How to Cure an Ailing 401(k)
Ever since their inception in the mid-1970s, 401(k) plans have provided employees around the country with a platform for saving for retirement. It used to be that companies, by way of traditional pensions, assumed most of the responsibility for saving for employees' retirement. Today, pension plans are less and less frequently used, and the introduction of the 401(k) has shifted the way people save for retirement. (To learn more about one of the most popular retirement plan options, read The 4-1-1 On 401(k)s.)
In theory, 401(k) plans are a novel idea; in practice, they are sometimes an abysmal failure. While few investments are more important than your company-sponsored retirement plan, millions of Americans are regrettably stuck in high-cost, outdated plans that almost guarantee failure. So what can a simple individual employee do about it? Plenty! This article will point out some indicators of a substandard retirement plan and outline your options for fixing it.
Symptoms of a Terrible Plan
The onus to save and invest for retirement now lies squarely on the employee's shoulders. But are employees really given the right tools? Are these plans really structured for do-it-yourself investing success? For most people, the answer is "absolutely not."
It's not always easy to spot whether you are stuck in a terrible plan because the dominant model is for providers (the company that designs and manages the plan's assets for a fee) to bundle all their services, including record keeping, investments and payroll procedures. With a plan structure like this, it's hard to know what fee you are paying for a specific service.
But one clear symptom of a crummy 401(k) plan is the presence of exorbitant mutual fund fees.
By way of background, every mutual fund has annual operating expenses, which vary widely depending on the type of fund. The largest operating expense is the fee paid to a fund's manager. Other costs include:
- Record keeping
- Custodial services
- Legal expenses
- Accounting/auditing fees
In addition, some funds have a marketing cost referred to as a 12b-1 fee that is also included in operating expenses. These fees are often shared with the plan administrator, but not ever disclosed to the plan participants. (Discover how investment strategies and expense ratios impact your mutual fund's return in Stop Paying High Mutual Fund Fees.)
It's also not uncommon to find proprietary products within a crummy plan, meaning the plan provider (i.e., the brokerage firm, fund company or insurance provider) handpicks its own, often high-cost, funds to be made available on the 401(k) platform. Revenue sharing is another common practice whereby the plan administrators share in the mutual fund fees with the mutual fund providers; it is often poorly disclosed to participants. This creates an instant conflict of interest in which specific funds are selected for the plan so that third parties can collect extra fees from unsuspecting employees.
Another symptom of a bad 401(k) plan is a limited list of fund choices. On the flip side, having a gigantic list of overlapping funds with limited asset class diversity is equally undesirable. Investment menus in corporate plans should be streamlined with 12 to 20 diverse choices for employees. Preferably, no plan should offer company stock as a choice (at the least, it should cap the amount employees are allowed to invest in company stock). The last thing you want as a 401(k) participant is to experience an Enron-esque event. (Read What Enron Taught Us About Retirement Plans to learn how past mismanagement of employer stock-ownership plans can help you learn what to avoid today.)
Understanding Fiduciary Responsibility
Your employer has a legal obligation to hold its corporate plan up to a certain standard. The Employee Retirement Income Security Act (ERISA) is a federal law that sets minimum standards for retirement plans in private industry. The Pension Protection Act of 2006 created additional guidelines.
ERISA gives employers a fiduciary level of responsibility for managing 401(k) plans. This means they are required to act in the best interest of the party whose assets they are managing (you and other employees in the plan). Fiduciaries are expected to manage the assets for the benefit of the other person rather than for their own profit and cannot benefit personally from their management of assets. Plan sponsors have a fiduciary responsibility to act with loyalty and prudence, to diversify plan assets and to act in accordance with plan documents. Fiduciaries, including the employer, who do not follow the principles of conduct may be held responsible for restoring losses to the plan or plan participants.
More and more companies have been placed under the spotlight for breaching their fiduciary responsibilities as plan sponsors. A unanimous May 2015 U. S. Supreme Court decision held that an employer (Edison International in Rosemead, Calif.) can be sued for failing in its "continuing duty to monitor" to prevent mutual funds in 401(k) accounts from charging unnecessarily high fees. Employers, not employees, have the burden of monitoring these plans.
Another employer under fire was Wal-Mart (NYSE:WMT). Like many of the lawsuits filed against large plan sponsors since late 2006, the 2008 lawsuit against Wal-Mart accuses the company of violating its duty as a fiduciary by offering "costly" funds in its 401(k). As a result of this increased attention, companies are increasingly under the gun to do what's best for employee participants.
Treatment Options for a Crummy Plan
Federal law grants retirement-plan participants certain rights with regard to their plan assets. If you're not happy with the quality of your plan choices or the level of fund costs, you can do something about it.
The first step in fixing your personal 401(k) is to get informed. Do your homework on the types of investments available through the plan and research the mutual fund costs and results against their respective benchmarks. Good places to do this might be Morningstar or FundGrades. If you're not happy with what your research reveals, go speak with your company's HR benefits manager.
In addition to expense ratios, ask if any of the following fees are assessed against your personal plan assets:
- Sales loads
- Wrap fees
- Mortality and expense risk charges
- Advisor fees
- Fee-based brokerage or transaction-fee charges
- Stable value "spreads"
- Surrender charges
Keep in mind that retirement-plan options and providers do not have to be set in stone. Employers have the ability to change plan providers as they deem necessary. While this can be quite a lengthy and bureaucratic process, especially if you work for a large company, change can happen. If you have trouble getting someone's attention on the matter, you might want to print them a copy of the Securities and Exchange Commission's (SEC's) Guidelines for Selecting Pension Consultants. A copy of this document might snap them quickly into reality on how serious you are.
In an ideal world, employer-sponsored retirement plans would be forced to reveal their annual expenses to participants in dollar terms, not expense ratios, and limit their fund choices to low-cost index funds for global diversification.
Retirement-plan participants often give up more than 1.5% to 2% per year in returns to cover fund expenses, and they don't even know it! Compare that to a cost of less than 0.25% for an index fund. Every dollar you can save on expenses or administrative costs is an extra dollar (plus compound interest) for your nest egg. According to the Department of Labor, fees can diminish your lifetime 401(k) accumulations by as much as 30%! (Find out how to save on commissions and fees in Don't Let Brokerage Fees Undermine Your Returns.)
If you find yourself stuck in a terrible retirement plan with no fixes in sight, you may want to consider opting out of it entirely and invest your money in other tax-deferred or tax-free vehicles such as annuities and tax-free bonds. The first hurdle in this decision depends on whether your employer offers a match for your contributions. If the answer is no, then consider whether it makes good financial sense to contribute to the plan. If a match is offered, you should contribute up to the amount to qualify for the match and look for better places to direct the rest of your retirement savings.
Instead of (or in conjunction with) the 401(k), consider opening a Traditional IRA, Roth IRA, brokerage account, annuities, bonds or some combination thereof. Take control of how you structure your portfolio, keeping in mind that broad diversification, proper portfolio monitoring, discipline and cost efficiency will go a long way toward helping you reach your goals. (For further reading, see Roth IRA Or Traditional IRA...Which Is The Better Choice?)
The Bottom Line
For many Americans, 401(k) plans are often their biggest retirement asset, so preserving and growing this portfolio is key. If your account values continue to vanish because you are stuck in a crummy plan, take action. The whole notion of 401(k) plans was to give employees better control over their financial destiny. However, this does not seem to be happening in practice. The onus is on employee participants to make informed investment decisions and on employers to provide superior choices. It's your money, so there's no excuse to not get involved.
For further reading, see Six Ways To Maximize The Value Of Your 401(k).