401(k) Plans: What They Really Cost

Showing Us the Money
Ian Ayres has created a ruckus by warning companies that run high-cost 401(k) plans that he will publish their names unless they change their ways. I discussed the Yale professor's efforts on Monday, The Wall Street Journal filed an article two evenings later, and Mitch Tuchman covered the subject for Forbes on Friday. It's quite the story: The professor descends from the ivory tower to make plan sponsors an offer they can't refuse. Talk about a nontraditional approach!

More quietly, though, Ayres and co-author Quinn Curtis (associate professor, Virginia Law) have issued a traditional academic paper on the subject. Entitled Measuring Fiduciary and Investor Losses in 401(k) Plans, the paper examines the costs of 12,475 plans, offered by a variety of 401(k) providers, and features a variety of company sizes. It's an excellent resource for seeing how 401(k) plans currently stand.

The conclusion is straightforward: 401(k) fund fees are overstated by the media. For example, the PBS Frontline documentary The Retirement Gamble frequently uses 2% as an assumption of fund fees within a 401(k) plan. Figures of that level are common in media reports, which is why a mainstream television show that reached millions could use such a statistic without being challenged. These figures are not, however, realistic.

The paper's database shows much less. The professors calculate an expense ratio for the funds in each plan in the database.* They then compute the average ratio across all plans. (In doing so, they equal-weight the plans.) That figure ends up being 0.71% per year--not remotely close to 2%. Even at the 95th percentile--i.e. the line determining the 5% of plans that have the highest-cost funds--the expense ratio falls short of the Frontline assumption, landing at 1.73%. 

[*This calculation is an odd duck, being the asset-weighted expense ratio for a single portfolio that the professors create for each plan (their estimation of that plan's "optimal" portfolio). This ratio is not technically the plan's average fund expenses, but it should be close to the mark, since the professors do not take fund costs into consideration when forming the portfolios.]

It's true that some plans levy additional fees that are not included in fund expense ratios. Those costs don't move the needle very far, though, being 0.13% per year for the typical plan and 0.54% at the 95th percentile.

Question: Is this study representative of the overall 401(k) marketplace? Not quite. The database bunches in the middle. With $3.6 billion in assets being the largest plan covered, the database lacks the giants. It also lacks the tiniest fish, as the smallest plan in the database is $60,000 and the median asset size is $13 million. So it's not the perfect study. On the other hand, its figure of 0.71% in average fund fees looks to be representative from the investor perspective, as the few giant plans that have many participants will generally have cheaper funds, and the many tiny plans that have few participants will generally have pricier funds. Roughly speaking, the data gaps should even out.

Flunking the Taleb Test
Nassim Taleb tweeted that he disagrees with Friday's column, which claimed that mutual fund managers pass the "Taleb test." He's not alone in that. Neither the column's comments nor the emails I received had much use for my argument. (Poor mutual fund managers, they truly are at the bottom of the investment-management ladder.)

Well, fine. If Taleb writes that mutual fund managers flunk the Taleb test, then they flunk the Taleb test. It's his test, after all. He gets to do the grading. I won't concede the larger point, though. If you wish to hold mutual fund managers' collective feet to the fire, so that they feel true pain if they underperform, having them put more money into the funds that they run is not particularly useful. The career damage (in terms of foregone salary and bonus) for failure likely will be greater than the monetary harm done by owning lagging funds, and the psychological and reputational damage probably will be greater yet. The issue that Taleb raises won't easily be solved by demanding that managers "eat their own cooking."

Lance Puffs
Remember the puffery defense? Standard and Poor's gave that legal defense a whirl by claiming that reasonable people would have known the company exaggerated when it said that its credit ratings were independent, objective, and free of conflicts of interest. Now it's Lance Armstrong's turn. According to Armstrong, he didn't defraud the U.S. Postal Service by taking performance-enhancing drugs while accepting sponsorship money. After all, the Postal Service had to know that professional cyclists were doping, Armstrong concluded. 

Oh, Lance. 

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.