James Kwak: the mutual fund company that oversees your 401(k) plan is out to get you

Economist James Kwak is now a law professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. In this piece James examines the conflict of interest between the asset management industry and the suffering 401K investor. Excerpt: 

(…) But wait, there’s more! In addition to these very real problems, 401(k) plans are generally run by the asset management industry, which (surprise!) does not always have your interests at heart.

Most defined contribution plans allow participants to select from a menu of investment options, largely mutual funds. The question is, who decides what’s on the menu? About three-quarters of the time, these decisions are made by a mutual fund company acting as the plan’s trustee.** And (surprise again!) mutual fund companies are more likely to push their own funds onto employees than other companies’ funds—despite the fact that they are legally obligated to act in the best interests of plan participants.

Although many people have suspected this all along, we now have convincing evidence from a paper by Veronika Pool, Clemens Sialm, and Irina Stefanescu aptly titled “It Pays To Set the Menu” (which was sent to me by two different readers). The paper uses a clever empirical approach. In any given year, a mutual fund may be included in 401(k) plans overseen by that fund’s sponsoring company (e.g., the Fidelity Magellan Fund may be included in a plan whose trustee is Fidelity) and also in other plans not overseen by that company. It turns out that there are many such funds.

Let’s say such a fund has a bad year. If plan trustees are acting solely in the interests of their participants, we would expect the identity of the trustee not to affect the chances that the fund is dropped from the investment menu. But that’s not the case: a poorly-performing fund is much less likely to be dropped from a menu controlled by its sponsoring fund company than from a menu controlled by a third party. Fund companies are also much more likely to add their poorly performing funds to plan menus that they control.

Much more.

5 thoughts on “James Kwak: the mutual fund company that oversees your 401(k) plan is out to get you

  1. I’ve been concerned about this, but don’t know how to protect myself. I cannot analyze numerous investment options, so I am depending on Fidelity and Merrill Lynch to do an acceptable job.

    The performance of all mutual funds and stocks is subject to considerable variation, so looking at past results is not necessarily a good predictor of future results.

      • But exactly how do you evaluate them? Low fees are nice, but sometimes you get what you pay for.

      • Good question – we are still evaluating. Mainly because Wealthfront is USD-denominated whereas we need mostly AUD. But there are very few choices in AUD. I think there is only one AUD fixed income ETF period.

        All the evidence and academic research points to low-cost index investing as best investment return for a given asset allocation. If one reads only one investing book I think it should be “The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between” by William Bernstein. This is what Wealthfront does, using best and cheapest Vanguard ETFs, and all for 0.25% with all trading costs paid by Wealthfront. That’s why one of the founding fathers of evidence-based investing, Burton Malkiel, joined Wealthfront as CFO (author of the seminal book “A Random Walk Down Wall Street”).

  2. Yes, we experienced that problem with one of Margaret’s old 401Ks. We had invested in Dodge and Cox Stock Fund, a very solid performer for many years. All of a sudden it was gone from the menu and our funds had been transferred into one of the fund company’s large cap stock funds. We called to inquire and were told that the funds were the same because they covered the same sector of the market. So, a BMW and a Chrysler are the same because they both have 6 cylinders and four doors.

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