Dirty Tricks That Keep Your 401(k) Returns in the Gutter

05/02/2010 05:12 am ET | Updated May 25, 2011
  • Dan Solin Author of the Smartest series of books

I recently reviewed a large 401(k) plan. I found many of the problems which make these plans such a rip-off: Mostly proprietary, high expense ratio, under performing, actively managed funds, conflicts of interest, revenue-sharing, hidden costs and fees and the misuse of "fiduciary" by an adviser to make the employer believe he is assuming liability for the selection and monitoring of investment options when all liability remains with the employer. Nothing new or surprising here.

Until I found the one index fund in the plan.

It was an S&P 500 index fund with an expense ratio of 0.50%. That seemed odd since the plan administrator had its own S&P 500 index fund with an expense ratio that was a fraction of that amount.

If there is one thing I have learned over the years, it is that the goal of the securities industry is to separate you from your money. Almost all of their actions can be understood in that context.

So why would an administrator bypass its own low cost index fund for a much higher cost one from a third party?

For two good reasons:

First, it receives revenue sharing payments from the third party.

Second, an index fund with a high expense ratio is going to have historical returns that under perform the index. When these returns are shown to plan participants, and compared to the high expense ratio, actively managed funds from the fund family of the administrator, most plan participants are going to select the proprietary funds.

An index fund with a high expense ratio should be an oxymoron. Yet, brokers continue to advise investors to buy these funds. Academics who study investor behavior call this phenomenon the "Index Funds Rationality Paradox."

A leading study concludes this conduct is "...largely driven by an identifiable group of unsophisticated investors that buy funds through brokers."

However, this is not the case with 401(k) participants if their only choice is one of these unsuitable index funds. They are caught between a rock and hard place: Either they buy an expensive index fund that will under perform the index or a more expensive, actively managed fund that is likely to do the same.

Either way, the mutual funds and the plan adviser win and the participants lose.

The employer is either ignorant of these shenanigans or doesn't care. It believes the plan doesn't cost it anything.

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