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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.
Paul Petillo
www.BlueCollarDollar.com
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