How 401(k) Conflicts Can Hurt Your Nest Egg

— -- Try going to the drawer or file cabinet where you keep your 401(k) plan documents and taking a hard look at the list of investments your plan offers. Did you ever wonder how these particular investments came to be included in your plan’s offerings?

The superficial answer likely is that your company, as the plan’s sponsor, accepted an array of investments offered by a large brokerage or insurance company that provides investment platforms to employers. But the real reason is that instead of benefiting you, these investment choices often serve the interests of the firms your company engages as service providers for its 401(k) plan.

Your prospects for a comfortable retirement are probably being significantly lessened by conflicts of interest that often drive the inclusion in 401(k) platforms of poorly performing investments for which hardworking investors are charged high fees. This double whammy means that you aren’t getting good investment returns and that plan service providers have their hands in your pocket, taking big chunks of the returns you do get.

The most fundamental conflict involves the nature of investments offered in these platforms. The typical 401(k) plan offers only actively managed mutual funds. This means that investment managers buy and sell stocks in these funds in an attempt to beat the market. These managers typically have poor performance but receive high fees for that performance. This increases costs for investors.

I believe these costs are needless and merely lower net returns — the money investors get to keep. Reams of objective academic research show that the best long-term returns come not from these actively managed funds, but from passively managed, low-cost index funds and exchange-traded funds (ETFs). These funds are called passively managed because, instead of buying and selling stocks in a mutual fund portfolio, they are managed to match independently constructed indexes, such as the S&P 500. This not only increases net returns by reducing costs, but also positions investors to reap the overall returns of the market. With actively managed mutual funds, investors suffer when investment managers guess wrong, and they do much of the time.

While many actively managed mutual funds charge investors between .6 and 1 percent per year, passively managed funds often charge between .05 to .15 percent. This difference has a huge impact on net returns over time.

Why don’t all plan providers offer passively managed funds in their platforms? The answer is that they wouldn’t trigger much compensation for plan service providers. There’s simply no financial incentive for plan bundlers to include index funds or ETFs.

This fundamental conflict is among many that are costing most 401(k) investors dearly. The most common types fall into one of these categories:

• Proprietary vendors. Many of the large brokerage firms that supply investment platforms for 401(k) plans have their own mutual funds and, not surprisingly, tend to include these funds in these platforms instead of outside funds that may perform better or have lower fees. Thus, these providers collect fees from plans for bundling funds and for managing the funds themselves.