401k Fees That Shouldn’t Matter
Last week we profiled out-of-pocket fees (“401k Fees That Matter,” Fiduciary News, April 27, 2010). These fees matter to the 401k fiduciary. ERISA plan sponsors can negotiate these direct fees and, if they choose to, pay them from company assets rather than plan assets. Paul Escobar, a retirement consultant with US Wealth Management, brings up an interesting dilemma when he says, “the focus these days is on ‘fees,’ and interestingly enough, on fees that largely, aren’t negotiable. The average plan can’t negotiate the expense ratios on a mutual fund or even embedded in ETFs, can’t negotiate the 12b-1 and can’t negotiate any hidden fee. So, as a result of ‘fees are everything’ we will be legislating to ignore performance or any qualitative measures for investments as would be considered by an expert prudent man.” Is Escobar on to something?
The DOL’s draft Investment Advice Rule (“Fact Sheet: Proposed Regulation to Increase Workers’ Access to High Quality Investment Advice”) states investment advice should emphasize fees over past investment performance. Unfortunately, the draft does not distinguish between fees that matter and fees that shouldn’t matter. Fiduciary News has previously commented on the potential problem with this approach (“Do Mutual Fund Fees Really Matter to 401k Investors and Fiduciaries?” Fiduciary News, August 25, 2009) This week’s article will instead explore recent academic research that might be new to the average fiduciary.
Common sense would suggest, all other things being the same, mutual fund fees will have a negative impact on fund performance. While this simple statement actually contains more complexity than would appear, a recently published research paper provides empirical support. In 2010, the Review of Financial Studies published “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,” by James Choi, David Laibson and Brigitte C. Madrian). The experiment asked 730 experimental subjects (all Harvard and Wharton staff and students) to each allocate a hypothetical $10,000 among four real front-end load S&P 500 index funds with a wide variety of fees and different inception dates.
The paper reveals that “despite eliminating nonportfolio services, we find that almost none of the subjects minimized fees.” This was the case even when, in the specific case of the MBA students, the subjects indicated fees were an important factor in making their decision. The researchers also found these sub-optimal decisions persisted even when subjects were given “cheat sheets” to better inform their decision making. In the end, this research reveals two important conclusions: 1) Disclosure and education, while offering modest improvements, still do not lead to “optimal” decision-making; and 2) Investment performance (in this case based on inception date) may have more influence on decision-making than fees.
So, should these indirect fees matter? Co-author James J. Choi, Assistant Professor of Finance at the Yale School of Management feels they should. Consistent with other research, Choi says, “While lower expense ratios predict better investment performance, expense comparisons are mostly useful among funds within the same asset class.” Choi does, however, bring up a potential problem with the DOL’s (strictly interpreted) draft Investment Advice Rule when he adds, “comparing expense ratios of bond funds to international equity funds, for example, would be like comparing apples to oranges.”
D. Bruce Johnsen, George Mason University – School of Law, has a different view. He wonders, like Escobar, if it makes sense focusing on these fees at all. Johnsen uses economic theory to support Escobar’s practical reality. His paper “Myths About Mutual Fund Fees: Economic Insights on Jones v. Harris,” Journal of Corporation Law, forthcoming) argues fees are irrelevant as a first approximation. Johnsen says, “the more difficult it is for investors to monitor and assess management quality, the higher the fee necessary to assure quality. By paying the manager a premium fee, investors assure that the adviser has more to lose in the long run by deceptively lowering quality.”
Johnsen feels investors may see fees as a proxy for “quality assurance.” But, he warns, “management quality is only partly a function of current or past returns. It may, for example, also have something to do with the procedural protections that go into assuring the adviser or his employees do not engage in self dealing.”
Choi’s empirical research doesn’t necessarily address Johnsen’s theoretical claim because “quality assurance” was not one of the eleven decision making factors included in Choi’s survey. Still, Choi offers, “I think the more likely explanation is that people overlook expense ratios, which hit you only slowly over time and are never itemized on a statement, but manifest themselves only through a lower NAV. People are more sensitive to loads, which are quite salient.”
So where does that leave us in determining the difference between those fees that really matter (direct fees) and those fees that shouldn’t matter (indirect fees)? Academics may argue to varying degrees, but regulators will have the final say. Unfortunately, different definitions of fees only confound the ERISA fiduciary.
Service providers charge direct fees (called a “management fee” by the plan’s investment adviser) over and above any mutual fund expense ratio. The DOL adds to the confusion by calling a portion of the fund’s expense ratio a “management fee” (the other portion is called “other fees”). Although technically correct from the point of view of the Investment Company Act of 1940, the confusion arises when one considers the direct management fee mentioned above. The fund’s expense ratio is similar to the expenses of a publicly traded company. They aren’t fees paid by the shareholders of the fund, they represent expenses paid by the fund to conduct its business. For publicly traded companies, investors look past performance (primarily through earnings). Likewise, it appears that for mutual funds, investors may place greater weight on past performance, despite what the SEC desires.
Perhaps Escobar sums up the feeling of many investment professionals frustrated by regulators’ inability to address their clients’ real concerns. “I cheered when the Supreme Court found that only ‘egregious’ fees could result in a breach of fiduciary duty,” says Escobar. “I humbly suggest,” he concludes, “that if it’s a participant-directed plan, participants should be given the opportunity to choose for themselves on the matter.”