Ian Ayres, Forbes:
In a working paper that was just accepted for
publication in the Yale Law Journal (coauthored with Quinn Curtis) and in a
recent Freakonomics blog post, I document the problem of “dominated funds[.]”
Retirement regulations have largely been successful in
giving worker/participant defined contribution plans the opportunity to
diversify. Most plans nowadays give participants a sufficient variety of
investment options that it is possible to allocate investments so as to
diversify away most idiosyncratic risks.
However, the 1974 Employment Retirement Income Security
Act’s (ERISA) emphasis on diversification has diverted attention from the
problem of excess costs. Courts evaluating whether plan fiduciaries have acted
prudently have tended to just ask whether the plan offered a sufficient number
of reasonably-priced investment opportunities. For example, in Hecker vs.
Deer & Co. (7th Cir. 2009), the 7th Circuit found it was
“untenable to suggest that all of the more than 2500 publicly available
investment options had excessive expense ratios.”
The Hecker approach is wrongly decided because it
effectively immunizes fiduciaries that offer what Quinn Curits and I
call “dominated funds” in their fund menus.
A dominated fund is a fund that no reasonable investor would
invest in given that plan’s other investment offerings. In our recent working
paper, we find that:
[A]pproximately 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 60 basis
points.
Informed investors should be investing 0.0 percent of their
plan assets in dominated funds, so it’s disturbing to see that when given the
opportunity, 11.5 percent of plan assets flow into these funds.
To my mind, dominated funds are a kind of product design
defect:
A car or computer manufacturer which included a button on
their product which had no beneficial purpose and would only cause the device
to perform less safely would run a substantial risk of being held accountable
under product liability for failing “to design a product to prevent a
foreseeable misuse.” The fact that informed consumers would not push the button
would not absolve the manufacturer from including an option that no reasonable
user should ever push if it was foreseeable that even some users would misuse
the product by pressing the button. The likelihood of investor misallocation is
just as foreseeable.
I’ve argued that the problem of dominated funds suggests a
simple reform:
Plan fiduciaries should have a duty to remove dominated
funds from their menu and to map participants to the lower-cost analog offering
(akin to 404(c)(4) “Like-to-Like” mapping procedure).
But a recent decision suggests the possibility of an even
more pernicious problem. Instead of failing to map participants’ investments
away from dominated funds, Tussey vs. ABB, Inc. suggests the possibility
that fiduciaries at times might be eliminating funds and mapping these
investments toward high-cost dominated funds. In the Tussey case, the
retirement plan at issue eliminated from its menu of funds the Vanguard
Wellington fund and “mapped” all investments in that fund to Fidelity Freedom
funds.
Mapping is the default allocation that fiduciaries use when
they eliminate a fund from their menu offerings. Participants who are invested
in the eliminated fund are reinvested in the mapped fund if they do not
affirmatively select an alternative menu fund that is still be offered. Many,
many employees don’t pay attention to plan notices that a fund is being
eliminated and are mapped to the default investment, so the mapping allocation
often determines where the bulk of the eliminated fund investments will be
reinvested.
Click here
for the full column.