The Good, the Bad and the Ugly of 401(k) Plans

— -- Many middle-class Americans—and even some with high incomes—feel that no matter what they do, they can’t build wealth because the obstacles are too great.

The good news is that you can accumulate wealth much faster than you think by making sound investments that lead to compounded investment returns—essentially, returns on your investment returns, and returns on these returns, and so on. With compounded returns, it’s astonishing how fast your wealth can grow.

The key to sustaining good returns is to avoid investing mistakes that prevent returns from growing at a compounded rate. In this regular column I will show you how to ensure that compounding is sustainable, enabling you to build wealth over time by avoiding preventable errors.

All too often, people make investing mistakes in their 401(k) plans. This is easy to do because, although these plans can be highly beneficial tools, many are deeply flawed and saddle the average investor with burdensome costs. What’s more, the typical 401(k) plan contains no offerings beyond mutual funds that may deliver poor performance. Often, the result for workers is poor net returns — what they’re left with after paying fees and expenses. This is truly unfortunate, because these plans are the main way that most Americans invest for retirement; many have no other retirement aside from meager Social Security benefits.

However, there are steps you can take to make the best use of your plan to get far better results. If you take these steps to manage your plan investments optimally, you can keep your compounding train rolling. For example, under current rules, a 30-year-old earning $55,000 a year, getting a raise each year of 3 percent and contributing 6 percent annually (pre-tax) to his or her 401(k) -- with an employer match of 50 percent, an annual return on investment of 6 percent and making accelerated contributions allowable beginning at age 50 -- could accumulate $1,067,716 by the age of 65 (assuming no withdrawals are made from the account).

These are the kind of results that Congress envisioned in 1974 when it passed legislation enabling 401(k) plans. This legislation, the Employee Retirement Income Security Act (ERISA), was intended to make investing for retirement easier and more profitable for the average person.

ERISA allows individuals to defer taxes on certain retirement plans, including 401(k) plans, until they take the money out during retirement, when their tax rate is expected to be significantly lower. These plans discourage participants from dipping into their accounts before retirement by imposing penalties for early withdrawal that apply until they are 59½. Section 401(k) of the act enabled employer-sponsored plans that workers may contribute to through payroll deduction, as well as employer matching contributions up to a point.

This was a great idea for various reasons, including the following:

Because people contribute to their plan accounts from their paychecks, they never see this money, so they can’t spend it. Out of sight and out of mind, this money goes into investment products chosen from the plan’s offerings.

Contributions are tax-deferred, so they lower employees’ tax bills. Tax on these contributions and the returns generated by investment isn’t due until money is taken out of accounts. The idea is to make these withdrawals during retirement, when most people are likely to be in a far lower tax bracket than when they’re working.

Matching money from employers who offer it (many don’t) gives employees a strong incentive to enroll in their companies’ plans—and contribute more to them. After all, this is free money and additional tax-deferred compensation that allows the participant’s account to grow and compound to a much higher level.

This all sounds good, right? Well, it was good in 1974 and can still be today. But unfortunately, the intent of ERISA—to give people a powerful retirement vehicle that easily helps them grow wealth—isn’t being widely realized. Immediately after ERISA was enacted, the financial services industry, seeing tremendous potential, dove into the opportunity-rich waters created by the act. The interests of investors have since been trumped by those of the large insurance and financial services companies that bundled 401(k) plans and the investment companies that provide products to them.

The result today is a 401(k) industry replete with conflicts of interest and sky-high fees. Many plans offer publicly traded mutual funds, many of which perform poorly. Some of the large brokerages and insurance companies that package these plans and provide them to employers often charge outrageous fees — often between 1 and 2 percent per year. Therefore, if your company’s employees’ contributions to a plan total $100 million, these plan providers would get at least $1 million per year for doing little more, in many cases, than selling your company its services and showing up once or twice a year to take someone to lunch.

These bundlers, known as plan providers, decide which investment companies can offer investments on their platforms. Instead of limiting these participating companies to those with the best-performing products, many plan providers select them in a process governed by self-interest: They charge mutual fund companies for shelf space in a pay-to-play arrangement that’s been documented for years. Many plan providers offer 401(k) investors their own proprietary funds. Yet even if your company rids your plan of all such conflicts and arranged to have the “best” mutual funds for you to choose from, you probably still wouldn’t get good returns because of the high fees endemic to this industry.

Atop these fees come those charged by 401(k) plan advisors, many of whom traditionally have had business relationships with the plan providers or investment companies with products in these plans. All this amounts to a 401(k) conga line of conflicted companies and individuals with their hands out for payments that siphon off substantial amounts from workers’ retirement resources.

Also missing from many plans are two key things that ERISA requires: One is financial education for employees to help them get the most out of their plans. The other is the services of a fiduciary advisor — that is, one that has not even the appearance of a conflict of interest — to help workers make thoughtful and informed investment choices to avoid investing mistakes.

None of these issues were supposed to arise from ERISA, which prohibits conflicts and requires employers sponsoring plans to assure plan participants low fees, good service and adequate education. But over time, these priorities have fallen by the wayside, prompting regulators in various presidential administrations to issue rules enforcing and underscoring the act’s original provisions.

The latest round of new rules came last year from the federal Department of Labor, seeking to end conflicts through increased disclosures and to require plan sponsors to ensure that fees are reasonable. But it’s doubtful that this latest attempt to resuscitate ERISA’s original intent will make much difference. For one thing, employers aren’t becoming sufficiently informed of these new rules to change what they’re doing in ways that matter. For another, the powerful legal machinery of the 401(k) plan industry is doing its customary best to neutralize the impact of the new rules.

Regardless of the outcome of the new rules, if you don’t participate in your plan, you’ll be throwing the baby out with the bathwater. You want to take advantage of your plan’s full potential while protecting yourself from disadvantages. Learning how to use your plan is critical, because in these plans you’re essentially your own lifelong financial planner. This is a key step in a broader effort to avoid common investing mistakes that can interrupt your portfolio’s long-term compounding. Remember: Assuring your retirement nest egg is up to you, and you alone.

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.