There was a period, back in the late 1990s, when 401(k) plans were hailed as the key to every household's financial dreams. Put money in your 401(k), the thinking went, and you will retire a millionaire, thanks to the magic of the stock market, which would reliably deliver 15% annual returns.*
A 401(k) plan is a defined contribution (DC) plan (other types include 403(b), 457, and SEP-IRA plans, as well as IRAs), meaning that participants put some of their income into the plan (along with, in some cases, additional money contributed by their employer); when they retire, they get that money back, along with any investment returns it has earned along the way. The lure of high investment returns is what made DC plans so attractive. By contrast, people with traditional defined benefit (DB) pensions--which pay a predetermined amount each year in retirement--were seen as suckers.
After two stock market collapses, defined contribution plans are no longer seen as a solution to all of life's financial problems, and for many well-known reasons. First, people don't save enough to begin with. Second, DC plans aren't reliable retirement savings vehicles, since it's too easy to take money out of a 401(k) plan. Third, the stock market doesn't always return 15% (on an inflation-adjusted basis, it's still well below 2000 levels). Fourth, and most importantly, DC plans place all that investment risk on the individual participant.
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.