Mike Smithers from IndexEdge.com wrote me several months’ back wondering whether the recent wave of litigation aimed at company sponsored retirement plans had caught my eye. They had. While the lawsuits are very interesting indeed, it never ceases to amaze me, I wrote, how the obvious is so often the easiest overlooked. 

I know that the average 401(k) investor simply opens their quarterly statement or checks their portfolio online but rarely ventures far beyond the performance of their holdings. The wealth of information that is ignored is well documented by fund companies. 

This makes the insistence of web-based publications of prospectuses somewhat suspect. Once the document is placed online, tracking the usage becomes much easier. This makes streamlining information for the end-user subject to editorial placement based on historical requests. But that is another story.

To read the prospectus in its current format finds a publication that is clouded with optimistic musings from the fund manager, performance numbers masked by the reshuffling of holdings at year end to boost investor interest in the hope of garnering some additional contributions, and now that the year 2002 has fallen by the wayside when they tally and tout their five year returns. This makes is difficult to find a good and clear picture of a fund’s results or future prospects.

People like me spend countless hours preaching vigilance when it comes to buying mutual funds. Look for good managers we tell them. Search out reasonable fee structures, and pay close attention to lengthy performance histories we repeat. And yet, when they open their 401(k), they simply ignore everything and buy the best performance. 

While Larry Swedroe, author of “The Only Guide to a Winning Bond Strategy You Will Ever Need” might call this flawed human trait recency, I prefer to think of it as urgency. Too many investors want results now and push their investments much harder than they need to and when they do, they are forced to assume risk where risk is not needed. 

Who would slight the plans for pandering such a weakness? As long as the basic tenet of capitalism remains - there will be winners and there will be losers - fund companies will do what they can to survive. But the companies who sponsor these plans are another matter.

Companies rejoiced, albeit silently, at the creation of the 401(k) and with new Pension Protection Act the deal was sealed. The lion's share of a company's pension costs was relieved when this happened. In return, the government demanded just a little fiduciary oversight. 

That oversight starts with explaining enrollment and continues right on through with helping the employee pick the right fund(s) for them. Instead, we have default enrollments into money market accounts, actively managed funds that are far from it (just ask the average employee what their fund's R-value is and I guarantee you they will have no clue) and inappropriate offerings that entice the average person to take outsized risks. 

R-value is assigned to actively managed mutual funds as a way to track their resemblance to the indexes they compare their performance. The higher the R-value, the closer that fund is to actually being an index. The higher the R-value - usually anything above 90 is considered suspect - the lower the corresponding fee should be. Some funds with high R-values may charge fees almost ten times higher than a comparative index.

Retirement is a tricky thing and a more elusive target. Each lost percentage point (or even percentage of a point) in fees puts the day of reckoning, the day when the employee realizes that what they have saved will not be enough a little closer. At the heart of the lawsuits is the belief that fund companies and the third party administrators of these plans have entered into a greased palm relationship with the corporations that hired them. 

 While I don't think lawyers are the answer, the adamant corporate denials seem suspect. Could it be that the cost of a more expensive plan is financially beneficial to the corporation as the litigation asserts? Could a company be that callous as to skim a percentage point of potential returns from their workers to enrich their own portfolios? As long as GAAP allows companies to include the value of pensions as a balance, shouldn't companies without them be allowed to skim some profit from their employee's futures? Of course the answer to these questions rests, at least according to the pending lawsuits, on which side of the issue you are.

Like the urge to sue, I have heard calls for audits as the answer to this incredibly vexing problem. While the costs are minimal, they are still seen as an expense. The fund companies and the plan administrator are at fault. In a world where choice is often sold as diversity, they have the upper hand. They have the ability to spin retirement solutions in such a way as paint a picture of wealth management without ever mentioning risk or cost. More choices does not necessarily turn into more wealth.

I see the solution as having one of three options or even a combination of all three.

Perhaps the solution is as simple as limited diversity. Perhaps 401(k) plans should be limited to six to eight choices and no more. The first choice would be to stock the plan with funds all clearly labeled as index offerings. But the problem with that solution is one of taxes. Indexed funds are probably best kept in a taxable account outside of a retirement account because of their inherent tax efficiency. 

Actively managed funds (with low R-values and equally low expenses) often have higher turnover ratios making them more of a tax burden. The funds would do best in an account that is designed to defer the tax bill. The key is to offer only funds to employees. No stocks and no ETFs 

The second choice would be to fill the plan with lifestyle funds. While this method of investing is still unproven - who knows whether a fund investing for an employee who won't retire until 2040 will provide the right mix of investments - it is a better option for the uninitiated. Lifestyle funds rebalance automatically - in theory anyway - over time providing a mix of equity and fixed income diversity as the worker ages. All the worker needs to do is invest and do so with more than just meeting the company match.

The last choice should be incentive based. Perhaps the plan should have an expense ceiling. If they are held at 1% to 1.25%, it might provide the incentive to actively enlist each and every employee to participate. The plan could shave tenths of a percentage point off the expense ratio as an employee reached a new threshold of participation (for every 5% the employee contributed, they might get a 0.1% fee kickback, which could be invested as well).

I hate the sound of litigation. The S.E.C. should be rattling the administrator's cages. The government should be pressuring the companies and the employee should get their collective head's out of the sand. Plans would adjust to investors who were wise to avoid high fee funds, high R-value offerings, and limited disclosure. While they may not be able to walk with their money, using their plan's offerings more judiciously would send a cohesive and much less expensive message.

© 2007 Paul Petillo
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Blue Collar Dollar.com
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