Who has the most influence on an employer’s 401(k) retirement plan investment menu — you as the plan sponsor? Participants? The company’s ERISA attorneys or investment committee?
Chances are, it’s the plan’s mutual fund manager.
A new study from two U.S. university business professors and an economist for the U.S. Federal Reserve concludes that fund managers involved in plan management “often act in ways that appear to advance their interests at the expense of plan participants.” This is counter to the ERISA requirement that those managing 401(k) plans — whether as sponsor or investment manager — make decisions for the exclusive benefit of plan participants and their beneficiaries.
The academic research, in an August brief titled “Are 401(k) Investment Menus Set Solely for Plan Participants?” underlies a forthcoming study to be published in The Journal of Finance. The research was sponsored by the Center for Retirement Research at Boston College.
‘Detectable’ Bias
Of particular note to plan sponsors and fiduciaries is the study’s finding that a “detectable” bias toward a mutual fund company’s own family of funds is especially pronounced in favor of its affiliated funds that delivered subpar returns over the previous three years. When mutual fund companies act as plan trustees they have the right to add or delete from the menu of participant investment options, but also are expected to select the most suitable options, possibly beyond their own funds, when available.
In general, the researchers wrote, mutual fund companies’ dual role of managing assets in search of positive returns in the financial markets and for fee payments while helping plan sponsors set their investment option menus “creates conflicting incentives.”
A predisposition by fund companies to fill retirement plan investment menus with poorer-performing funds could leave plan sponsors open to litigation by participants if they and plaintiff’s attorneys can demonstrate that the plan sponsor ignored or was unaware of historically underperforming stocks that damaged returns for their retirement accounts.
In addition, the CRR report said the lackluster performance of the subpar funds selected for many plans’ menus usually persists over time.
To test this theory, the researchers calculated fund deletion rates — the number of times in a given year a fund was removed from a 401(k) menu divided by the number of potential deletions, which were defined as the number of menus on which a fund was listed at the end of the previous year. They then determined separately when a removed fund was, or was not, affiliated with the plan trustee.
Investment managers were found to remove 13.7 percent of their own funds in the lowest three-year- performance group, “dramatically less” than the 25.5-percent deletion rate for unaffiliated funds at the same worst-performing level.
“These findings thus suggest that, with respect to setting 401(k) menus, mutual fund companies tend to influence decisions in ways that appear to adversely affect employee retirement income security,” the researchers wrote.
The implications of this type of bias are clear for individual plans, as well as for 401(k) assets in general. About 56 percent of the $4.7 trillion held in 401(k)s and other defined contribution plans is managed by mutual fund companies, according to 2015 Investment Company Institute figures included in the study.
Participants Stay with Weak Funds
Another sobering suggestion from the CRR study was that participants do not move to mitigate the favoritism shown to poorly performing mutual funds associated with plans’ investment firms. Nonetheless, the researchers concluded that biased menu changes are more to blame for higher inflows into affiliated funds than participants actually indicating a preference for these funds.
Although they said it was difficult to project how long funds with poor past performance will continue to underperform, the study authors said annual risk-adjusted returns for the bottom-performing affiliated funds kept on menus were up to 4 percentage points negative when compared with earnings from a passive portfolio of indexes with the same risk profile. So participants choosing and leaving their savings in such funds are likely to experience some impaired investment income security, if compounded to retirement.
The study used data on 2,494 plans from 1998-2009, much of it drawn from U.S. Securities and Exchange Commission filings and Form 5500 annual reports submitted to the U.S. Department of Labor. The plans in the sample had 9 million participants and held one-third of 401(k) assets in plans sponsored by publicly listed companies during the study’s timeframe. These plans made nearly 50,000 menu changes in the years studied. Information on the mutual funds that were, or could be, included in 401(k) menus was drawn from the Center for Research in Security Prices’ Survivorship Bias-Free U.S. Mutual Fund Database.