost menu alternatives by more than 60 basis points. We argue that existing fiduciary duty law (aided by improved rule-making by the Department of Labor) can be used to challenge plans that imprudently expose investors to the risk of excess fees. In particular, we argue that (i) evidence of excessive fees can be powerful evidence of an imprudent fiduciary process, and (ii) fiduciaries act imprudently if they included dominated option in their menus, even if plan participants have other offerings with which to construct prudent retirement portfolios.
But because heightened fiduciary duty reforms are unlikely by themselves to solve the problem of excess fees and dominated funds, we also propose three additional structural reforms: First, we recommend that the requirements for default fund allocations be enhanced to assure that the default investment is reasonably low cost. Second, we recommend that the Department of Labor (DOL) designate certain plans as “high cost” and mandate that participants in these plans be given the option to execute in-service rollovers to low-cost plans. Finally, we recommend that participants be required to demonstrate a minimum degree of sophistication by passing a DOL-approved test before being allowed to invest in any funds that would not satisfy the enhanced default requirement.
Number of Pages in PDF File: 42
Keywords: ERISA, defined contribution, 401(k)
JEL Classification: J26working papers series
Date posted: February 22, 2014 ; Last revised: March 20, 2014
© 2014 Social Science Electronic Publishing, Inc. All Rights Reserved.
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