It might seem obvious that letting a mutual fund firm administer a 401(k) plan and also provide the investment options is as bad as letting a fox guard the henhouse. The risk, of course, is that the mutual fund recordkeeper would recommend its own funds. It might also seem obvious that the industry trend for plans with open architecture — giving participants equal access to virtually every investment option in the marketplace — has solved this problem.
Actually, nothing about that whole relationship is what it seems, according to a new academic paper.
To start, three business professors — two from Indiana University Bloomington and one from the University of Texas at Austin — analyzed Department of Labor and Securities and Exchange Commission filings of 2,645 plans from 1998 through 2009, looking for bias. They found that mutual fund firms that act as recordkeeper, or trustee, to a 401(k) plan “display favoritism toward their own funds” in both adding and dropping options from a plan’s investment menu.
For instance, in the lowest-performing 10 percent of a style category, competitors’ funds are typically “two-and-a-half times more likely to be deleted from those menus” than are recordkeepers’ own versions, according to the paper, which was published in January and is entitled “It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans.” Overall, proprietary funds are a whopping 50 times more likely to be added.
The professors — Veronika Pool and Irina Stefanescu of Indiana and Clemens Sialm of Texas — used a variety of methods to measure the impact on performance. But at a minimum, they say, the bias drags down returns by 2.9 percent to 3.6 percent per year.
So is this recordkeeping arrangement terrible for plan sponsors?
Maybe it was in the past, retort pension consultants and mutual fund managers, noting the academic paper relies on data that’s four years old. Today, open architecture arrangements are more widely available and allow sponsors equal access to virtually every fund in the marketplace.
When the professors started their research, “companies like Fidelity and T. Rowe Price were offering only their own funds,” says Robert Liberto, the senior vice president who heads defined contribution search and vendor selection at investment consultancy Segal Rogerscasey. “But larger plans started putting pressure on them that they wanted outside options.”
Today, fully half of the time Fidelity Investments is hired as a 401(k) recordkeeper the investment options are already in place, says Susan Powers, a senior vice president and head of investment consulting at the mutual fund giant.
So the problem is solved, and recordkeeper-foxes aren’t guarding the henhouse, right?
Well, that’s not clear either. The recordkeepers still influence decisions at smaller plans, Liberto and other experts say. And even at big companies, recordkeepers “have allowed open architecture with the expectation that they will be at all the committee meetings, so they will have the opportunity to present all their funds,” says Robyn Credico, director of defined contribution consulting at Towers Watson.
Pool, an assistant finance professor at Indiana’s Kelley School of Business and the lead author of the paper, says she and her co-authors have already done a before-and-after comparison. Coincidentally, they compared the data before and after 2006, when the Pension Protection Act was passed — which also happens to track pretty closely with when open architecture became widespread. They found “no significant difference” in recordkeeper influence.
Okay, bottom line: Should plan sponsors forbid their recordkeepers from also providing investment options?
The paper doesn’t say that outright. “I’m not sure that’s a good idea,” comments Pool, “because those service providers have to be paid somehow.” Getting paid a fee for assets under management may well be the most cost-effective approach, Pool says, because she and her colleagues found that the fees for the proprietary funds are usually a few basis points lower than those of rivals.
Says Pool, “We would like to raise awareness of the different incentives and the effect that those incentives could have.”
Pool intends to raise that awareness by updating the data; the three professors have applied for funding to make their research current. Until then, the debate on the efficacy of open architecture on 401(k) plans will remain just that: open.
