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401(k) Fees Need to Get Better

Jason Stipp
John Rekenthaler

Jason Stipp: I'm Jason Stipp for Morningstar. Yale professor Ian Ayres is making waves in the 401(k) industry by threatening to expose what he's identified as high-cost 401(k) plans. So what might the study mean for the 401(k) industry? What should it mean? How should we interpret it? Here to offer some insights is Morningstar's John Rekenthaler.

John, thanks for being here.

John Rekenthaler: Sure, Jason.

Stipp: You've written about the study in a couple of columns in the last week. We're interested to take a step back at this point and talk about exactly what the study itself was looking at. We've heard a lot about the letters that he sent. But [let's talk about] what the study is looking at, what we can take away from it, and what might come next. There are two major things you're saying the study was looking at: costs and the menu of investments and how investors use them. How are you thinking about those two objectives of the study?

Rekenthaler: As we say, take a step back. This guy is a professor, so he assembles a database. He has a database of 12,000 401(k) plans, and he had very ambitious goal. His goal is to look and compare how people could have done with an ideal portfolio--his definition of ideal portfolio--and how far have they fallen short of the mark, and is this because of costs of funds, investor decisions on how they've put together funds, or the menu, the choice of funds that they were given. Do they have enough exposure to different classes in 401(k)? Were they given the chance to put together a complete portfolio by the menu, how much did the funds cost (because that cuts down returns), and did they assemble funds correctly? I really think only the cost piece they are able to truly do. Otherwise, it's rather technical to go through, but they have to make various assumptions. They don't know where the markets are going any more than anyone else does, and we don't know their efficient portfolio that the professor has put together in their paper is more efficient than your portfolio or my portfolio. So I'm not really going to address those issues, but they do have a great database of fees of costs of 12,000 plans, and I think that's valuable information and that's really what they're mining for the letter.

Stipp: The costs are the costs, right? The other assumptions that they're making for these other points about how well investors are using the funds--there's a lot of squishiness in there.

Rekenthaler: Very squishy.

Stipp: But they have the data on the fund costs and you said in your column this week that some of the conclusions look pretty reasonable about what the average cost of a 401(k) might be.

Rekenthaler: That's right. The data seemed to be pretty complete. It's important to know, and I think it's a fair criticism of 401(k) plans, that some of the jibing that comes at the professor and what his work is [about not having] all the costs in there, is because they're hidden in some fashion. That's not very complementary for the 401(k) industry to defend itself by saying we've got these hidden costs that actually don't show up there and you didn't capture all the costs. But setting that aside, the typical 401(k) plan in this database is about $13 million, so it's a pretty good sized plan compared with a mom-and-pop bagel shop that might have a 401(k) plan. But $13 million is not a gigantic plan compared with Ford and the major companies. It's 71 basis points or 0.71 or 7/10 of 1% for the average management fees or expense ratios for the funds in there.

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Stipp: That's quite a bit lower than some of the other fees that we've seen, or averages that we've seen in other programming as high as 2%, I think, on Frontline.

Rekenthaler: I've even seen somebody say as high as 5%, which was pulling out a mutual fund one time somewhere that had a 5% expense ratio. But that, of course, isn't remotely representative of what people go through in a 401(k) plan.

Stipp: So how should we view this 0.71? It's low compared with some of those other estimates, but when you look at it, does that seem high to you? Is it something that we should be talking about loudly and letters should be sent out that this 0.71 is way too high; it's higher than it needs to be?

Rekenthaler: I don't know if higher than it needs to be is a wrong way of phrasing it, because how do 401(k) plans start? A 401(k) plan is an initiative by private enterprises, by for-profit companies getting out there spreading the word. It costs a lot of money to market these, create these things, create the recordkeeping systems, and so forth. We used to have higher costs. There is a reason why there were higher costs, and this has not been, especially for record-keepers, a fabulously profitable business. But the fact remains, as this becomes a centerpiece for the American retirement system, 70 basis points is just too much to come out of, particularly when you've got Treasury yields that moved up a little recently. But 2.5%, 3%? You're talking one quarter of Treasury yield. It's a number that will come down. Political pressures will push it down and market pressures will put it down, and we see a lot of plan sponsors that have helped to push it down by demanding and pushing on providers and saying you need to give us cheaper options.

Stipp: That seems to be one of the objectives of the professor sending these letters, is to really pressure the plan sponsors to be more aware of what they're paying and to push for lower fees. In some cases the plan sponsors may not know what's reasonable or what they could be asking for potentially?

Rekenthaler: That's right. The letters being sent are targeting the plan sponsors of relatively high-cost plans for their size, as identified in his database. So he's not trying to communicate with the ones, in his view, that have got it figured out, but [with] the ones that appear not to be pressuring their providers or selling for higher-cost funds. It's a rude letter, so one can agree or disagree with the tactics. But I think, when I step back and look at it broadly, this is part of the market forces. He is one element of the market forces that are driving costs down and will continue to drive costs down. In 2013, 70 basis points is much lower than the average cost of the typical mutual fund when you just equal-weight the mutual fund database, and it's quite a bit lower than where we were 10 or 15 years ago in 401(k) plans. But it will need to get better. In 10 or 15 years we're going to say 70 basis points is too much for a typical company, and the number will be lower. So he is part of the market forces. He is a particularly quirky and interesting part of the market forces.

Stipp: It seems to make sense to target the plan sponsors as well, because they're really the fiduciaries in this arrangement. They're the ones that ultimately are going to be responsible for the fees being what they are for the plan that they negotiate. The investment provider doesn't necessarily have any real reason to lower fees, because they're not fiduciaries. We've seen this play out in the courts.

Rekenthaler: Right. The investment providers get paid more fees or higher, so that's a natural business incentive to charge more. When push comes to shove, as we saw with lawsuits, when a lawsuit comes and somebody files on behalf of the investors in a 401(k) plan and files a lawsuit and says the fees are too high, then the investment providers says, wait a moment, I'm not the fiduciary, the plan sponsors are fiduciary and it's not my fault if fees are too high. And the courts have agreed with that. So there is a natural business incentive to charge more, and I can't blame the company for doing its business.

Stipp: All right, John. Well, this is a very interesting case. Thank you for following it so closely. I think it will be interesting to see how this plays out. I'm sure you'll be keeping a close eye on and thanks for joining me today.

Rekenthaler: Jason, Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.