Sunday, March 13, 2005

401(k)s Inadequate - Not just a diversification issue

The enormity of the conclusions drawn by an academic study on the inadequacy of investment choices in 401(k) is getting journalistic attention based on several references to the study I have seen over the last few weeks. Liz Weston reports on MSN that:
  • "A study of 401(k) plans released last month found that 62% failed to offer enough plan choices for workers to build adequately diversified portfolios.The cost of inadequate diversification is huge. Workers who had enough choices, and who used them properly, averaged annual returns of 10.7% over a 20-year period, according to the study, which was conducted by professors at New York and Fordham university business schools. That compares to the 7.5% averaged by the workers with inadequate plans."
  • Other conclusions drawn by the study include:"The funds included in plans are riskier than the general population of funds" and "index funds chosen by 401(K) plan administrators are on average inferior to the S&P 500 index funds selected by the aggregate of all investors"

The authors of the study, Martin Gruber, Edwin Elton and Christopher Blake selected a sample set of 401(k) plans and compared those plan investments against a hypothetical set of 8 market indices distinct in style, asset class and adjusted for management expenses (after determining this bundle of indices represented an optimal efficient frontier). The researchers conclude that the majority of 401(K) plans do not offer the breadth of capital market coverage of their "efficient" 8 asset class benchmark and therefore offer inadequate choice.

The inadequacies in 401(K) plans may be partially attributable to asset class scope but the study doesn't reflect the economic and practice issues that probably contribute much more to the inadequacies than scope of choice alone. Key issues I see are in the study are:

Sample bias- the middle decile plan size in the study was $25MM. This is at the low end of most large vendors core markets. The study also excluded any plan with separate investment accounts or commingled funds. These vehicles are important in capturing the positive economic leverage in asset management and applying it to plan servicing costs. Simply put..plans that only use mutual funds, as in the study, will likely have the most constraints and issues primarily because the economics of these investment alternatives are less attractive to non proprietary plan providers in the 401k market. Plans in this size range using only mutual funds often have fairly tight constraints on investment scope and choice. Smaller plans investment expenses are higher as a % of plan assets and fund alternatives are more likely to be from the same investment fund families or providers. Economics rather than performance tend to drive the fund alternatives available in the small market. This reflects the reality that that investment expenses cover over 95% of total plan costs including administrative and recordkeeping and that plan service costs as % of plan assets is higher in the small market. Significantly, both plan sponsors and participants do not want to see/pay for plan service costs separately. This issue creates plan inadequacies by making overall economic considerations primary in determining the investment choices made available and selected by plan sponsors.

Benchmark Index expenses don't cover plan servicing costs-The authors adjust their benchmark portfolio for typical index expenses. This unfairly benefits the benchmarks on a comparative basis since typical index expenses do not cover the costs of plan servicing and recordkeeping while the actual actively managed funds in the study must....either indirectly through the higher margins in proprietary investment products or directly through higher priced advisory mutual shares with 12b-1 fee revenues. I believe the bigger adequacy issue as being underrepresentation and utilization of index funds for existing asset classes in 401(k) plans than the availability of additional asset classes like high yield or emerging markets. Plan economics are behind this issue as well. Active management of investments provides more fees to subsidize plan service costs and provide margins for the investment managers/fund family. A recent Greenwich study found that large DB plans allocate about 16% to equity indexing while small and midsize 401(K) plans allocate only 6%

Correlation is higher when funds are concentrated within a fund family - These same facts can explain why the study concludes that the 401(k) plans are riskier. It was noted in the study that the sample fund variances were actually lower than in a random sample. The higher correlations explained the higher overall risk. Higher correlations among the sample funds seems consistent with the economically driven incentives to keep plan investments within a proprietary fund lineup or within a fund family that offers the best economics to the plan or the provider. The clustering of investments this way minimizes manager diversification and likely causes more holdings and investment strategy overlaps between funds in a plan creating inadequacy.

ERISA mandates that Pension plans provide their participants with a sufficient set of investment alternatives such that they can construct diversified portfolios that suit their circumstances. Evidence indicates that, from an ERISA perspective, the majority of plans do provide sufficient choice. Changing the paradigm so that plan servicing costs could be isolated and charged to participants separately would facilitate broader investment offerings and plan sponsor fund selection processes which would probably yield more index and fund alternatives as well as broader choice. All these elements would contribute to greater 401(k) plan adequacy.


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