Despite prior evidence that retirement plan participants are passive and do not react to new information, a new study finds that the Department of Labor’s participant fee disclosure regulation apparently did have an impact.
The National Bureau of Economic Research’s newly released “Out of Sight No More? The Effect of Fee Disclosures on 401(k) Investment Allocations” study found that participants became more attentive to fund fees and to short-term fund performance following the DOL’s regulation.
Using hand-collected data on investment menus for a large sample of 401(k) plans using plan-level annual filings from 2010 to 2013, along with participant’s allocations to each of these options, researchers Mathias Kronlund with Tulane University, Veronika K. Pool with Vanderbilt University, Clemens Sialm of the University of Texas at Austin and Irina Stefanescu with the Federal Reserve Board studied whether the 2012 participant-level disclosure reform affects investment decisions in 401(k) plans.
While noting that there are several reasons why one may expect to see no change in allocations following the new disclosures, the researchers found that participants’ sensitivity to fees increased after the reform. “We show that participants became significantly more attentive to expense ratios and short-term performance after the reform,” the researchers write. “The disclosure effects are stronger among plans with large average contributions per participant and weaker for plans with many investment options,” they add.
This result apparently holds using several different measures of fund flows. For example, the paper notes that funds with a one-standard deviation higher expense ratio (i.e., 0.36 percentage points) experience a statistically significant reduction in their plan share of 0.17 percentage points per year after the regulatory change. The researchers further observe that this annual portfolio reallocation is also economically significant, as it corresponds to around 6% of the median fund plan share of 2.9%.
In looking at whether their findings were driven by participants simply allocating more money to cheaper funds, or whether they are also actively withdrawing from the funds that are more expensive, the researchers found that investors actively moved money away from expensive funds.
The paper further observes that index funds may benefit disproportionately from the reform, as these funds tend to be among the cheapest options in many plans. As such, part of the heightened fee sensitivity in the study’s baseline results may be a result of investors switching from more expensive active funds toward cheaper passive funds.
“We confirm that investors allocate significantly more flows toward index funds after the reform. Yet, we find that flows become more sensitive to fees within both actively managed funds as well as within the set of passively managed funds,” the researchers note. “Taken together, these results suggest that the regulation implicitly promotes passively managed funds and thus contributes to the popularity of indexing.”
The paper further explains that, while participant-directed flows became significantly more sensitive to one-year returns after the reform, the results on changes in flow sensitivity to 5- and 10-year performance are generally not significant. “Higher sensitivity to one-year performance may occur since one-year performance is typically displayed more prominently in the first column of the disclosed data table,” the researchers observe.
Alternative Explanations
While the results show that participants responded to the new disclosures by allocating more flows to cheaper funds and to funds with higher one-year performance, the paper notes that a potential alternative explanation is that plan sponsors or providers mapped participants to cheaper funds by changing the menus. For example, the authors note that one such possibility is that sponsors may have changed the default option around the DOL’s reform.
In further examining changes in participant investments in company stock, the researchers found that, when a plan’s mutual fund investment options are particularly expensive, participants shift more assets toward the employer’s stock once they acquire better information about these fees through the disclosures. They also found that plan participants chase short-term employer stock performance more aggressively after the regulatory reform. “This reallocation toward company stock is an unintended consequence of the fee disclosure,” the researchers observe.
