Exclusive Interview: Quinn Curtis Reveals True Intent of the Curtis/Ayres 401k Fee Paper
Quinn Curtis is Associate Professor of Law at the University of Virginia Law School. He holds a Ph.D. in finance from Yale University and a J.D. from Yale Law School. In addition to retirement plans, he’s written on mutual fund regulation and issues in corporate governance. Curtis grew up in Columbus, Ohio and attended Ohio State as an undergraduate, and remains an avid Ohio State fan. He teaches securities regulation and corporate law. Prior to law school, he worked as a programmer at Microsoft.
He recently teamed up with Yale Law Professor Ian Ayres to author several papers on 401k fees. While these papers have generated their fair share of controversy, as Curtis explains, their intent is really, rather than arguing over investment theory or even the definition of “high” fees (like many others, Curtis and Ayres remain critical of how costly plans are), their paper hopes to shed light on the method the courts currently use to judge fiduciary issues pertaining to retirement plans. It’s their conclusion that, in being too restrictive, the courts may be allowing choices that common sense would suggest can be harmful to investors. Curtis and Ayres hope this paper would have courts reconsider their approach by, for example, looking at individual investment options rather than the menu as a whole.
FN: Can you tell the readers of FiduciaryNews.com how you first got interested in studying retirement benefit plans?
Curtis: I came to this area from studying mutual fund regulation. I’ve written before on mutual fund fee litigation under 36(b). Fees in retirement plans and fees in mutual funds are related topics, but the additional complexity of the plan menu creates a unique set of issues for participant directed retirement plans, and makes them particularly interesting.
FN: As the DOL has stated, it’s long been known that any fees can be a detriment to one’s retirement savings. What does your paper add to this body of knowledge?
Curtis: As an initial matter, I wanted to push back a bit against the characterization of our piece as finding “widespread fiduciary breach.” I think a better reading is that we think fees are too high, especially for more expensive plans, that menus are often constructed in ways that lead investors to hold high-fee options when better options are available, and that tightening the fiduciary standard is one way this could be addressed. We think courts should give costs more weight in adjudicating alleged breaches, but a court is always going to look at specifics in adjudicating whether a duty has been breached. In fact, the particularized nature of the fiduciary duty inquiry and the challenge of establishing a breach is one reason we argue that additional policy tools are probably warranted to address costs.
There are a couple of things that I hope people take from this paper. First, we ask whether the most of the fees that investors are paying are incurred because it’s not possible to hold a lower-cost portfolio given the plan menu, or whether they are a result of choices that investors make in passing over low cost options and holding higher cost options. The answer is that about half of the fees investors are paying in excess of index funds are a result of investor choices that deviate from an optimally diversified portfolio. The law treats those investor choices differently from the construction of the plan menu, so it’s helpful to make that distinction. Second, we show that there are a lot of individual funds in plan menus that are much more expensive than funds of identical style and active or passive management strategy and don’t add much in terms of investors’ ability to diversify. These are the dominated funds, and we find them in about half of the plans.
Third, we argue that the current approach to evaluating claims of fiduciary breach is problematic. Right now plans can defend against claims that they included poorly chosen funds in the plan menu by pointing to other options available in the menu that investors could have opted to hold. I think that permitting this defense is a mistake. The question should be whether each fund is a reasonable option to include, not whether a smart investor could have avoided the pitfalls. Courts should still consider a range of factors in evaluating each menu option, but the presence of a options that a court determines to be bad shouldn’t be offset by the presence of better options in the same menu.
FN: Kathleen McBride, one of the founders of The Institute for the Fiduciary Standard, said you were “roundly criticized for revealing their data sources last time,” but many believe knowing the data source will help in their understanding of the interpretation of your results. Can you tell us a little about the source of the data and the types of plans in the data base (maybe a size range by number of participants and assets)?
Curtis: The source of our data is described at length in a separate working paper linked from footnote 54 of the paper. We use a comprehensive dataset of plan menus and plan-level costs to identify plans that offer menus of ’40 Act funds, then use mutual fund data to compute the fees of the investment options. These plans are a little smaller than average, since very large plans often use vehicles with non-transparent fees, but we are also missing smaller plans that offer insurance products, so we ultimately have data that oversamples in the middle, in terms of size.
FN: You just said you “use mutual fund data to compute the fees of the investment options.” How do you account for non-mutual fund related fees like custody, recordkeeping, administration, fiduciary and investment advice fees?
Curtis: Our dataset of plan menus includes total non-fund plan-level expense information for each plan based on the Form 5500.
FN: How do your conclusions break down by size of plan (e.g., are the fee problems more pronounced in smaller plans)? By type of plan (e.g., are the fee problems more pronounced in plans with insurance products)?
Curtis: Fees are definitely higher in smaller plans. There’s also a lot more dispersion in fees in the smaller plans, which suggests that the market there might be less competitive. Large plans, I’d argue, are much more likely to do well, with lower fees and less dispersion. We can only evaluate plans offering mutual funds, but plans using insurance products may well be more expensive.
FN: In looking at performance data, did you only look at registered investment companies or did you include other products (e.g., variable annuities, collective trusts and alternative investments)? If so, how did you performance data on those products?
Curtis: As noted above, we are limited to looking at mutual funds.
FN: Your paper is based on return data from the years 2010-2013, when passive funds outperformed active funds. If you ran the return data from the years 2000-2009, when active funds outperformed passive funds, how would this change your results?
Curtis: For the return information we report on dominated funds, we are comparing active to active and index to index, so the paper shouldn’t be sensitive to that. For the computation of optimal portfolios, we use a factor model estimated over 2002-2007, so we are picking up the period in question.
More generally, I think that we haven’t taken as strong a line on the active-passive debate as was suggested in the previous FiduciaryNews.com article. I do think that a greater emphasis on passive funds would benefit a lot of investors, but the idea of using retail index funds as a baseline for cost isn’t to suggest that everything above that is necessarily a problem. The idea is that the passive baseline allows us to have a simple, attainable cost floor that’s available to any individual investor. That, in turn, lets us put a price tag on everything is excess of that floor. When 10% of the sample exceeds that floor by 500%, I don’t think that’s a problem that alpha will cure. The literature strongly suggests that avoiding particularly high cost active funds is prudent, and a significant number of plans aren’t doing that.
FN: Your paper references research by Choi et al (see “Yale/Harvard Study Reveals Disturbing 401k Fee Paradox,” FiduciaryNews.com, June 1, 2010), which shows evidence that investors will pick higher cost index funds even when offered lower cost index funds. Your paper mentions this same phenomenon but doesn’t explain the nature of the differences in fees (e.g., commissions, 12b-1 and revenue sharing fees). Can you elaborate how your paper also shows evidence of these fees?
Curtis: The purpose of referencing this study is to illustrate two phenomena: (1) Investors naively diversify by spreading their money around to the available options. (2) Investors seem to struggle to process fee information, even when applied to index funds tracking the same index. We mention it as part of the argument that including bad options in plan menus is harmful to investors, even if there are other options available. It’s harmful because the evidence suggest that participants will hold those funds even if they shouldn’t. This is why the large menu defense is a problematic way of interpreting the fiduciary standard.
For fiduciaries, I think there’s a concrete takeaway from this research: Expanding choices has benefits, but leaving funds in the plan that don’t make sense in light of other available options can be harmful. Sometimes pruning can provide as much benefit as expanding a menu.
FN: Along the same lines, there have been several papers (see “Does New Study Seal the Deal for Fiduciary Standard – or Just Warn Plan Sponsors?” FiduciaryNews.com, January 19, 2011) that show funds with commissions, 12b-1 and revenue sharing fees underperform by 1% a year on average (i.e., enough to make up the long-term difference in returns between passive and active funds). Does your paper reveal similar conclusions regarding performance variations? What more does your research tell us about the impact of these fees?
Curtis: That’s an important literature, and ought to cast doubt on the advisability of those funds. We didn’t investigate that particular question, though.
FN: Several commentators have mentioned that the presence of financial advisors can make a significant difference for 401k plan participants. How does your research differentiate between plans that offer individual advice and those that don’t.
Curtis: This is a real challenge for research in this area, because services are not part of the regulatory disclosure. However, we did try to account for the potential value of services, and I believe we take the services argument seriously. We looked at participation rate, contribution rate, and how plan portfolios were allocated on a pre-fee basis using expected Sharpe ratio. These are measures that might reflect the presence of valuable services for investors. We found that plans with high costs had worse outcomes on all those dimensions relative to low cost plans. It may well be that some plans provide services that are useful and valuable to employees in exchange for higher costs, but if that is true on average, we can’t see evidence of that in our regressions. I’d say that fiduciaries ought to look closely at whether the services they are providing are creating tangible benefits for participants. Even then, paying for those services at the plan level means that employees who may not need them are subsidizing employees who use them. One of our proposals is to flag plans with particularly high costs and let employees in those plans use in-service rollovers to move to other retirement accounts. In our view, that would let participants decide whether trading high costs for more services, if indeed they are getting more services, is worth it.
FN: Last year in an interview with Fred Reish, he said “high” fees were not necessarily bad fees. Indeed, the DOL seems to agree with this statement, saying, to the effect, they’d like to see all plans pay above average fees and receive above average service. Your conclusions seem to be more absolute in terms of “high” fees. How do you reconcile this with the previous comments by Reish and the DOL?
Curtis: There are obviously a lot of critics of high costs out there as well. Our findings regarding services, discussed above, makes us skeptical that high costs are typically justified, but the question of a fiduciary breach is always going to be a particularized inquiry. We think that courts should put more weight on the fees charged and put the onus on plans to defend particularly high-cost options. It’s possible that plans could meet that burden, but under the current standard, we’re not even reaching the question.
What’s more, we emphasize policies that create choices. If we permit investors to roll into IRAs out of high cost plans, then those investors can decide whether the services are worth the costs attached to them. This “voting with their feet” approach creates some scope to settle the question, plan by plan, of whether costs are offset by other benefits for plan participants.
FN: Rather than focus on “testing” participants before they’re allowed to invest in “high” cost funds, why wouldn’t it be better to simply eliminate all funds with commissions, 12b-1 and revenue sharing fees?
Curtis: I’d love to see those changes implemented, especially revenue sharing. Reducing conflicts of interest in menu construction and increasing transparency could go a long way to producing better menus, and we call out that issue in the paper.
The sophistication test is, as we frankly admit, more radical than some of our other suggestions, but it addresses the concern that some investors who opt out of the default funds in plans that use them are making choices that seem likely to leave them with less money for retirement. Requiring that investors either demonstrate some sophistication on a test or seek unbiased professional advice before making certain allocations is a way of addressing problematic allocations while still preserving options for investors with genuinely different allocation needs. The goal is to stake out a middle ground between the “soft paternalism” of freely-changeable defaults and the “hard paternalism” of banning certain options. In general, there’s value in expanding the menu of policy options available.
FN: Do you have anything else you’d like to add for our readers’ benefit?
Curtis: Thank you for the opportunity to respond.
FN: Quinn, thank you very much for taking the time to offer your thoughts to the readers of FiduciaryNews.com. I have no doubt you’ve enlightened many of them as to the true nature and intent of your exercise.