Is Your 401(k) or 403(b) Really Protecting Your Best Interests?

Facts do not cease to exist because they are ignored.
Aldous Huxley

I have seen a number of articles recently online and in the trade publication I receive talking about “retirement readiness,”how to better prepare a plan’s participants for a successful retirement. Most of the articles focus on increasing employee participation in a company’s plan, in some cases forcing enrollment through automatic enrollment, and increasing the amount of employee contributions to a plan.

Very few of the articles address the issue of the quality of the plan itself, even in the face of ongoing decisions and multi-million dollar settlements of cases alleging excessive fees and/or imprudent investment options within a plan. The obvious question is whether it is fundamentally unfair to force employees in a fatally flawed 401(k) or 403(b) plan?

The excessive fees cases typically focus on issues such as revenue sharing, with mutual funds in the company’s plan returning some of the money received from 12b-1 fees and other fees to a plan to help pay for a plan’s bookkeeping and other administrative costs. A Wall Street Journal article reported that one organization estimated that a two wage earner family would lose approximately $155,000 over their lifetime to a plan’s fees. While the fees for such services typically vary according to such factors as the size of a plan, most experts have told me that such costs should not be more than approximately more than $35 per plan participant in most cases.

While the excessive fees cases generally target the amount of the bookkeeping and administrative fees themselves,  the impact of 12b-1 fees, and the evidence supporting the justification for the excessive fees, is also a consideration. If a mutual fund within a plan charges an annual 12b-1 fee, the fee is typically 0.25 percent of the total amount invested in the fund. Many people see the small percentage amount and simply dismiss the fee as insignificant, and that’s exactly what the mutual fund wants investors to do. But is it really insignificant?

It is not unusual to see millions of dollars in various investments within a plan. The cumulative impact of an “insignificant” 0.25 percent 12b-1 fee provides a much different picture.  An 0.25 percent 12b-1 fee on a fund with $5 million invested in would produce $12,500 per year for that fund. Multiply that by the number of other funds in a plan charging a 12b-1 fee, and it is easy to see why 12b-1 fees are not insignificant at all.

Pension plan service providers, mutual funds and plan sponsors attempt to justify 12b-1 fees as helping plan participants by avoiding having to make plan participants pay for a plan’s bookkeeping and other administrative costs. Interestingly,very few plans allow the plan participants to decide if they would rather pay their portion of such costs instead of paying 12b-1 fees.

If we assume an annual bookkeeping fee of $35 per participant in a plan with 100 participants, the total cost for the plan would only be $3,500, much less than the $12,500 hit from just the one fund 12b-1 fee. At 100 employees, that $12,500 12b-1 fee would translate into a $125 fee per plan participant, a fee approximately 257 percent higher for the same services.

That’s exactly why you have seen, and will continue to see. the numerous lawsuits against 401(k) plans. The evidence of such abusive practices is so clearly in violation of ERISA’s fiduciary duties that the decision to bring an action is a no-brainer, the proverbial “low hanging fruit” as business schools like to teach.

Bottom line, check the prospectus for each investment option within your 401(k), 403(b) or other pension plan and do the math for yourself. If you and other plan participants find such abusive practices in your 401(k) or 403(b) plan, ask your plan’s sponsor and administrator to eliminate funds charging a 12b-1 fee from the plan and allow plan participants to pay their pro-rate portion of a reasonable annual bookkeeping and administrative fee. A refusal to allow this request could constitute a breach of the plan sponsor’s fiduciary duties of loyalty and prudence.

Another key issue in most of the cases that have been filed against 401(k) plans is the quality. or lack thereof, of the investment options provided by the plans. the primary investment option in most pension plans are mutual funds. In most cases, the lawsuits cite both the fees charged by such funds and the persistent under-performance of such funds.

Historically, most of the mutual funds offered within 401(k) and 403(b) plans were actively managed mutual funds, this despite the fact that history has proven that the overwhelming majority of actively managed equity-based mutual funds have proven to be inefficient in terms of both cost and performance. The most recent Standard & Poor’s SPIVA report stated that in 2015, 74.81 percent of all domestic equity-based mutual funds under-performed the broad-based S&P Composite 1500 Index. The five and ten-year performance of said funds were equally bad, with an under-performance record 88.43 percent and 83.18 percent, respectively. The poor performance record was consistent among individual categories (large cap, mid cap and small cap) as well.

What makes the poor performance record of such plan investments even worse is the fact the actively managed funds typically charge much higher annual fees than passively managed, or index, mutual funds. As Rex Sinquefield, one of the founders of Dimensional Funds, once noted,

We all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it.

Poor performance and costs reduce a mutual fund’s end return to investors. Each additional 1 percent of fees and expenses reduce an investor’s end return by approximately 17 percent. Under-performance is an opportunity cost in that it further reduces the return an investor could have earned in a prudent investment alternative.

I recently performed a forensic analysis of the 403(b), 457(b) and Optional Retirement plans of a major American university. Out of a total of 128 mutual funds, only 16 passed my prudence screen based on their nominal five-year annualized returns. That number shrank to only six when the funds were evaluated on their five-year risk adjusted return.

Those findings are fairly consistent with my findings from other forensics analyses of the investment options offered within 401(k), 403(b) and 457(b) retirement plans. The findings are surprising not only in terms of the high percentage of poor investment options, but also because plan sponsors face unlimited personal liability for any breach of their fiduciary duties under ERISA, including the failure to select and maintain prudent investment options within their plan.

A quick and simple method of evaluating the prudence of the investment options within a plan is to use the Active Management Value Ratio™ 2.0 (AMVR), a metric I created for both my law and investment education practices. The AMVR is the same cost/benefit analysis that many of us learned in our first year Econ 101 class. The only difference is that the AMVR uses an actively managed mutual fund’s incremental cost and incremental return to determine the fund’s cost efficiency. The AMVR only requires a limited amount of data,all of which is available for free online, and takes only a few minutes per fund analyzed. Further information about both the AMVR and the steps required in calculating the metric are available here.

The ongoing trend of cases against 401(k) plans indicates two main things for retirement plan participants. First, a significant number of 401(k) plans and other retirements are not providing plan participants with a meaningful opportunity to become retirement ready, the opportunity to invest in investment options that are efficient both in terms of cost and performance.

Second, since a number of plan sponsors are not taking the proper actions to correct the problems within their plans, it is incumbent on plan participants to learn how to evaluate their plans and to take the time to do so. Fortunately, the AMVR can perform a meaningful analysis of a fund in one or two minutes. When plan participants detect an imprudent investment option or excessive fee in their plan, they should get together and address the situation with their plan’s sponsor. Since plan sponsors face unlimited personal liability for any breaches of their fiduciary duties under ERISA, one would hope that they would be receptive to such requests.

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