Yale/Harvard Study Reveals Disturbing 401k Fee Paradox
Will a 401k investor choose a fund with lower fees or a fund with higher returns? The average fiduciary might think this a silly question, but its answer might just reveal a hidden liability should the Department of Labor make good on its proposed Investment Advice Rule. Why? The DOL’s current draft requires fiduciaries to emphasize lower fees and not historic returns when selecting investment options for 401k plans. Despite this nudge away from past performance, 401k investors will continue to see (SEC mandated) performance disclosures.
If the DOL requires the 401k plan fiduciary to ignore a fund’s investment performance, but the SEC still requires funds to disclose that performance, the answer to our “silly question” rises to importance. One would hope 401k investors would also ignore investment performance. But, what if they don’t? Who’s left holding the liability bag?
A new study (“Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,” by James Choi (Yale), David Laibson (Harvard) and Brigitte C. Madrian (Harvard), April 2010, Review of Financial Studies) reveals this precise paradox. The three researchers conducted a series of experiments designed to remove the white noise found in the low/high fee debate. Here’s how they did it:
White Noise #1: “You get what you pay for” (Part I) – The ongoing active vs. passive debate – Index funds tend to have lower fees than actively managed funds. This makes sense given there’s more work involved in actively managed funds. The debate centers on whether active beats passive or active beats passive. With this debate comes the “you get what you pay for” counter-argument by active managers; hence, the introduction of white noise in the low-high fee debate. It’s really difficult to compare apples to oranges, so the Choi-Laibson-Madrian research team ignored the debate altogether and compared only S&P 500 index funds (thus also avoiding the “which index is the best index” question).
White Noise #2: “You get what you pay for” (Part II) – The higher fees means higher service debate – Some in the industry argue various “nonportfolio” services justify higher fees, even among the S&P 500 index fund offerings. The nonportfolio services argument suffers from subjectivity. Choi et al decided to steer clear of such capricious data and only include funds without nonportfolio services
White Noise #3: The Rational Investor debate – Theory suggests investors who make rational decisions ought to pick lower cost funds, especially when White Noise #1 and #2 have been stripped out. To make it even more likely, the researchers selected subject pools more likely to support the theory of the rational investor. The largest subject group consisted of Harvard staff members. These white-collar non-faculty employees have spent many years managing their own finances and 60% of them have some form of graduate school education. The next largest subject groups consisted of Wharton MBA students with an average combined SAT score of 1453 (98th percentile). The remaining subject group included Harvard students with an average combined SAT score of 1499 (99th percentile). The researchers found all three groups possessed greater measurable financial literacy than the average American investor.
To summarize: The researchers picked four otherwise identical S&P 500 funds (they did have different fees and different inception dates). They picked very intelligent subjects. The funds only offered performance as no nonportfolio services were included. Despite all this, the study revealed a disturbing paradox. “Almost none of the subjects minimized fees” and paid a remarkable 1-2% more than they needed to. The staff and Harvard student groups admitted they paid little attention to fees in making their decision. Ironically, the Wharton students “claimed that fees were the most important decision factor for them, yet their portfolio fees are not statistically lower than college students’ fees.”
How could this be when all funds were the same portfolio? Since each fund represents the S&P 500 index, one would expect similar future investment performance. Although some minor tracking errors can exist, the “since inception” performance varies because all funds started on different dates.
Here’s the important news: When it comes to making their investment decision, all three subject groups placed a high weighting on past returns. This suggests the common sense answer to our opening question: investors will choose higher returns over lower fees. Such a decision making process may cause increased fiduciary liability for fiduciaries, who may be required to ignore past performance, once we add the White Noise of higher cost actively managed portfolios which can produce better performance results than lower cost index funds.
Did the researchers offer any methods to solve this paradox? They tried three methods to help the subjects make the “right” decision (i.e., pick the lowest cost fund). In the first case, they distributed a one-page “cheat sheet” that summarized fund fees to the subjects. This was meant to highlight the fee differential between the funds. In the second case, they gave the subjects a one-page FAQ about S&P 500 index funds. Here, the researchers wanted to make sure the subjects knew none of the four funds had any investment advantage over the other and, indeed, should perform the same. In the final case, the researchers provided historical return information based on the inception date of each funds. This last case was meant to duplicate the sometimes misleading nature of mutual fund advertising.
“In sum, although better disclosure and financial education may be helpful, the evidence of this article and Beshears et al (forthcoming) indicates that their effect on portfolios is likely to be modest.” On the bright side, Choi et al conclude subjects who make suboptimal choices have less confidence in their decision. The researchers anticipate there’s a greater chance these people might make better choices in response to professional investment advice. So, there may be hope that further research might be able to take advantage of this.
Unfortunately, it doesn’t improve the position of the ERISA plan fiduciary, who may be forced into a position of providing investment options counterintuitive to the decision making process of the typical 401k investor.