Review & Outlook

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You Wouldn’t Represent Yourself in Court, So Why Are You Trying to Invest Your Own 401(k)?

13 October, 2014 by Matthew O'Brien, Ph.D. in Commentary

The root cause of all the problems with defined contribution retirement plans is the absence of any fiduciary duty on the part of most plan providers.  In the recent deluge of TV documentaries, news articles, think tank papers, and government reports about excessive 401(k) fees, this point gets obscured.  Fees are too high, but the reason why they are too high is because plan providers are not fiduciaries.  A fiduciary is legally obligated to act in the best interests of its clients, and the fiduciary standard is the highest standard of care known to the law.

Retirement investors and employee benefit administrators are often surprised to learn that their 401(k) providers aren’t fiduciaries.  (People generally are in the dark about their retirement plans: the Wall Street Journal reports another study, which echoes a previous study from the AARP, that shows nearly half of retirement plan investors mistakenly think that their plans are free.)  Brokerage firms, banks, and insurance companies typically operate without any fiduciary duty to their 401(k) clients.  Yet having a non-fiduciary provide your 401(k) plan is just about as reasonable as consulting with a pharmaceutical company’s sales rep to find the right medication when you get sick.  When you’re sick, you should see a physician; when you want to invest, you should see a genuine advisor, not a salesman.  The so-called “financial advisors” and “wealth managers” who provide 401(k) plans on behalf of their bank, brokerage, or insurer employers are not advisors.  They are salesmen, because they are compensated as salesmen, based upon commissions.  A few days ago the New York Times chronicled a very common story about how ordinary investors are misled and taken advantage of by brokers (“Before the Advice, Check Out the Adviser,” The New York Times, Oct. 10, 2014).

Nevertheless, excessive fees borne by 401(k) investors is not the most consequential problem they face.  As I have emphasized on the blog before, the most consequential problem is the “investor behavior penalty” inflicted by self-directed plans that require ill-informed participants to moonlight as asset managers.  Ordinary retirement investors trade too frequently, mis-allocate their assets, foolishly try to time the market, and often let their savings sit idle in money market and stable value funds.  The overall impact of such investor behavior has a worse effect on long-term performance than the effect of excessive fees.  (In a subsequent post, I’ll follow up with some of the bracing statistics about the gap between reported mutual fund performance versus actual mutual fund investor performance.)

But why do 401(k) plan providers like to have participants pick their own investments?  Hint: it’s not because having such “choice” leads to a higher account balance by the time you retire.  The reason why is because self-directed plans allow 401(k) plan providers to make a lot more money than they would if they had to take full discretionary care for plan assets.  Self-directed plans allow 401(k) plan providers to sell their funds — and other companies’ funds that kick back revenue to them — without incurring the liability of a fiduciary standard of care.  It is the employer plan sponsor who technically bears the fiduciary duty to the employee participants since its is the employer who technically picks the funds that are included in a 401(k) platform.  Plan providers offer “advice” — that is, sales pitches — about which funds to pick, but it is the employer who is on the hook if they screw up.

Thus Lockheed Martin is one of the latest firms on the hood for allegedly including funds in its retirement plan that charged excessive fees.  According to Pensions & Investments:

The lawsuit, which was filed in September 2006 and has been remanded twice, now represents more than 100,000 employees and retirees questioning the fees and investments of two Lockheed Martin 401(k) plans, including a stable value fund and company stock, which the plaintiffs allege were imprudent investments.

In addition to upholding the excessive fee and company stock investment claims, U.S. District Court Judge Michael Reagan in East St. Louis, Ill., also on Friday allowed the plaintiffs in Abbott vs. Lockheed Martin Corp. to proceed with their stable value fund claim, which he said “compels certification.” A Dec. 1 trial date is expected to be confirmed in September.

Since employers and their employees are tasked to do the investing in a self-directed plan, the fund companies, brokers, and insurers who provide most plans are freed up to focus on product design and sales.  That is, they design model 401(k) plan platforms, online portals, etc. that can be scaled up and sold indiscriminately.  If 401(k) plan providers took full discretionary care for their plans, then they would have to get involved in the slower, more costly, and non-scalable business of investing in the best interests of their clients.

The upshot is that retirement investors end up with a lot less money then they would otherwise.  Here is one estimate of the impact from a recent study at the Boston College Center for Retirement Research:

lost 401k

Graphic: Boston College Center for Retirement Research

The solution to these problems lies in 401(k) and 403(b) plan sponsors deciding to work with genuine fiduciaries to oversee and invest their plan assets.  In ERISA law, this is called working with a §3(38) manager or advisor.  A §3(38)  investment manager relieves the plan sponsor and trustee of their fiduciary duty to make investment decisions in the best interest of the plan participants; the §3(38) manager takes on this responsibility.  The plan sponsor and trustee retains the responsibility to monitor periodically the §3(38)  manager.  This arrangement should be distinguished from a §3(21) investment fiduciary, who is an advisor paid to make recommendations about investments to the plan sponsor and trustee.  When a plan sponsor and trustee work with a §3(21) advisor, they aren’t relieved of their fiduciary responsibility, because they retain ultimate decision-making authority for the plan investments.  Both share the fiduciary responsibility.

Complicated?  All the more reason why retirement plan sponsors need to work with a fiduciary whom they can trust.