The Problem of Dominated Funds
This is the second 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.
Even my own retirement plan at Yale may have a dominated funds problem. The good news is that Yale has successfully negotiated with TIAA-CREF so that the Yale menu of funds now includes super-low cost “Institutional Class” index funds with a net expense ratio of just 7 basis points. But the bad news is that Yale’s menu still includes a similar stock fund with much higher costs. In my last retirement post, I wrote about how my Stanford “CREF Stock Account” charges 49 basis points (.49 percent) as its annual “Estimated Expense Charge.” Yale has kept me in the higher cost fund even after it introduced the similar, lower cost option. I’m not saying that this particular instance is a dominated fund problem, as the CREF Stock Account has a small amount of active management that may justify its higher fees. I haven’t crunched those numbers to be sure. But there’s a good chance that the Institutional Class index fund dominates.
The larger point is that the Hecker-the-more-the-merrier approach is a trap for the unwary.
Our analysis 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). The Department of Labor should develop algorithms – such as the one used in our paper – to identify in advance when a fund is “dominated” by other plan offerings or is much more expensive than similar funds offered by other plans. This reform would NOT subject fiduciaries to liability because individual funds ended up having poor results. Rather, based on ex ante information, the algorithm would ask:
Is there another fund offered in the same plan menu of the same investing style as the candidate fund with fees at least 50 basis points lower?
Eliminating dominated funds from plan menus would almost certainly increase the global risk-adjusted returns of ERISA plans.