Do 401(k) service providers show favoritism towards their own mutual funds when setting investment menus?
This is the question that three researchers – Clemens Sialm, Irina Stefanescu and Veronika Pool – sought to answer in a new paper published in the Journal of Finance.
The short answer, according to the paper, is that setting a 401(k) menu is not a purely meritocratic process: plan sponsors are influenced by service providers to include propriety funds on menus, and poor-performing affiliated funds are less likely to be removed from menus. These under-performing funds then continue to perform poorly.
The authors find that affiliated funds are less likely to be removed from investment menus than unaffiliated funds regardless of past performance; but the disparity widens for the poorest-performing affiliated funds. From the paper:
The figures show that affiliated funds are less likely to be deleted from a 401(k) plan than unaffiliated funds regardless of past performance. More importantly, the difference in deletion rates widens significantly for poorly performing funds. For example, funds in the lowest performance decile in Panel A have a probability of deletion of 25.5% for unaffiliated funds but of only 13.7% for affiliated funds. Indeed, the deletion rate of affiliated funds in the lowest performance decile is lower than the deletion rates of affiliated funds in deciles two through four.
Overall, the difference in deletion rates between affiliated and unaffiliated funds is statistically significant for the nine lowest performance deciles.
The researchers bring up a solid rebuttal to their own thesis: what if service providers aren’t simply displaying favoritism; what if providers actually have more favorable, superior information on their own funds?
So, the authors investigated:
While our evidence on favoritism is consistent with adverse incentives, plan sponsors and service providers may also have superior information about the affiliated funds. It is therefore possible that they show a preference for these funds not because they are necessarily biased toward them, but rather due to favorable information that they possess about these funds. To investigate this possibility, we examine future fund performance. For instance, if, despite lackluster past performance, the decision to keep poorly performing affiliated funds on the menu is information-driven, then these funds should perform better in the future. We find that this is not the case: affiliated funds that rank poorly based on past performance but are not deleted from the menu do not perform well in the subsequent year. We estimate that, on average, they underperform by approximately 3.96% annually on a risk- and style-adjusted basis. These results suggest that the menu bias we document in this paper has important implications for employees’ income in retirement.
The full paper – which presents its arguments in significantly more depth than presented in this post – can be read in full here.
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