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The Big Flaw in 401(k) Reform

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Here is the harsh reality: 401(k) plans are a false crutch for employees. They simply don't work, if you define "work" as providing funds that will permit retirement with dignity -- if at all. According to Fidelity Investments, average balances in 401(k) plans as of March 31, 2011 were $74,900. Those 55 and older had saved $233,800 on average. Given increased life expectancy, it is understandable that another study found that 61 percent of those surveyed said they were more scared of outliving their assets than they were of dying.

Things are not so grim for those who "service" the burgeoning 401(k) industry. These fees abound. It would take an actuary to figure them out. They include plan administration fees, investment fees and individual service fees. The big kahuna are the investment services fees which can include sales charges (also known as loads and or commissions) and management fees. The U.S. Department of Labor summarized these fees here.

There has been a lot of focus on fees. Studies have shown that plans with lower fees typically have higher average account balances. The Department of Labor has issued a new rule to improve the transparency of fees and expenses to employees in 401(k) plans. This rule (Labor Regulation 408(b)2) goes into effect April 12, 2012 and requires plan providers to disclose all fees to employers. Employers will be required to demonstrate they have a process in place to evaluate these fees and disclose them to employees.

While this is a good start, it will do little to increase average balances in 401(k) plans. The typical plan offers a mish-mash consisting primarily of actively managed mutual funds (where the fund manager attempts to beat a designated benchmark, like the S& P 500 index) with a few index funds and target date retirement funds tossed into the mix. Employees are left to put together a suitable risk adjusted portfolio. Many have no idea how to do so.

Here's what real reform would look like:

  • Every plan should be required to have a minimum of five risk adjusted, globally diversified portfolios (ranging from conservative to aggressive), consisting solely of low management fee stock and bond index funds. Employees would take a short risk capacity survey and select the portfolio suitable for them;
  • Investment advisers to 401(k) plans should be required to state in writing that they are "3(38) ERISA investment fiduciaries", which means they can have no conflicts of interest. They would accept 100% of the liability for the selection and monitoring of the investment options in the plan. These advisers would be required to provide investment advice to all participants to be sure they have chosen a portfolio suitable for their investment objectives and capacity for risk.

These simple reforms would radically improve the expected returns of plan participants.

The underlying fallacy in current efforts at 401(k) plan reform is that employees are capable of making intelligent investment choices when presented with a dizzying array of mostly poor investment options. I recently spent time with a group of nurse anesthetists whose plan we advise. It never occurred to me to ask them to give me ten needles and five choices of anesthesia (some good and some dangerous) and let me handle their next patient.

Why do we assume employees can be skilled investment advisers? We need reform that makes the process of making investment selections in 401(k) plans foolproof. Current reform just doesn't cut it.


Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, will be available December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.