401(k) Plans’ Pervasive Problem of Excess Fees

(March 11, 2014) – Roughly 16% of young US investors would be better off opting out of their 401(k) plan and saving for retirement in a retail index fund, a study has argued.

The fees charged by these defined contribution (DC) schemes would outweigh the vehicles’ tax advantages over the course of a career, according to Yale School of Management Professor Ian Ayres and University of Virginia Associate Law Professor Quinn Curtis. 

Their analysis of more than 3,500 DC schemes found an average fee premium of 86 basis points above a low cost index fund. That spread would fall to 43 basis points for the typical member if he or she chose the optimal 401(k) menu option.

“Our data also cast doubt on the competitiveness and efficiency of plan fees,” Curtis and Ayres wrote, noting that the problem of excess fees is especially acute in small plans. “While we find a strong relationship between the assets in a plan and the overall cost of the plan, there is wide variation between similarly sized plans in terms of total costs.” 

A large DC plan on the high end of the fee spectrum would be nearly twice as costly for members as comparably sized scheme on the low end, according to the study.

While fees emerged as a “pervasive” problem among DC plans, the researchers found that diversification was not. Investors could nearly top-out the benefits of portfolio diversification using the typical employer’s 401(k) options. For the plans included in the dataset, menu limitations shaved just four basis points off of investor returns relative to an optimally diversified portfolio.  

However, the authors found that plan sponsors facilitated poor allocation decisions as well as wise ones. Just over half (52%) of the menus analyzed included at least one “clearly inferior” investment option. For example, a plan offering two passive US small-cap equities products—one with fees of 0.35% and the other costing 1.5%—would fall into this category.

While members are free to avoid such products, previous research has indicated that investors tend to spread assets across whatever options are on offer. By dropping “clearly inferior” menu items, plan architects in Ayres and Curtis’ study could have cut schemes’ total cost by 11%.   

“Plan advisors often defend their fees by claiming that they educate employees about the importance of retirement savings,” the authors concluded. “But our results suggest that high-cost plans are not inducing more employees to participate more or to contribute more. In fact, they hint that the opposite may be the case; it may be that costly plans discourage investor participation, reduce investor contributions, and produce poorer allocation decisions.”

The full text of Ian Ayres and Quinn Curtis’ paper—“Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans”—is available here.   

Related Content: More 401(k) Options Mean Worse Outcomes