Poorly performing funds are less likely to be removed from and more likely to be added to a 401(k) menu if they are affiliated with the plan trustee, according to “It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans.”
Veronika K. Pool and Irina Stefanescu, both of Indiana University at Bloomington, and Clemens Sialm of University of Texas at Austin and the National Bureau of Economic Research (NBER), the authors of the paper, investigated whether executives from mutual fund families acting as trustees of 401(k) plans play favorites with their own funds, and whether plan participants undo this affiliation bias through their investment choices.
Executives from mutual fund families often serve as trustees of defined contribution (DC) plans, the authors noted, and play an active role in creating the menu of investment options for the plan participants.
The Employee Retirement Income Security Act (ERISA) requires trustees to be prudent in making investment choices for their 401(k) clients, yet mutual fund trustees have a competing interest to maximize investments in their own proprietary funds. Little is known about whether and how these conflicting incentives influence the menu of options in 401(k) plans, the paper said.
DC accounts are a main source of retirement income for many beneficiaries, making this potential conflict a concern, the authors said. Since retirement savings compound over long time horizons, any inefficiency or trustee bias can significantly affect the employees’ wealth at retirement and have larger societal consequences as well.
To investigate the favoritism hypothesis, the authors hand collected information on the menu of mutual fund options in a large sample of DC plans for the period 1998 to 2009 from annual filings of Form 11-K with the Securities and Exchange Commission (SEC). The sample includes plans that are trusteed by representatives from a mutual fund family as well as plans with non-mutual fund trustees.
Same Fund, Different Views
Most 401(k) plans in the sample that have a mutual fund trustee adopt an open architecture, whereby investment options include not only funds from the trustee’s family but from other mutual fund families as well.
An interesting feature of the dataset is that a given fund often appeared on several 401(k) menus administered by different trustees, appearing on some menus as an affiliated or trustee fund, and on others as an unaffiliated or non-trustee fund. The authors could then contrast how one fund could be viewed across two different investment menus.
The authors found that despite their fiduciary responsibilities, trustees have a strong preference for their own funds. Trustee funds were less likely to be removed from the plan across the board, the paper said. Moreover, the biggest difference between how trustee and non-trustee funds are treated on the menu occurs for the worst-performing funds, which have been shown to exhibit significant performance persistence.
For example, mutual funds ranked in the lowest decile based on past performance (among the universe of funds in the same style category over the prior 36 months), are approximately two and a half times more likely to be deleted from those menus on which they are unaffiliated with the trustee than from those where they are affiliated with the trustee.
Similarly, the authors found that trustees were substantially more likely to add their own funds to the menu across all performance deciles. Trustee fund additions exhibited lower prior performance than non-trustee additions, and the probability of adding a trustee fund was less sensitive to performance than the probability of adding a non-trustee fund.
Interestingly, mirroring the authors’ results for deletions, they found that addition probabilities were inversely related to performance among poorly performing trustee funds.
Can Participants Make a Difference?
The trustee’s tilt toward affiliated funds need not affect plan participants, however, according to the paper. Although the investment opportunity set of the plan is determined by the menu choices selected by the employer and the trustee, participants can freely allocate contributions within the opportunity set.
If participants anticipate trustee biases or are simply sensitive to poor performance, they can, of course, undo favoritism in their own portfolios by, for instance, not allocating capital to poorly performing trustee funds.
In order to investigate whether trustee favoritism has an impact on the overall allocation of plan assets, the authors also examined the sensitivity of participant flows to the performance of trustee and non-trustee funds. They discovered that participants are generally not sensitive to poor performance and thus do not undo the trustee bias, which, in turn, indicates that plan participants can be affected by the trustee’s choices.
While the evidence of favoritism is consistent with adverse trustee incentives, trustees are also likely to have private information about their own proprietary funds, the paper said. Therefore, the authors theorized that it is possible trustees show a strong preference for these funds in menu-altering decisions not because they are biased toward them, but rather, due to positive information they possess about these funds.
To investigate this possibility, the authors examined future fund performance. For instance, if despite lackluster past performance the decision to keep poorly performing trustee funds on the menu is information driven, then they should perform better in the future.
They found this is not the case: trustee funds that ranked poorly based on past performance but were not delisted from the menu did not perform well in the subsequent year. They estimated that on average they underperformed by approximately 3.6% annually on a risk-adjusted basis. This figure is large in and of itself, but its economic significance is magnified in the retirement context by compounding. The results suggest that trustee bias has important implications for the employees’ income in retirement.
The subsequent performance of poorly performing affiliated funds indicates that these trustee decisions are not information driven and are costly to retirement savers, the authors concluded.
The paper can be downloaded here.