One increasingly popular feature in 401(k) plans is a so-called managed account option. The way this option typically works is that a 401(k) plan’s participants will have their retirement assets invested automatically in their plan’s fund options by a computer algorithm that makes allocations based upon age, sex, salary, etc. Instead of being left to themselves to pick mutual funds, plan participants have their investments “managed.” I use scare quotes here because the managing is done by a pre-set algorithm, and the in the reams of fine print that accompany 401(k) plan documents the providers of managed accounts are careful to disclaim any fiduciary responsibility to the owners of the assets they “manage.” According to the Wall Street Journal’s MarketWatch:
Managed account providers, who usually work in partnership with the 401(k) record keeper, have recently seen strong gains in 401(k) assets. Cerulli Associates, a research firm that specializes in the asset management industry, recently reported that there were $108 billion in assets in 401(k) managed accounts. Assets under management at market leader Financial Engines grew 35% in 2012, to $64 billion, after rising 26% in 2011. Other managed account providers–including Morningstar, GuidedChoice, and Fidelity Investments—also saw gains of 26% to 48% in 2012, according to Cerulli.
Managed accounts address a real structural problem that afflicts most 401(k) plans: self-direction. Requiring individual 401(k) plan participants pick their own mutual funds produces bad results, on average. Most people are too busy and too inexperienced manage their own retirement investments, and to the extent that managed account services get people out of money market funds and into a reasonable equity and fixed-income fund allocation, then managed accounts are helpful.
The problem with managed account services is twofold: first, many are overpriced, and second, they don’t get to the root cause of the problem they address. Managed-account providers are cutting prices to compete, which may help 401(k) investors get more reasonably priced plans. Nonetheless, when managed account fees get layered on top of existing mutual fund expense ratios, overall annual expenses paid by plan participants can easily reach and exceed 2% of assets. Managed account fees tend to range between 0 and 100 basis points (100 basis points = 1%). This is why the Government Accountability Office recently issued a report warning on the effects of excessive fees in managed account 401(k)s: Improvements Can Be Made to Better Protect Participants in Managed Accounts (GAO-14-310: June 25, 2014) As the Department of Labor has pointed out, an additional one percent in fees will reduce the resulting balance of a career’s worth of investment savings by about one-third.
I recently evaluated a 401(k) plan with about $15 in assets that was provided by a big bank. The bank partnered with a leading managed account provider to offer a managed account feature in the plan, which amounted to an extra 63 basis point fee — 13 bps for the manged account provider and 50 bps for the bank. Neither the bank nor the managed account provider was acting as a fiduciary to the plan, which would have required acting in the plan’s best interest. If they were fiduciaries instead of brokers, then they probably couldn’t have justified the plan arrangement.
The root cause of the problem that managed accounts are supposed to address can be solved in much simpler, less expensive ways. Instead of layering yet another fee and complex service on top of a disparate range of mutual funds, a 401(k) can be re-organized around a few low-cost target date funds and a default investment option that automatically directs participant savings into a balanced fund, unless they choose to opt out. A target-date fund is a “fund of funds” that has an automated glide-path to re-allocate investor’s assets as they get older and their investment profile changes. It is important to have a genuine investment fiduciary vet and pick the funds, because there are many target date funds that hide big embedded fund fees, and others are excessively complex insurance products that masquerade as an investment product.
In many cases, there is an even better alternative for 401(k) plans: dispense with mutual funds altogether and have employee participants direct their savings into one of several risk-based or “lifestyle” investment strategies (e.g., growth, balanced, preservation, etc.) that are invested in individual stocks and bonds through a professionally-managed separate account. O’Brien Greene manages separate account portfolios for our 401(k) clients. Separate accounts, unlike funds, have zero administrative costs and are free of the complex layers of hidden fees and revenue sharing arrangements that afflict many mutual funds. Furthermore, 401(k) plan participants get the benefit of having institutional-level money managers exercising full-time fiduciary responsibility over their retirement savings, all for a single, fixed fee that is lower than the cost of the average mutual fund.