401(k) plans are a great deal for employers. Their cost is subsidized by brokers and advisers, at the expense of the plan participants (employees), who are supposed to be the primary beneficiaries.
Let me give you a little primer on 401(k) plans. The plan sponsor (typically the employer) is a "fiduciary" to plan participants This means it is supposed to act in the best interest of those participants. Nice theory. The reality is quite different.
It is in the best interest of plan participants to have investment options in their plan that will generate the highest rates of return at the lowest cost. Based on reams of academic data, only index funds (including ETFs) meet this criteria. They are much lower cost than actively managed funds (where the fund manager attempts to beat the returns of a designated benchmark).
The majority of actively managed funds underperform their benchmark index over the long term. It is impossible to discern which of the outperforming actively managed funds will repeat their outperformance in the future. In fact, outperformance over most five year periods seems to be a positive indicator of underperformance in the ensuing period.
A 401(k) plan consisting only of a broad range of low management fee stock and bond index funds is in the best interest of plan participants. An even better option would be for the plan to offer broadly diversified portfolios of these funds for varying risk levels (from conservative to aggressive). Few employees have the ability to put together a risk adjusted portfolio in an appropriate asset allocation (the division of their portfolio between stocks bond and cash) on their own.
Few 401(k) plans offer these options. Indeed, as Ron Lieber discussed in a recent article in The New York Times, most 401(k) plans don't even offer a decent array of index funds. He notes that only 37 percent of plans offer index funds covering a broad domestic stock index, a broad international stock index and a broad domestic bond index. As I recommended in The Smartest Investment Book You'll Ever Read, with just these three funds, investors can put together a portfolio that has historically outperformed the returns of 95 percent of professionally managed money.
The reason for excluding index funds is simple. Index funds don't pay brokers, advisers or insurance companies a kickback (known as "revenue sharing payments") which are the price of admission to the plan's lineup of investment options. Lieber raises the issue of whether the absence of an array of index funds in 401(k) plans might violate the fiduciary duty of the plan sponsor. He concludes that no Court has directly addressed this issue, but encourages plan sponsors to take prompt remedial action before it is too late.
Lieber correctly notes that a Court is unlikely to conclude the absence of index funds is illegal. A combination of world class lawyers retained by the securities industry and recalcitrant judges, reluctant to roil a huge retirement plan system, is the perfect storm for plan participants.
Legalities aside, what about the moral and ethical issues? The present system subsidizes the cost for employers and eviscerates the savings of plan participants. Many forward thinking employers believe this is simply wrong. They are changing their plans and retaining advisers who fully disclose their fees, take no compensation from mutual fund families, and populate their plans with investment options that are really in the best interest of plan participants.
As Lieber notes, you are not powerless. Approach your plan administrator and insist your plan include a broad array of index funds. Even better, lobby for an all-indexed plan. When you approach retirement, you will reap the fruit of your efforts.
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.
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But maybe one of the most important issues is proper asset allocation. Too many folks just don't understand the risk and reward profiles of the various investment options and how to maximize your risk adjusted returns. I've seen particpants invest 100% of their contributions in company stock. Sometimes it works out, but other times it ends in tears. Others will only buy a "guaranteed" or fixed investment and often this will not return enough to build your assets over time.
One more issue is the lack of true diversification options. I've seen many plans that offer 3 or 4 different funds buying the same stocks. This isn't diversification! Rarely do 401k's offer an option of commodities like energy, precious metals and agricultural products. These have been important diversifiers during the current commodity inflation cycle.
I agree that 401k participants should be given the choice of low cost index funds, but there are larger issues with most plans, and how participants manage their funds.
The 401k is the most powerful savings tool offered to many employees. In the instance where the company matches a part of your contributions, it's a home run.
When I first started working after college, I made it my business to put the maximum 8% pre-tax and 8% after tax into my plan. My employer put in 4% which was the maximum, their formula was a 100% match for your first 4% pre-tax contribution.
Believe it or not, some employees didn't participate to get the 4% match. I made it my mission to make sure all my colleagues would at least put in 4% so they got their 4% "bonus." One staffer said she couldn't afford it, so I encouraged her to put in 1%. After a couple of pay periods she admitted she didn't even miss the money. A couple of month later, I convinced her to move it to 2% of pay. Then I told her to bump it each time she got a salary increase so you wouldn't miss it.
A year later she ran up to me and was so excited she had accumulated nearly $5,000 in her plan. She exclaimed she never had any savings.
Trouble was, employers started raiding these accounts and this man (his name escapes me) did a complete turn around on his view and condemned them.
We refused to participate, and are glad we didn't when we discovered my husbands employer had no intention of matching funds.
I will dig up the information and link it.
We lost roughly 1/4 of our client base, most of whom could not believe that low cost passive funds have and will outperform most active managers. The remaining clients who stayed with us were all a bit cautious at first, but now they are completely happy. We even had one of our clients forward the Ron Lieber article to us, I had missed it.
We believe that it is legally indefensible to not offer passively managed funds. At some point in time, aggrieved participants will be looking for restitution.
THEY ARE OPTIONAL. IF YOU CHOOSE TO PARTICIPATE YOU FOLLOW THE RULES. YOU ARE NOT FORCED TO DO THIS.
http://www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/upia94.pdf
Here's a good summary.
http://en.wikipedia.org/wiki/Uniform_Prudent_Investor_Act
Not one mention of what is illegal?
BLUF, what exactly is your claim that 401k are illegal?
'SECTION 7. INVESTMENT COSTS. In investing and managing trust
assets, a trustee may only incur costs that are appropriate and reasonable in relation
to the assets, the purposes of the trust, and the skills of the trustee.'
Most Investment companies are located in NY, some in DE. Most workers work in one of the 50 states. The HQ of the companies, one of the fifty.
It doesn't matter what the states want. Its a Federal matter. And their is no precedent to speek of.
One thing that went practically unmentioned in this article is a simple and obvious solution for 401K plan participants- pick up the phone and call HR. Get your coworkers to lobby them. They normally want to help the employees out on this stuff, and they are usually the folks in charge of deciding which company you go with and which funds you have available. Fidelity is pretty darned cost-effective as a servicer, and if you go with their index mutual funds, you can get the costs down to less than 1%/year.
But Mr. Solin is right in that if you do not get a company match and intend to stay with your employer for a long time, at the very least, make your Roth contribution in your own IRA first.
I'm not complaining considering I don't know "jack" about it. But I do work for a larger multi-national company and I do readjust my picks at the start of each year.
Let people keep what they've earned ... and not tax them to their last cent. Even the "evil" employer (gasp!). Get the government out of "managing" peoples' money. Government's in charge of the military, court system, stuff like that.
In my own experience, it was only a couple of decades or less ago that employees approached our Fortune 500 employer's plan administrator to complain that the 401k offered no alternative to stock and bond funds -- like a money market or simply cash -- that could even be used as a holding area from selling in anticipation of moving the 401k or retiring with a reduced risk profile, not to mention to minimize losses. It was unconscionable, really, and randomly punished those whose life events happened to coincide with a down market. Fortunately the administrator did add a safe cash-like alternative to the mix. It is definitely worth it to get these situations addressed.
I worked for a good company, which treated employees and the environment well. I repeatedly lobbied for them to include socially responsible funds in the 401K options, explaining that by not doing so they were forcing their employees to invest in companies that failed to meet their own high standards. They kept saying that "Fidelity doesn't offer socially screened funds" and so they did not include them in our choices. Even when socially screened funds are offered, they usually are limited to one or two offerings. My own feeling is that the responsible funds should be the default options. One or two funds could be available for people who say, well, I don't care how much land I destroy or people I hurt, I just want the highest return possible, but for the rest of us there should be a wide range of responsible choices.
The plan providers would be breaking their fiduciary responsibilities with respect to diversification.
This proves that our American way of life has been hijacked by the wealthy and the white collar criminals the enable them!!!