Mar 29 2014, 9:56am CDT | by Forbes
This is the first in a series of posts about the problem of excess fees charged to defined contribution retirement plans.
Retirement regulations have largely been successful in giving worker/participant defined contribution plans the opportunity to diversify. Most plans nowadays give participants a sufficient variety of investment options that it is possible to allocate investments so as to diversify away most idiosyncratic risks.
However, the 1974 Employment Retirement Income Security Act’s (ERISA) emphasis on diversification has diverted attention from the problem of excess costs. Courts evaluating whether plan fiduciaries have acted prudently have tended to just ask whether the plan offered a sufficient number of reasonably-priced investment opportunities. For example, in Hecker vs. Deer & Co. (7th Cir. 2009), the 7th Circuit found it was “untenable to suggest that all of the more than 2500 publicly available investment options had excessive expense ratios.”
The Hecker approach is wrongly decided because it effectively immunizes fiduciaries that offer what Quinn Curits and I call “dominated funds” in their fund menus.
A dominated fund is a fund that no reasonable investor would invest in given that plan’s other investment offerings. In our recent working paper, we find that:
[A]pproximately 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.
Informed investors should be investing 0.0 percent of their plan assets in dominated funds, so it’s disturbing to see that when given the opportunity, 11.5 percent of plan assets flow into these funds.
To my mind, dominated funds are a kind of product design defect:
A car or computer manufacturer which included a button on their product which had no beneficial purpose and would only cause the device to perform less safely would run a substantial risk of being held accountable under product liability for failing “to design a product to prevent a foreseeable misuse.” The fact that informed consumers would not push the button would not absolve the manufacturer from including an option that no reasonable user should ever push if it was foreseeable that even some users would misuse the product by pressing the button. The likelihood of investor misallocation is just as foreseeable.
I’ve argued that the problem of dominated funds suggests a simple reform:
Plan fiduciaries should have a duty to remove dominated funds from their menu and to map participants to the lower-cost analog offering (akin to 404(c)(4) “Like-to-Like” mapping procedure).
But a recent decision suggests the possibility of an even more pernicious problem. Instead of failing to map participants’ investments away from dominated funds, Tussey vs. ABB, Inc. suggests the possibility that fiduciaries at times might be eliminating funds and mapping these investments toward high-cost dominated funds. In the Tussey case, the retirement plan at issue eliminated from its menu of funds the Vanguard Wellington fund and “mapped” all investments in that fund to Fidelity Freedom funds.
Mapping is default allocation that fiduciaries use when they eliminate a fund from their menu offerings. Participants who are invested in the eliminated fund are reinvested in the mapped fund if they do not affirmatively select an alternative menu fund that is still be offered. Many, many employees don’t pay attention to plan notices that a fund is being eliminated and mapped to an alternative investment, so the mapping default allocation often determines where the bulk of the eliminated fund investments will be reinvested.
The district court found the mapping from the Wellington to the lifecycle Freedom funds was a fiduciary breach. Currently the Wellington fund charges just 26 basis points in annual fees, while the Fidelity Freedom funds charge more than 3 times as much – 82 basis points. To be clear, I’m not sure that the Freedom fund would meet the stringent requirements we set for dominant funds in our forthcoming Yale Law Journal article. But in some ways that underscores how conservative the article’s identifying algorithm is. I agree with the district court that it was a bad idea for the fiduciary to push investors toward such excessive fees.
Why in the world would fiduciaries replace a low-cost, well-performing fund like the Wellington fund with a high-fee target date fund? The plan fiduciary argued that the move was motivated by wanting to offer “a fund that employed a ‘dynamic approach.’” But a motivation to offer a dynamic target date fund doesn’t explain why the plan needed to eliminate the low-cost Wellington fund. Instead, the district court found that the fiduciaries were “motivated in part by [their] desire to decrease the fees that ABB was paying and to maintain the appearance that the employees were not paying for the administration of the Prism Plan:”
Indeed, the Vanguard Wellington Fund with its low fees, and long-standing consistent performance history, made it a very attractive fund to maintain on the Plan’s investment platform. The Court believes that the Wellington Fund’s removal was not due to any failure of its merits, but because the Freedom Funds that replaced it generated more in revenue sharing for Fidelity Trust.
Revenue sharing is a kind of kick-back that the investment companies which operate the individual funds pay to the plan advisor as compensation for particular funds being included in the fund menu. The plans can indirectly benefit from revenue sharing because the plan advisors (in this case Fidelity Trust) will often comp the costs of recordkeeping and other administrative expenses if the fiduciary will agree to include high-cost funds that will then pay higher revenue sharing to plan advisor. Indeed, in this case, Fidelity Trust offered to drop its recordkeeping fees from $10 to zero for employees of the Main PRISM Plan” if “the Wellington Funds were mapped to the Freedom Funds.” Replacing the Wellington Fund with the Freedom fund was important to the Fidelity Trust because the Wellington fund had provided the Trust with “only 15 basis points in revenue sharing as compared to the 35 basis points provided by Freedom Funds.”
To my mind, the district court’s factual findings make out a clear case of a fiduciary breach.
[The fiduciaries] failed to compare differences in expense ratios or revenue sharing percentages between the Wellington Fund and the Freedom Funds or other balanced funds on the Plan platform, which affect an investment’s return. . . . After the Wellington Funds were mapped into the Fidelity Freedom funds, thereby changing the hard-dollar fees charged, ABB did no “mathematical calculation” of what the Plan now paid Fidelity in recordkeeping fees. . . . The inconsistency between Mr. Cutler’s reasons for removing the Wellington Fund and the decision to map the Wellington Fund to the Freedom Funds, coupled with the large discrepancy in the expenses of both funds, underscore the Court’s finding that Mr. Cutler’s recommendations were motivated in part by his desire to decrease the fees that ABB, Inc., paid.
Given these findings, I was surprised to read that on March 19ththe Eighth Circuit vacated the district court’s finding of a mapping breach (and remanded the case back to the trial court for further consideration). The appellate decision focused on a single sentence of the district court opinion in which the trial court referred to the relative returns that the two funds made after the mapping – specifically, that “between 2000 and 2008, the Wellington Fund outperformed the Freedom Funds.” The appellate court concluded based on these eleven words that:
The district court’s opinion shows clear signs of hindsight influence regarding the market for target-date funds at the time of the redesign and the investment options’ subsequent performance. While it is easy to pick an investment option in retrospect (buy Apple Inc. at $7 a share in December 2000 and short Enron Corp. at $90 a share), selecting an investment beforehand is difficult.
The Eighth Circuit is correct that a fiduciaries decision should turn on ex post fund returns. But the core factual findings of the trial court concerned ex ante available information – particularly regarding the differentials in fees and revenue sharing. Indeed, a close reading of the district court’s opinion suggests that the passing mention of the funds’ post 2000 returns might have related to the reasonableness of the fiduciary’s decision to stick with the high-cost target date funds for these ensuing years after being able to see their inferior returns. All-in-all, I’m hoping that on remand the district court on remand sticks to its guns. Mapping toward a dominated fund is a clear fiduciary breach.
The Tussey facts suggest that the Department of Labor should pay more attention to mapping. Participant investors routinely remain silent as their assets are defaulted toward the fiduciary recommendations. Mapping to higher cost funds should raise a regulatory red flag. Here are two simple mapping reforms.
Source: Forbes Business
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