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The 3 Things Wrong With Most 401k Plans and How to Fix Them
IN THE BEGINNING
The first 401(k) pension plans arrived on the scene back in the early 1980s, they are named after the section of the Internal Revenue Code (IRC) that allows employees the option of deferring a certain portion of their salary to a special account without being taxed at the time of deferral. At the time of the 401(k) plans arrival, most employees in America had retirement plans that paid out a set monthly amount of money, based on a formula that took in to account the employees’ length of service and the amount of their salaries/wages during their hightest earning years. These plans were known as Defined Benefit Pension plans as the amount of money the employee was to receive during retirement was specified.
The 401(k) plan, and it’s close sibling, the 403b plan, which is offered to employees of non-profit and government run institutions like hospitals, and schools, do not pay out a set monthly amount upon retirement but instead allow the employee to set aside a certain amount of their salary/wages in a retirement account that they can invest as they see fit. These plans are known as Defined Contribution Plans as the employees knows how much money is going in, it’s just the amount that they will have when they retire that is a mystery as they are at the mercy of the investment markets. The Defined Contribution Plans are also different in that they allow the employees to invest on their own behalf in a wide range of vehicles such as stocks, bonds, and mutual funds. This is different than the Defined Benefit Pension Plans as these plans are invested by the employer without any input from the employees, and are mostly invested in conservative vehicles such as bonds and other fixed income investments. A final difference is that the 401(k) Plan is “portable” meaning some or all of the amount of money in them belongs to the employee (the employer can also contribute to the employees’ 401k Plan as an incentive or via a profit sharing arrangement) depending on the “vesting schedule” hence if they happen to leave their current employer they can take some or all of the money with them to their new employers’ plan or roll it over to a self-directed IRA. The Defined Benefit Plans did not allow this type of flexibility, and in more than a few cases employees were terminated for bogus reasons right before they were supposed to start collecting their pensions . This is one of many things that lead to the passage of the 1974 Employee Retirement Income Security Act or ERISA legislation.
The battle still rages on to this day as to which plan best serves the American worker, but regardless of who wins this argument, I don’t think you’ll see the Defined Benefit Plan making a comeback anytime soon, as they are a tad expensive to a sponsoring company, plus with the hugest generation in American history about to retire, and the smaller generations following it make the Defined Benefit Plan very difficult to work. I personally see advantages and disadvantages to both, and I generally like the 401k type plans. My problem is that the way that most 401k plans are set up is making it impossible to attain the objective that they were intended to, that objective being that the American people have enough money to survive and even thrive when they are no longer working for a paycheck. Below are the three reasons preventing the 401(k) plan from doing what it was intended to do.
1) MANY PLANS HAVE FEES AND EXPENSES THAT ARE TOO HIGH- It’s pretty much been established by noted experts as John Bogle of Vanguard Funds fame, Burton Makiel author of the infamous book “A Random Walk Down Wall Street”, and others that high expenses kill investment returns, and if most people knew how many hands were in the cookie jar known as the 401(k) plan, lynch mobs would probably begin forming. Management fees, 12b-1 fees, “Shelf Space” Fees, and trading costs are among many of the different expenses that various parties help themselves to, often completely unknown to the 401(k)participant. Even worse, most Plan Sponsors (better known as employers) don’t even know the expenses that they and their employees are being hit up for. These fees aren’t easy to find, either. Some are buried so deep in the Summary Plan Description that often experienced investment advisors have trouble finding them unless they sit down and carefully review each page. Also, most Summary Plan Descriptions are pretty thick and many fee disclosures are sprinkled throughout the document. Most plan sponsors have never had an objective review done on their plan that could identify high and unncessary expenses. While high 401k plan expenses, have been prohibited dating back to the 1974 ERISA Legislation, they didn’t receive much press until the market decline of 2000-2002. This is bacause most people don’t pay much attention to high expenses when the market is going up like it was for the most part from 1982 through 2000. It’s when the market is flat or declining that high expenses become painful. With the passage of the newer Pension Protection Act of 2006, and the market decline of 2007- 2008, expect the sparks to fly again real soon regarding 401k plan fees and expenses.
2) THE INVESTMENT OPTIONS IN MANY 401(k) PLANS ARE MEDIOCRE AT BEST- In a perfect world, the investment options in 401(k) plans would be chosen because they were in the best interests of the plan participants. Their costs would be low, and their returns high. Unfortunately though, this is not a perfect world, and the investment options in most plans are not chosen because they are the lowest cost options or the highest returning options. Many are chosen because they are managed by the company offering the 401(k) plan. Another reason is that the mutual fund company, or insurance company that manages the investment option has deep pockets, thus can afford to pay the various 401k plan providers to have their fund on their platforms. Actually, the one that indirectly pays the platform fee is the people in investing in that fund, but I won’t get into that right now. The bottom line is that most 401k plans have one or two really good investment options, several poor ones, and many that are somewhere in the middle, and figuring in the potential expenses these funds charge (see above), mediocre is not going to help people attain their retirement plan goals.
3) THE EMPLOYEES OF MOST COMPANIES ARE NOT INVESTMENT EXPERTS AND ARE NOT INTERESTED IN BECOMING INVESTMENT EXPERTS- Do you remember the movie “The Day After”? That movie was about aftermath of a nuclear bomb attack on America, but it very well could have been the aftermath of open enrollment in the average company’s 401k plan. In both scenarios people are dazed, confused and wondering what they should do next. The good thing with the movie is that it’s just a movie and will eventually end. The bad thing with the open enrollment is that it’s real life and the decisions that the people make will determine whether or not they will have enough money to enjoy their retirement. Some people have an investment professional that helps them with personal investments that they can call for help setting up their 401k plan, but the majority are generally clueless and and don’t know who to turn to for help. Unfortunately, the plan salesperson or broker is generally not permitted to dispense investment advice, nor is the H.R. person who administers the company’s 401k plan because in both cases giving the advice would make both the still confused employees to do one of four things:
a.) They look at the performance figures of the various investments and invest their money in the investment options that did well the previous year. While this idea may seem to make sense, rarely do investment categories do well two years in a row, and of the ones that do, even fewer do well three years in a row. In fact, in most cases being the top dog for a year or two is often followed by a long fall.
b.) Ask friends, family, or co-workers. This is fine if any of these people do research in proper investing techniques and methodologies. But often these people are just as uninformed as the person asking for help.
c) Rely on TV, magazines or other media. Again, this is fine if the media is truly interested in dispensing information that is truly helpful, but most media outlets don’t do this. Most media outlets are more interested in stories that attract attention and increase viewership/readership. If one is reading a magazine article to help him invest his 401k money entitled “Ten hot funds to buy right now” this is not a good sign.
d) Invest all of their money in money market funds, stable value funds or company stock
So how can these problems be solved? Is there a way to reduce retirement plan expenses, increase the quality and quantity of the investment options offered and provide help and guidance to those who need it? Actually there is, but the solution is not widely known and it’s not being championed by the large insurance and mutual fund companies, the ones with the deep pockets and multi-million dollar marketing budgets. For them, the status quo is just fine.
The first thing that must be done is to “unbundle” the services in the 401k plan. Most retirement plan providers have the various investment and administrative functions “bundled” in to one big convenient package, and while that may seem to be a good thing at first glance, it opens the door for a lot of price gouging, and overcharging in many areas that while disclosed, is often subtle and hidden. Once these services are unbundled into their various components, and the charges within these various components brought out in to the open, only then can things be meaningfully analyzed for fairness sake. If it’s found that a current provider of services is overcharging, it is then possible to go out and find a provider that charges less for the same services. In some cases, not only does a company reduce the cost, the new provider performs the service better as well as cheaper.
The second thing that must be done is to eliminate the off the shelf pre-packaged solutions of investments and instead implement an “Open Architecture” plan where a plan sponsor, with the assistance of an objective Registered Investment Advisor (more about him/her later), can choose from a wide variety of investment options that are chosen based on their merit (i.e. consistent investment returns in a wide variety of market conditions) or their expenses(preferably as low as reasonably possible, index funds and Exchange Traded Funds (ETFs) are examples.) Open architecture plans are becoming more and more prevalent with the passage of the Pension Protection Act of 2006. In fact, even many of the providers of the current pre-packaged “closed architecture” plans are beginning to offer “open architecture” solutions as they aren’t stupid. They can see the direction the industry is headed and are making sure they have a presence in the “new age” as well as the present age.
The final thing that must be done is to hire an independent Registered Investment Advisor to help the plan sponsor (employer) evaluate their current plan and determine if an entire plan change is needed, or if the current plan is still good but the investments are just not diversified properly to ensure that the participants will have a financially secure retirement. Registered Investment Advisors are different from brokers in that they are overseen by a different entity than brokers (brokers are overseen by FINRA, which is a self-regulatory organization, advisors are overseen by the SEC, a government entity.) Brokers and advisors are also compensated differently. Brokers make a commission on products that they sell whereas an advisor charges his/her clients a fee for the assets managed or even an hourly fee, neither of which are dependent on which products are used to implement the plan. Finally, and most importantly, brokers and advisors are held to different standards. A broker is only required to make sure that the products he/she recommends are suitable for a particular client. An advisor, however, has a fiduciary duty to always act in his/her clients best interests. While a broker is a fine solution for people that already know how to properly invest and are only looking for someone to provide various financial products, most people are looking for advice and guidance and that is best given by someone that is sitting on the same side of the table as the client and who is required by law to always act in the client’s best interests. Besides helping an employer evaluate their current plan and facilitating a change if it’s deemed necessary, the advisor can also be made available to employees that need help and those employees can choose to have an additional fee taken out of their account to compensate the advisor for the help and guidance they receive. The employees that don’t need the help don’t get charged. While more and more brokers are being given the authority to help with investment advice as the Pension Protection Act of 2006 drastically changed the 401k marketplace, the brokers are required to use an unbiased computer generated model to guide 401k participants, whereas the advisors, since they have always had the duty to act in their clients’ best interests are not required to use the computer generated model and can pretty much do busineess as they always have.
Hopefully this article shed some light on a topic that is very important, as the questionable future of social security, and the disappearance of the Defined Benefit Pension Plan, the 401k plan is quickly becoming America’s workers sole means of retirement income. We simply can’t afford to knowingly have it be less than it can be. If you have any other questions on the “21st century” 401 (k) plan, be sure to drop me an email. As always you can be assured of objective thought as well as a professional opinion.
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