GOD AND MAN [and the 401(k) Plan Industry] AT YALE
April 2014 Part 1
By Philip J. Koehler, Esq.
In the Spring of 1951 the late William F. Buckley, Jr. was twenty-five and freshly graduated from Yale University. One would have thought that was cause for some rejoicing, but Mr. Buckley was not happy with Yale. His central complaint was that the administration generally, and the faculty in particular, had conspired to indoctrinate him and his fellow undergraduates in the dogmas of “liberalism” and “collectivism” that had, in his view, festered globally in reaction to the events of the first half of the 20th century, while they denigrated any sort of religious point of view or, what he described as, the ideas of “a free market economy” and “personal responsibility.” This, he argued, was manifestly contrary to Yale’s charter, which, since 1701, provided that Yale was intended to be a place “wherein Youth may be instructed in the Arts and Sciences [and] through the blessing of Almighty God may be fitted for Publick (sic) employment both in Church and Civil State.” Buckley was so aggrieved by the disrespect for Yale’s foundational document that this conspiracy betokened that he laid out his critique in his first book, “God and Man at Yale,” which was published later that year.
Given his long and prolific career contributing to our civil political discourse, his wit and humor, Buckley might be forgiven his narcissistic tome decrying a privileged young man’s sense of disappointment with a Yale education. I think it is safe to say that, unlike much of today’s political discourse, Buckley did not suffer the regurgitation of mere dogma well. He argued for the sake of opening the minds of people who disagreed with him, rather than rallying his supporters. For him, the debate was the thing. Through his facial expressions and tone of voice, it was clear that he relished the chance to reveal the holes in opposing arguments by applying a certain purism to a central thesis or principal and then out-thinking his opponent’s objections on different levels.
The book survives mainly because it gives us a glimpse inside the author’s brilliant mind at a formative stage. It is interesting to observe a theme that would echo throughout Buckley’s later writings. For him the school’s then 250-year old charter was as vital to the design of the curricula and to faculty development as it had ever been. This, of course, aligns with his strict construction of the U.S. Constitution, the Declaration of Independence and the Federalist Papers. Buckley rarely blanched at divining what our ancestors were actually thinking as they put pen to paper and furthermore, whatever that was, when it came to important foundational documents, that they intended that generations centuries hence would be bound by their intent, unless they took appropriate steps to modify the document in light of prevailing circumstances. Buckley never revealed the source of his power to function as, what Stephen Colbert calls, a “time traveling mind reader,” but he was such a skillful debater, who elegantly embroidered his arguments with a sparkling poly-syllabic wit and inexhaustible vocabulary, that he tended to overwhelm most of his opponents with style points.
Thirty years later another bright young man grasped his Yale diploma. He went on to graduate from Yale Law School and then earn a Ph.D. in economics from MIT. Since 1994 Ian Ayres has been the William K. Townsend Professor at Yale Law School and a Professor at the Yale School of Management. Professor Ayres is a columnist for Forbes magazine, a commentator on public radio’s “Marketplace,” and a contributor to the New York Times’ “Freakonomics Blog.” He has published 11 books (including the New York Times best-seller, Super Crunchers) and over 100 articles on a wide range of topics.
With Buckley-esque brashness, in June 2013, Professor Ayres sent about 6,000 letters to U.S. companies, informing them that his research on excessive 401(k) plan fees shows that their plans are unreasonably “high cost plans.” In one version of the letter, Professor Ayres reminds the plan sponsors of their fiduciary responsibility under ERISA and says that he intends to publish his list of “high cost plans” in 2014, using Twitter, with separate hashtags for each plan sponsor. Last February he published that study (co-authored with Quinn Curtis, Professor at the University of Virginia School of Law): “Beyond Diversification: The Pervasive Problem of Excessive Fees and “Dominated Funds” in 401(k) Plans.” To quote the study:
“We show that the primary problem for investors in 401(k) plans is not loss due to lack of diversification, but loss due to excessive fees. On average, 401(k) menus provide investors sufficient options to diversify, but investors in many plans bear costs well in excess of retail index funds that are unlikely to be mitigated by returns. In addition to the excess fees imposed on investors by high-cost menu options, many investors incur costs by making cost-inefficient choices over the available menu. Overall, we find that investors in an average plan pay 86 basis points in fees in excess of low cost index funds. We estimate in 16% of analyzed plans that fees are so high that, for a young employee, they consume the tax benefits of investing in a 401(k). Nor do the observed costs appear to simply be due to economies of scale; we find substantial variation in total costs over plans of similar size. These results put the policy spotlight squarely on the problem of fees in reducing investor returns.”
Predictably, as with Professor Ayres’s barrage of letters last year, the study provoked a strong and mainly negative reaction from the 401(k) Plan industry, its lobbyists and the many defenders of the status quo. Much of the criticism of the study is based on a misunderstanding of its data set, which is more fully explained in a tandem paper he published in December 2013, ”Measuring Fiduciary and Investor Losses in 401(k) Plans” (available at http://papers.ssrn.com/abstract=2107796).
The study develops a baseline for measuring the separate effects of fiduciary menu construction and investor allocation decisions. The baseline is a set of optimal portfolios for the plan menu of investment options for each of approximately 3500 plans that offer only mutual funds in the fund line up. The study uses mutual fund data for the period 2002-2008 to compute the fees of the investment options and determine the fraction of the total investment that each mutual fund should receive in order to produce the total plan portfolio with the maximum risk-adjusted return. With these hypothetical portfolios in hand, the study measures the plan level losses arising from various sources, relative to a risk-adjusted, after-fee return that was achievable in the market by investing in low-cost well-diversified plans. Applying this methodology, the study isolates four categories of potential losses:
Menu Diversification Losses. These are the losses that arise because 401(k) investors are restricted to the plan’s fund line up.
Menu Excess Expense Losses. These are the losses that arise due to excess plan administrative fees and excess investment management fees charged the 401(k) investors by the mutual funds.
Investor Diversification Losses. These losses arise from the differences in returns that investors could receive had they invested in the hypothetical optimal portfolio for their plan, and the returns investors are actually expected to receive based on the actual portfolio at the plan level.
Investor Excess Expense Losses. These losses arise from the difference between fee losses on the optimal post-fee portfolio and fee losses on the actual portfolio investors hold. It reflects the higher fees that 401(k) investors incur by deviating from the hypothetical optimal menu portfolio.
The study focuses on the examination of the first two loss categories, which are the result of decisions made by plan fiduciaries, which Ayres terms “fiduciary losses.” While the decisions of the 401(k) investor drive the last two loss categories, which he terms “investor losses,” the study finds that there is a positive correlation between “Menu Excess Expense Losses” and “Investor Excess Expense Losses.” The industry’s knee-jerk reaction aside, now that this study is part of the growing body of excessive 401(k) plan fee literature, investment fiduciaries would be well advised to familiarize themselves with it or, at the very least, direct their consultants to review its implications, if any, for their own plans.
One interesting new consideration that the study adds to the literature is how use of revenue sharing funds in the plan’s lineup contributes to the cross-subsidization of a plan’s general administrative expenses. It’s commonly understood that revenue sharing shifts a plan’s general administrative expenses, which would be shared proportionately at the plan level, to charges absorbed at the fund level, and this shift creates several problematic outcomes. One is the unsystematic allocation of these general administrative expenses among participants, shifting more of the burden onto those who invest in the revenue sharing funds, as opposed to nonrevenue sharing funds or revenue sharing funds where the revenue sharing is rebated back at the fund level.
As Buckley might have seen it, the industry’s dogma about revenue sharing is that it pays the plan’s general administrative expenses, which justifies the inclusion of high fee funds in the plan’s lineup. However, this overlooks the demonstrable fact that where
the plan’s lineup includes both revenue sharing and lower cost, nonrevenue sharing funds, the less sophisticated investors disproportionately invest in the revenue sharing funds, causing them to subsidize the more sophisticated investors who are better equipped to understand the erosive effects of excessive fees on their retirement security. While the study did not attempt to document the demographics, it’s fair to assume that sophistication in this sense correlates well with compensation. Therefore, a plan that includes a mix of revenue sharing and nonrevenue sharing fund options in its lineup creates a perverse outcome where the nonhighly compensated participants tend to subsidize the highly compensated participants. As the study puts it:
“We see no normative foundation for this cross-subsidization. Administrative costs are real costs associated with plan operations and are not particularly onerous in efficiently-structured plans. Why should unsophisticated investors fund the retirement accounts of workers with the sophistication to opt out of low-quality choices?”