Second Look at Headline Grabbing 401k Fee Survey Reveals Major Questions
You had to have lived under a rock last week to miss some of these shocking headlines: “401k fees could reduce average nest egg by 30%, study says,” (Los Angeles Times, May 29, 2012); “Guess How Much Your 401k Plan Is Costing You in Hidden Fees,” (Business Finance, May 31, 2012); “401k Fees Have Employers, Employees in the Dark,” (ABC News, May 31, 2012); and, most damning of all, “Should we scrap the 401k system and start over?” (Reuters, June 1, 2012). All these stories had as their genesis a report titled “The Retirement Savings Drain: The Hidden & Excessive Costs of 401(k)s.” Published by New York-based Dēmos, which bills itself as a “multi-issue national organization,” the report cited two primary sources in its analysis, and neither readily agrees with the report’s focus or its conclusions.
According to the Dēmos press release accompanying the report, and the conclusion that perhaps most teased mainstream media reporters, their analysis reveals how “an (sic) median-income, two-earner household will pay nearly $155,000 over the course of their lifetime in 401k fees.” The report purports to show “how the nation’s shift in retirement policy toward individual retirement accounts has made savers vulnerable to losing almost one-third of their investment returns to a complex, inefficient market.” Furthermore, the report maintains the DOL’s new Fee Disclosure Rule “will not address the other factors that keep fees high nor fix the structural weaknesses in the current risky, individualized retirement system.”
Ah, but the devil is in the details. Several of the articles cited above, despite the grave headlines, began to isolate some of the cracks in the analysis. The Dēmos report referenced data from both the Investment Company Institute, a national trade association located in Washington D.C. that represents mutual funds and other registered funds and which regularly surveys 401k plans using mutual funds, and BrightScope, Inc., a 401k rating firm located in San Diego. Both groups took exception to the report’s use of their data.
“Dēmos misrepresented our transaction cost research,” says Mike Alfred, chief executive of BrightScope when asked by FiduciaryNews.com about the report. He further explains, “In our research, we stated that it’s possible for the transaction costs to equal the stated expense ratio. We did not say that transaction costs always equal the explicit expense ratio. It’s like saying that because scientists have verified the existence of an eight foot tall man that therefore all men must be eight foot tall – an obviously flawed argument. Consequently, Dēmos has probably overstated the average expense borne by individual participants by as much as 150 basis points.”
Robert Hiltonsmith, a Policy Analyst at Dēmos and author of the report, told FiduciaryNews.com he’s seen Alfred’s criticisms. Hiltonsmith says, “As far as I know, he [Alfred] never claimed that I exaggerate costs by as much as 150 basis points. He mentioned that his data showed that larger plans can have total costs (expense ratios (including revenue sharing + trading costs) of as low as 40 basis points. My analysis never claims to only look at large plans, and has no reason to; not all people have access to large plans, and thus I’m interested in the market average. My claim is clearly answered in my methodology section, which cites his brief on transaction costs merely as a shorthand of citing some of the other academic research out there.” Hiltonsmith believes the consensus of that academic research is that trading costs generally “exceed” the explicit expense ratio for actively-traded funds and assumes a 0.95 percent expense ratio for the stock fund in model, which is the asset-weighted market average. He calls that a “conservative” estimate, “since it’s the lowest of the three averages (plan-weighted, participant-weighted, asset-weighted).” He says, “presuming trading costs equal to the expense ratio for that stock fund is completely in line with the research consensus. So, I completely disagree with Mike’s criticism, and think my methodology speaks for itself.”
Still, Alfred stands by his statement. Ironically, Alfred is well known as an advocate of lower fees for 401k plans. “Our main focus at BrightScope has always been to bring true transparency to the 401k marketplace,” he told FiduciaryNews.com. Alfred adds, “We don’t care whether that truth is good, bad, or ugly. We will report the data exactly as we see it. This Dēmos report appears to be an example of misrepresenting the truth to push a specific agenda. While I have been a vocal critic of high 401k fee plans in the past, I’ve never been supportive of exaggerating the truth to push a specific agenda. So, I don’t think anyone should be surprised by my skepticism about the conclusions made in this report.”
And Alfred is not alone in his skepticism. The Dēmos report attacks mutual fund expense ratios in general as being higher than investment management fees in pension plans. Hiltonsmith believes “the research consensus is that the average defined benefit plan is about half the cost of an average defined contribution plan” and points to mutual fund expense ratios as the primary culprit. A spokeswoman for the Investment Company Institute, when FiduciaryNews.com brought this specific claim to her attention, said, “Mutual funds and large accounts managed for institutional investors (for example, a pension plan), are very different—with different legal and regulatory requirements, services, and business costs and risks—and naturally, as a result of this, often have different fees.”
Academic research, in particular that of George Mason Law School Professor D. Bruce Johnsen, bears this out, as was outlined in a previous FiduciaryNews.com article (“Exclusive Interview with Mutual Fund Fee Myth Busting Professor,” FiduciaryNews.com, October 26, 2009). Johnsen said, “I feel the myth most relevant to 401k plans and their fiduciaries is the one that states mutual fund fees should match pension fund fees” and “To assume high fees reduce returns dollar-for-dollar is simply wrong, lower fees are not necessarily better where you cannot observe quality.”
Hiltonsmith opposes this view. “I’d like to disagree with a point made by Professor Johnsen: ‘[the argument that] mutual fund fees should match pension fund fees…is a myth.’ This is precisely what we, as retirement savers looking to maximize our retirement savings, should want from mutual fund fees: that they are as low as possible. These efficiencies can only be achieved, however, from increased pooling of funds. The current 401k system, hyper-fragmented amongst over 700,000 plans invested in tens of thousands of funds, cannot possibly minimize fees given the significant informational and entry/exit barriers faced by participants and (particularly) small plans. We need a system where small plan-sponsoring employers, an increasingly-crucial segment of our nation’s economy, can offer their employees the same quality of retirement investment options as are available to larger employers. And this won’t and cannot be achieved by financial education and transparency alone.”
But the ICI is not done with its criticism. “The Dēmos report grossly mischaracterizes the 401k system,” Brian Reid, chief economist at the ICI, told FiduciaryNews.com. He says, “The most glaring problem is that it asserts that the typical 401k investor incurs fees and trading costs that cause them to underperform the market by as much as 2% a year. Academic studies (e.g., Laurent Barras, Olivier Scaillet and Russ Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” The Journal of Finance, Vol. LXV, No. 1, February 2010), find that after fees and expenses (including trading costs) three-quarters of actively managed funds neither underperform nor outperform the market, meaning that investors are getting their asset management, liquidity, and all other services for free. The bottom line is that the report’s claim that the typical fund underperforms the market by 2% per year paints a factually inaccurate picture of 401k plans.”
Although willing to concede the issue for short-term periods, Hiltonsmith remains unconvinced of this recent research. “I most certainly agree that different classes of funds ‘takes its shining turn in the sun,’ return-wise, over various short time horizons (up to a decade),” he says, “but I don’t believe that over the long run – meaning over a lifetime savings horizon (30+ years) – actively-managed funds outperform passively-managed ones, a belief which is, to my knowledge, still strongly supported by research.” Hiltonsmith did not provide FiducaryNews.com with links to any recent research to back up this statement.
Furthermore, Reid goes on to say, “The Dēmos 401k report uses ICI data incorrectly. The Dēmos report misuses ICI data in its examples and significantly understates the return the typical 401k investor gets by investing in the funds offered in his or her plan. Specifically, the Dēmos report uses an average fee for all funds, when according to ICI data, the mutual fund costs in the 401k market tend to be lower than fees for the average fund. The methodology of the Dēmos report is flawed because in calculating trading costs it incorrectly assumes the trading costs are equal to the expense ratio – thereby doubling the costs. The Dēmos study does not take into account the actual trading behavior of funds. The mutual funds used in 401k plans tend to have modest portfolio trading, according to our research. The report authors then subtract these inflated costs from stock and bond market performance figures, incorrectly implying that funds underperform the market by the level of fees.”
In the end, it is the Dēmos report characterization of fees which makes it controversial. Ironically, though, while challenging the reports credibility, our conversation with Hiltonsmith seems to have revealed one important conclusion the author himself may have inadvertently underplayed. It’s a conclusion both Alfred and the ICI would agree with.
By focusing almost exclusively on the mutual fund expense ratio, Hiltonsmith initially misses the target of the DOL’s new Fee Disclosure Rule. After all, mutual fund expense ratios have long been disclosed and Hiltonsmith admits he focused on them “because they’re more readily available” and because he believes “those ratios often include bundled recordkeeping fees” and, presumably, other fees as well. Why he takes this position is made clear when he explains his own company’s 401k plan. He says, “I’d like to note that I think that the complexity of our own plan, and my own confusion in unraveling its intricacies, can serve as a case study to illustrate the difficulty that small employers face in fulfilling their fiduciary responsibilities; in many cases, I believe it’s unfair to expect small employers with extremely limited resources to act as fiduciaries.”
Indeed, it is this universal criticism of bundling that all parties can agree on and, when read in that light, may certainly be more than enough to justify some of the report’s conclusions.
David Abbey, senior counsel for pension regulation at the Investment Company Institute, offered this piece of advice to FiduciaryNews.com when asked about the Dēmos report: “The ICI has long supported the DOL’s new disclosure requirements and we applaud the DOL’s efforts in this area. Mutual funds hold about ½ of all 401k assets and have long provided fee information. The new rules going into place will ensure comparable fee information across all retirement vehicles. For plan sponsors, the most important thing is ensuring that the plan is getting good value for the services and investments that are being provided. In this respect, it is important that plan sponsors don’t singularly look only at fees, but also examine the package of and quality of services and investments that those fees are buying. For plan participants, the fee disclosure rules will ensure that the fees associated with plan participation and investments will be identified in a uniform way thus making it easier for such investors to compare and contrast the fees associated with various potential investment options when deciding how to invest contributions to the plan. Like plan sponsors, plan participants need to go beyond just focusing on fees and also consider the quality of the investment, including incorporating into the analysis factors such as performance, risk profile, and management tenure, among other things.”
Indeed, in this sense, Abbey appears to be echoing the consensus on the DOL’s interpretation of fees. In a recent article, (“New 408(b)(2) ‘Guide’: Not Necessarily What 401k Plan Sponsors Hoped For,” FiduciaryNews.com, May 12, 2012), we quoted Fred Reish, who warned against focusing on low fees since, when it comes to fees, “plan money must be used to buy value for the participants” and it is obtaining that value – not necessarily obtaining the lowest fee – that is the 401k plan sponsor’s primary fiduciary duty. As Abbey says, the “DOL appears to be trying to ensure greater uniformity of disclosures from service provider to service provider and investment type to investment type. For example, the disclosures are already provided by mutual funds, such as expense ratios, management and other fees, and performance data, will now be required to be disclosed for other investment vehicles. With such uniformity, both plan sponsors and participants should find it easier to make the comparisons they need to make better informed investment choices.”
Right now, Hiltonsmith believes 408(b)(2) will “help drive costs down significantly.” Still, he says, “I don’t, however, think it will ‘fix’ the 401k/IRA system.” It might be interesting to see Hiltonsmith’s take on the matter once the new rule has had some time to percolate through the system. Perhaps, in maybe a year or so, we’ll be seeing a new updated Dēmos report.
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