Yale Law Professor Again Targets Industry Fees

A Yale Law School professor known for making waves in the retirement industry released a study arguing plan sponsors tend to establish investment menus that encourage underperformance.

Ian Ayres, a lawyer and economist serving as the William K. Townsend Professor at Yale Law School, may be familiar to industry members and observers from a curious series of events that unfolded in mid-2013.  Starting in late June, Ayres sent a series of ominous letters to retirement plan sponsors and employers warning their retirement plan’s fees are too high. In all, about 6,000 letters were sent to a long list of employers that sponsor retirement plans, though in somewhat different versions (see “Improve Your Plan—Or Else?”).

One version told the recipient Ayres intended to “publicize the results of our study in the spring of 2014” and to “make our results available to newspapers including The New York Times and Wall Street Journal, as well as disseminate the results via Twitter with a separate hashtag for your company.” The letters caused a flurry of responses from service providers and industry advocacy groups, most of whom appeared incensed over Ayres’ threat to name individual companies—a move that opponents said could encourage opportunistic and costly litigation (see “Professors’ Study Riddled With ‘Deficiencies’”).

Now, some nine months later, Ayres seems to have made good on the first part of his warning-threat—releasing a study that suggests retirement plan administration and investment-related fees lead to an average participant loss of 86 basis points compared with low-cost index funds that could be used as retirement savings vehicles.

Ayres published the paper in collaboration with Quinn Curtis, of the University of Virginia School of Law. The 40-page document argues that, notwithstanding fiduciary requirements imposed on plan sponsors by the Employee Retirement Income Security Act (ERISA), a wide range of plan administrators are complacent in the establishment of investment menus with options that predictably lead to substantial underperformance of retirement portfolios. The research utilizes data from more than 3,000 401(k) plans with more than $120 billion in assets.

In 16% of analyzed plans, the research team finds that, for young workers especially, the fees charged in excess of an index-based fund can entirely consume the value of tax benefits related to investing in a 401(k) plan.

“We also document a wide-array of ‘dominated’ menu fund options where the costs of fees in holding the fund so outweigh the benefits of additional diversification that rational investors would not invest in these assets,” Ayres and Curtis write in the paper’s abstract. “We find that approximately 52% of plans have menus offering at least one dominated fund.”

The paper defines a dominated fund as an investment option in a plan that is “clearly inferior to other investments in the same menu,” whether because of higher fees or performance-related factors. In the plans that offer dominated funds, the paper says such funds hold about 11.5% of plan assets. The paper finds these dominated investments tend to be outperformed annually by their low-cost menu alternatives by more than 60 basis points.

“We argue that existing fiduciary duty law (aided by improved rule-making by the Department of Labor) can be used to challenge plans that imprudently expose investors to the risk of excess fees,” the pair writes. “In particular, we argue that (i) evidence of excessive fees can be powerful evidence of an imprudent fiduciary process, and (ii) fiduciaries act imprudently if they included dominated option in their menus, even if plan participants have other offerings with which to construct prudent retirement portfolios.”

Curtis tells PLANSPONSOR the paper does not seek to blame either plan sponsors or industry providers for charging excessive fees and damaging the retirement readiness of participants.

“I wouldn’t characterize this study as a blame game,” he says. “What we found is that there are incentives for a fiduciary to include what we’ve termed ‘dominated funds’ in their lineup. And the law has supported those incentives by creating safe harbors for certain breaches of fiduciary duties. What we’re trying to ask is, how do we structure the regulations and the fiduciary duties so that we can give plan sponsors the right motivation to set their employees up to succeed in the choices they’re making in the menu?  That said, the responsibility for offering a quality menu ultimately rests with the plan sponsor.”

That question gets to another primary argument presented in the paper. The study argues courts have been far more likely to hear and decide fiduciary breach cases in terms of ERISA-related procedural considerations and the availability of diverse funds in an investment lineup. In other words, the courts have shied away from examining the specific issue of whether fees in retirement plans are excessive or not. The study examines the phenomenon at length, suggesting the courts could go a long way towards addressing some of these issues without requiring new legislation or regulation by policing the inclusion of high cost funds more closely, regardless of other options in the menu.

“Some of the Circuits are doing better at this than others,” Curtis points out.

Regarding industry pushback, Curtis says he has seen some argumentation that the study does not do enough to consider what participants are receiving in return for higher fees within some plans—similar to many of the arguments leveled towards Ayres’ earlier mailing campaign. Curtis rejects this interpretation, pointing to page 18 of the study, where he and Ayres examine key plan metrics across higher and lower cost plans and find no evidence to suggest the more expensive plans are doing better for their participants. 

“You would think that these high cost plans would have something to show for it—they would have higher participation rates, or higher contribution rates, or their participants would be allocating their assets better,” Curtis says. “But, what we really saw on each of those pieces is the opposite—that the high costs plans seemed to have worse outcomes on these metrics. The evidence doesn’t really suggest that all of these fees are justified by the level of service, as far as we can measure them.” 

Ayres and Curtis go on to argue that, because heightened fiduciary duty reforms are unlikely by themselves to solve the problem of excess fees and dominated funds, three other major industry reforms should be enacted.

First, the team recommends the requirements for default fund allocations be enhanced to assure that the default investment is reasonably low cost. Second, the pair recommends the Department of Labor (DOL) designate certain plans as “high cost” and mandate that participants in these plans be given the option to execute in-service rollovers to low-cost plans. Finally, Ayres and Curtis recommend participants be required to demonstrate a minimum degree of sophistication by passing a DOL-approved test before being allowed to invest in any funds that would not satisfy the enhanced default requirement.

As of the close of business on February 28th, there did not appear to be any indication that Ayres was preparing to tweet the names of specific companies or plan sponsors. Ayres did not immediately return messages asking for comment.