I ended my last column with the conclusion that diversifying the way retirement savings are invested is the most important, and the one indispensible, function the employer/plan sponsor serves in the 401(k) system. Critically, in determining which funds will be in the plan fund menu and in choosing (or designing) the qualified default investment alternative (QDIA) (typically, a target-date fund).
Given that premise, it is (as they say) problematic that sponsors have been, for more than ten years, the target of—pick your metaphor—a deluge/flood/tsunami/tidal wave of litigation on this very issue.
If we want to preserve our employer-based system, we are going to have to do something about that. Here are three suggestions.
First, we need to get rid of the near-exclusive focus on the issue of fees.
The burden of this litigation is that there is an objective standard against which sponsor fiduciary decisions can be judged. The argument (by participant advocates, think tanks, academics and litigators) often assumes that returns are, in effect, a commodity. That the only thing that matters is fees. And that, therefore, there is only one right choice—the lowest fee option.
Consider the following quote from the complaint in Anthem:
Many Nobel Prize winners in economics have concluded that virtually no investment manager consistently beats the market over time after fees are taken into account. “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs.” William F. Sharpe, The Arithmetic of Active Management … “Accordingly, investment costs are of paramount importance to prudent investment selection, and a prudent investor will not select higher-cost actively managed funds without a documented process to realistically conclude that the fund is likely to be that extremely rare exception, if one even exists, that will outperform its benchmark index over time, net of investment expenses.”
If it’s not obvious, if there is only one right choice, there is no possibility of “diversity.”
I would concede that there are in fact investments that, in many respects, are commodities. Most obviously, S&P 500 index funds. The returns on two different S&P 500 funds should be (with some minor exceptions and perhaps a little bit of “noise”) identical. Thus, it’s understandable that a participant-plaintiff might challenge the selection of an S&P 500 fund with an expense ratio of, for instance, 43 basis points when there are plentiful “identical” funds charging in the single digits.
Of course, an investment in an S&P 500 fund is not really diversified—there are only 500 companies in S&P 500, right? There is (according to the Investment Company Institute) over $5 trillion in 401(k) plan assets. You can’t put all of that in 500 companies. And yet, much of the work by the academics and think tanks seems to take the return on the S&P 500 as a given, available to all at no cost.
But there is a cost—the loss of the ability to diversify. The S&P 500 has had a great ride since 2008. Are we just assuming that these 500 companies are going to outperform all the others for all time? And how will the others raise capital?
That’s issue one. Holding sponsors to a “Sharpe-standard” is going to destroy the one thing that our employer-based system actually contributes to the market: diversification.
Second, we need a solution to the issue of search costs.
The defendants in 401(k) plan fee cases nearly always quote language from the John Deere litigation that “nothing in ERISA requires every fiduciary to scour the market to find and offer the cheapest possible fund (which might, of course, be plagued by other problems).”
Among those “other problems” is the cost of finding the lowest-priced fund. I understand that the fiduciary should be expected (as a fiduciary) to try to get as good a deal as she would have gotten if she were managing her own money. But we need to be realistic. Just how much time are we going to expect, especially, small and medium-sized employers to devote to the process of calling up every mutual fund out there to get the best deal on an index fund?
In this regard, I would propose a simple solution. Any sponsor that provides a reasonably robust brokerage window that includes low-cost index funds should not be sue-able because it also includes in its fund menu (even in its core fund menu) some higher-priced (or even arguably over-priced) funds.
And for all the participant advocacy groups, think tanks, academics and litigators who want to beat up on employers in this regard: Why not devote your energies to a marketing campaign targeted at 401(k) plan participants, telling them to just buy the cheapest S&P 500 fund available? Or, even, start your own fund or co-brand with a low-cost fund provider.
Third: could we please just have a clear standard here? Do we have to develop one through decades of litigation? Isn’t this an example of what Jeremy Bentham called “dog law”—“When your dog does anything you want to break him of, you wait till he does it, and then beat him for it.” If it’s not clear, in this case the plan sponsor is the dog.
The employer in the Anthem litigation is being sued for picking an S&P 500 index fund with an expense ratio of 4 basis points when there was one with a 2 basis points expense ratio available. If someone had said—“you know if you select an S&P 500 fund that costs more than 2 basis points you will get sued”—then sponsor fiduciaries would have all gone out and selected the 2 basis point fund.
Right now—more than 10 years after this flood-of-litigation began—we still don’t know if sponsor fiduciaries are expected to get the “best deal available” or just a “good enough” deal.
As I said in the last column, asking sponsors to make these investment decisions may in fact add to the 401(k) system’s cost. I would argue, however, that employer involvement is an asset to this system—in the diversity of investment that it produces. If we want to keep employers in this system, we are going to have to cut them some slack.
Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services corporations with the regulatory issues facing their plan sponsor clients. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/ about retirement plan and policy issues.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight or its affiliates.
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