The 401(k) Gravy Train Has Sprung a Leak

07/20/2010 08:17 pm ET | Updated May 25, 2011

The perversion of 401(k) plans into an $80 billion annual trough from which brokers, insurance companies and mutual funds shamelessly feed, is disturbing to anyone who understands how this system works.

There's so much blame to go around it's hard to know where to start. Employers are either ignorant of how their employees are being ripped off by excessive fees and poor performing investment choices, or they just don't care as long as their plan costs them "nothing." Brokers and insurance companies know exactly what they are doing: maximizing fees (and penalizing returns) through "revenue sharing payments" extracted from mutual funds who are pandering to be included as investment options in the plan. Mutual funds populate the plans with high expense ratio funds and earn obscene profits from having a captive audience of mostly unsophisticated plan participants.

Two recent developments may foretell a crack in this sleazy, ethically bankrupt system.

The Center for Retirement Research at Boston College issued a report which looked at the costs of the typical 401(k) plan. The report questioned the common practice of including actively managed funds (where the fund manager attempts to beat a given benchmark) as investment options in 401(k) plans. The authors concluded the inclusion of these funds exposed plan participants to a "substantial amount of additional risk" because only a small percent of these funds were able to beat their benchmark by the amount necessary to cover their high transaction costs.

The solution to the crap shoot of trying to pick the tiny percentage of out-performing actively managed funds is to eliminate them from 401(k) plans altogether. Instead, the report recommends the use of Exchange Traded Funds and commingled trusts which could "boost the net returns on participants' balances by 0.7 percent of assets or more."

An even better solution would be to offer participants only pre-allocated portfolios of globally diversified, low cost stock and bond index funds.

The reason why costs are so high in most 401(k) plans is that it suits the interest of brokers and mutual funds to keep them high, which increases their profits. However, a recent federal court decision may provide a meaningful disincentive for this conduct. In Tibble v. Edison International (CV 07-5359), Judge Stephen V. Wilson ruled on a class action brought by participants in Edison's 401(k) plan. The case was brought in the United States District Court for the Central District of California.

In a ground-breaking decision which could change the landscape of 401(k) plans, Judge Wilson ruled Edison violated ERISA by including the retail shares of three mutual funds in its 401(k) plan when less expensive institutional share classes of the same funds were available. Judge Wilson held "a prudent fiduciary acting in a like capacity would have invested in the institutional share classes", since the only difference was the cost of the two shares.

The potential damages for the plan participants could be substantial. The Court set forth a methodology which involves computing the difference in cost between the two share classes over the relevant time period and also calculating the loss of additional investment opportunity caused by the reduction in returns to the plan participants.

Over the years, I have reviewed many 401(k) plans. Over 90% of them use retail shares even though lower cost institutional shares were available. The cost to plan participants (and the benefit to brokers and mutual funds) is in the billions of dollars.

While these developments are most welcome, there is a long way to go. As indicated in the study by The Center for Retirement Research, and in hundreds of other academic studies, no prudent investor should invest in actively managed funds which are unlikely to equal benchmark returns, when index funds will always track the index, less low transaction costs. Most index funds have only one class and their cost is typically significantly less than the cost of both the retail and the institutional shares of actively managed funds.

Plan participants who wish to gamble with their retirement funds could be offered a self-directed brokerage option.

Hopefully, the next litigation development will hold fiduciaries responsible for the inclusion of actively managed funds, and for their failure to include pre-allocated portfolios of low cost index funds, Exchange Traded Funds or passively managed funds, as investment options in 401(k) plans.

When this decision is handed down, the leak in the 401(k) gravy train will become a flood.

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