A new study by two law professors shines an unflattering light on the high costs of typical 401(k) plans. These costs, of course, reduce investment returns. Insidiously.
The professors recognize two types of costs: those associated with plan fiduciaries, costs which the authors refer to as "fiduciary losses," and the costs of investors' allocation "mistakes." In the law professors' view the total of the two types of costs "consume about a quarter of the optimal potential risk premium."
There are plenty of takeaways from the study, which as best I can tell analyzed data from over 12,000 401(k) plans. This takeaway, however, resonates:
"Our results suggest that investors incur unnecessary losses due to fiduciaries’ decisions to include a preponderance of costly funds in plan menus. Plans that feature index funds show lower fiduciary losses. A portfolio consisting of only retail share classes of Vanguard index funds incurs lower fiduciary losses than 90% of plans in our sample."
One of the law professors stirred the 401(k) plan community pot by writing companies sponsoring plans he believes burden plan participants with higher-than-average costs, notifying those companies of his analysis.
One prominent law firm responded in an "open letter" that alleges the professor's analysis is "outdated and based on incomplete information." The law firm concluded that plan sponsors should not rely on his letters and study, basing the firm's conclusions on its work for unnamed plan sponsors. The law firm cites several reasons in support of its conclusion. However, in this writer's view the supportability of the law firm's response largely hinges on a single statement -- which will become legally suspect in the not too distant future, this writer predicts -- that "... it is commonly accepted that the use of actively managed funds is prudent."
* * *Postscript: I've been planning to post about the new study since reading James Kwak's August 9, 2013 blog post about it. Procrastination sometimes pays in investing. But procrastination didn't pay in this instance since columnist Scott Burns has now beaten me to it: see The Conspiracy for Failure in 401(k) Plans. Kwak's post is here. Kwak in his post notes that a study co-author is his former professor.
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The study, published in the Journal of Financial Economics, analyzed data from over 2,000 401(k) plans. It found that, on average, plan costs reduce returns by about 0.75%.
While that may not sound like much, it can have a significant impact over time. For example, if you have a 401(k) balance of $50,000, that 0.75% fee would eat up $375 of your returns every year.