It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans

Veronika Krepely Pool is an Associate Professor & the Gregg T. and Judith A. Summerville Chair of Finance at the Kelley School of Business at Indiana University. This post is based on a forthcoming article by Professor Pool; Irina Stefanescu, Economist at the Federal Reserve Board; and Clemens Sialm, Professor of Finance at the University of Texas at Austin.

401(k) plans have experienced significant growth in recent years, gradually replacing other pension arrangements. Many participants in these plans have no financial investments other than their retirement savings. Therefore, an important economic issue emerging from the growth of defined contributions is whether current employees can accumulate sufficient wealth for retirement in their 401(k) accounts. As investment decisions in these accounts are made by the participants who often lack financial expertise, the answer to this question is likely driven by the quality of the investment choices offered by the plans.

Most 401(k) plan sponsors hire service providers to help with plan design and administration. Mutual fund families play an important role in this market, most frequently undertaking the role of the trustee or recordkeeper. While typical 401(k) menus often offer investment options from several mutual funds companies, conflicts of interest may affect the set and quality of the investment opportunities offered to plan participants.

Our article, published in the Journal of Finance and entitled It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans, takes a first step to investigate this issue. We focus on the conflicting incentives mutual fund families face as service providers of 401(k) plans. While these families work with plan sponsors to create menus that serve the interests of participants, they also have an interest in promoting their own proprietary funds.

To investigate this “favoritism hypothesis”, we hand collect information on the menu of mutual fund options offered in a large sample of 401(k) plans for the period 1998 to 2009 from annual filings of Form 11-K with the U.S. Securities and Exchange Commission (SEC). Building on Cohen and Schmidt (2009), we also collect information on the identity of the trustee of these employer-sponsored 401(k) plans. Most 401(k) plans in our sample adopt an open architecture whereby investment options include not only funds from the trustee’s family (i.e., affiliated funds) but those from other mutual fund families as well. An interesting feature of our dataset is that a given fund often contemporaneously appears on several 401(k) menus that are administered by different fund families. This data feature provides us with a unique identification strategy and allows us to contrast how the very same fund is viewed across menus where the fund is an affiliated fund and menus where it is not.

We document significant favoritism in 401(k) menu decisions. We show that affiliated mutual funds are less likely to be removed from a 401(k) menu and that the sensitivity of fund deletions to prior performance is less pronounced for these proprietary funds. Similarly, affiliated funds are significantly more likely to be added to a menu and fund additions are also less sensitive to prior performance for affiliated than for unaffiliated funds. We also show that the reluctance to remove poorly-performing affiliated funds from the menu are not information driven. Those funds that are kept on menus despite their poor past performance generate a significant subsequent negative abnormal return for the participants investing in those funds. Interestingly, mutual fund affiliation does not affect how participants allocate their contributions, suggesting that participants do not offset these biases in their own portfolios.

The full article is available for download here.

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