Don't Touch the Third Rail of Your 401(k) Plan

10/11/2016 05:05 pm ET Updated Sep 05, 2017

In The Smartest 401(k) Book You'll Ever Read (which I wrote in 2008), I lamented the sorry state of 401(k) plans.

My recommendations

I noted they were beset with bloated fees. The investment options were often dominated by expensive, actively managed funds, likely to underperform less expensive index funds over the long-term.

I recommended a total overhaul of the system. My suggestions included a requirement that all 401(k) plans offer participants an array of low management fee Target Retirement Funds and a broad range of low-cost index funds, or ETFs, similar to those in the federal employees' Thrift Savings Plan. I also recommended prohibiting the common practice of "revenue-sharing", which permits fund families to pay fees to plan sponsors and other vendors to the plan as the price of gaining admission to the investment options offered by the plan.

Limited progress

Since the publication of my book, there has been limited progress in reforming this broken system. Most notably, the Department of Labor -- in a move vigorously opposed by the securities industry -- enacted a rule requiring advisors to retirement plans to put the interest of plan participants ahead of their own, and to disclose all conflicts of interest.

The plaintiff's bar, led by Jerome Schlichter, at the St. Louis law firm of Schlichter Bogard & Denton, have brought a series of lawsuits against sponsors of retirement plans, alleging these sponsors breached their fiduciary duty to participants by failing to monitor fees and expenses. These cases resulted in settlements totaling $926,500,000 in 2015.

The increase in litigation against plan sponsors has caused them to review fees, costs and investment options. While there's still a long way to go, hard working employees will be the beneficiaries of this welcome trend.

Traps for the unwary

While these are positive developments, there remain traps for the unwary. Most plans are still dominated by a confusing array of actively managed funds as investment options. In my 401(k) book, I included a "cheat sheet" to help participants find lower cost alternatives, if available.

My analog efforts have been replaced by a digital one. A relatively new start-up, FeeX, has automated the process of finding out how much you are paying in fees in your plan and other deferred accounts, and suggests lower cost mutual fund alternatives to those you are holding. I previously wrote about FeeX in this blog..

In stark contrast to FeeX, there's a continuous stream of information in the financial media that is potentially harmful to your retirement returns. One of many examples is this recent article posted on the website of CNBC. The author believes, "A self-directed brokerage account is the most underrated investment option in a 401(k) plan." He correctly notes this option offers participants a "brokerage window" where they can trade investments (stocks, bonds, mutual funds, etc.) that aren't in their plan's official investment lineup."

I can't think of a worse idea.

First, participants wouldn't need access to other investments if the ones in their plans were suitable in the first place.

Second, giving participants the unrestricted ability to trade on their own is a recipe for disaster. Most people are terrible at investing, often buying high and selling low. This depressing chart demonstrates why employees should not be trading on their own if they want to retire at all -- much less with dignity.

In my view, self-directed accounts are like giving drugs to an addict. They don't belong in any retirement plan. If they are in yours, don't go near them.

They are the third rail in your plan.

The views of the author are his alone. He is not affiliated with any broker or advisory firm.

Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.