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Don't Bother With That High Cost 401(k)

This article is more than 10 years old.

A 401(k) plan is broken when the fund expenses overwhelm the tax benefit of participation. Employer-sponsored 401(k) and similar tax-deferred savings plans encourage employees to save for retirement by deferring income taxes on their contributions. However, a recent study suggests that about 1 in 7 plans provide investment options that are so expensive that young workers would be better off not participating. They would be better off paying taxes and investing after-tax in low-cost index funds.

In their paper, Beyond Diversification: The Pervasive Problem of Excessive Fees and “Dominated Funds” in 401(k) Plans, Ian Ayres of Yale Law School, and Quinn Curtis of the University of Virginia School of Law, explain the trade-off between expenses and taxes. Part of their study compared the net after-tax accumulated gain of participation in an employer-sponsored retirement plan by utilizing the funds available, or not participating and investing in low-cost index funds outside the plan.

Utilizing data from more than 3,000 401(k) plans with more than $120 billion in assets, Ayres and Curtis provide evidence that fees lead to an average shortfall of 0.86% relative to comparable market returns. They found that 16% of analyzed plans had fees so high that young investors in those plans would be better off forgoing tax savings from participation and investing in index funds with after-tax dollars instead.

The study also points to the tendency of 401(k) plan investors to herd into one dominated fund, which tended to be higher cost than an index fund alternative. “We find that approximately 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 0.60 percent,” the authors noted.

In their more detailed paper, Measuring Fiduciary and Investor Losses in 401(k) Plans, Ayres and Curtis found three sources of low performance in the 401(k) market: overall expenses, limitations on fund choices, and investor bad behavior. On average, the loss to investors in 401(k) plans attributed to overall expenses of restricted investment choices accounted for a shortfall of 10.2% off the risk-premium available from the markets. An additional 13.1% shortfall off the market risk-premium (about 1.10%) was observed due to the individual participant’s choice of funds in their portfolios. Investors tend to chase returns and other behavioral issues that hurt results. Taken together, the average investor was underperforming the returns of a comparable market portfolio by more than 23%. This equates to about a 1.5% annual shortfall based on balanced index return of 6.5%.

Last year, Prof. Ayres made big waves in 401(k) market when he sent out 6,000 letters to employers of high cost plans saying he was going to expose their plans regarding high expenses. According to the Wall Street Journal, Ayres and his research partner intend to publicize the results in spring 2014.

Ayres and Curtis contend that when 401(k) investment choices are efficient and fees are low, then improving investor performance becomes entirely a function of improving the decision making by plan participants. Those efforts might include financial education and high-quality default portfolio allocations.

Fees matter in the 401(k) market. A plan is broken when a young investor loses more to fees than they gain in tax-deferral benefits in a high cost plan. It’s a win-win for employers and employees when a 401(k) plan creates a culture of savings by designing the investment options around low-cost index funds, and in particular low-cost balanced funds that are composed of index funds.

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