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.
- Pay to play. While charging you high fees for these platforms, these bundlers turn around and collect more fees from investment companies, charging them for shelf space in the plans they provide to employers. So mutual funds end up in these platforms based not on their performance, but on being the highest bidders. The investment companies running these funds are only too glad to pay this money, as it gets them millions of investors whom they can then charge high fees for management. This not only results in underperforming investments in your plan offerings, but also increases the costs that your plan must pay for these platforms and the fees you pay the mutual fund companies. All of these costs, direct or indirect, are ultimately borne by you.
- Brokers acting as advisors. Often, vendors to 401(k) plans are brokers, not independent advisors, who make a living from the commissions and fees earned on selling investment products. Brokers are sales people, so in advising employers on their 401(k) plans, they have a vested interest in setting their clients up with investments that result in the higher fees rather than those that offer the best performance.
The federal government is seeking to eliminate this conflict by trying to classify all plan advisors, including brokers, as fiduciaries. Current federal rules don’t require brokers to operate under a fiduciary standard – a status meaning that someone is legally liable for putting clients’ interests ahead of their own. The federal government is seeking to eliminate this conflict by trying to classify all plan advisors, including brokers, as fiduciaries.
More broadly, regulators have mounted a major push over the last couple of years to reduce conflicts by requiring increased disclosure of the compensation arrangements from all 401(k) plan service providers. These new rules, adopted by the federal Department of Labor (DOL), require companies sponsoring 401(k) plans to assure that fees are reasonable in the current market. (Many employers, however, aren’t aware of this requirement, despite repeated federal notices.)
To assure low fees, plan sponsors need to know where conflicts lie, and the new compensation disclosure regimen is designed to reveal them. Yet whether this regulatory push will have the intended effect — and whether regulators succeed in classifying brokers as fiduciaries — is doubtful because the industry is fighting these efforts tooth and nail with squads of highly paid lawyers and lobbyists.
What can you do about all this? Perhaps more than you think. Your 401(k) plan may be the only area where the interests of the average employee and top executives are the same. Though executives often have additional retirement savings, many also participate in their companies’ 401(k) plans and naturally want to get the best possible returns.
Consider going to your human resources department and suggesting that plan officials push plan providers to supply low-cost, passively managed investments to improve returns for employees and executives alike. The response will probably be something like: “No changes are possible. They offer what they offer, and there’s nothing we can do about it.”
But there is. While seeking compliance with the DOL requirement to assure reasonable fees, your company can learn about alternative plan providers, perhaps by issuing a request for proposals. In those RFPs, your company could state its interest in passively managed investments. If the current provider can’t offer them, perhaps a new one could. Thus, your company could shop around for a better plan with better investment choices for lower fees.
Most people would be reluctant to take this case to HR. And most people have retirement resources far lower than they would if they had a better 401(k) plan.
Conflicts of interest ultimately result in a significant drain on net returns by escalating fees. The best way to minimize this damage is for employers to include conflict-free, low-cost investment vehicles in their plans.
Any opinions expressed here are solely those of the author.
Gary Droz is managing director of MainLine Private Wealth in Pittsburgh and Wynnewood, Pennsylvania, and has worked in financial services for more than 30 years. He previously served as president and managing director of Innovest Financial Management, and co-founded the Senior Insurance Institute, which presented educational symposia throughout southeast Florida with the goal of educating seniors and addressing advanced life insurance issues. Droz has a BA in communications from the University of Pittsburgh. He has been a guest lecturer at the Tepper School of Business at Carnegie Mellon University, where he discusses the discipline of investment management.