401(k) Folly Continues

By John Wasik
May 29, 2013

Investors in most 401(k)-type plans are fighting a losing battle.

There are successful alternatives in the form of defined-benefit and low-cost government plans that work as decent models, but private employers are loath to offer them, even though they can cost less and perform better.

Meanwhile, the gap between the retirement haves and have-nots widens. In a recent study, old-style defined-benefit plans outperformed 401(k)s  “by the widest margin since the 1990s,” analysts at the  benefits consultant Towers Watson discovered. [EXPAND Read more]

The company examined some 2,000 plans and found that defined-benefit pensions returned an average 2.74 percent in 2011 (a flat year for stocks), compared to a negative 0.22 percent for 401(k)-type plans.  That was the widest margin since 1995, when the firm first started doing their research.

When vetting these results, it’s essential to note that expenses play a big part in reducing 401(k) returns. Middlemen eat up several percentage points of return because employees are offered a suite of overpriced, actively managed mutual funds.

Retirement savers pay dearly for their choice of funds: At 1 percent annually, expenses alone will reduce returns at retirement age by 20 percent.

Instead of one professionally managed fund that’s risk adjusted for the age of the employee (or company’s employee group), thousands of off-the-shelf actively managed funds are offered in 401(k)s.  Not only is it inefficient, it’s wasteful in terms of money that could be invested.

As Alicia Munnell at the Boston College Center for Retirement Research recently wrote:

“Actively managed funds are expensive on average.  The evidence from the Investment Company Institute (ICI) and other organizations shows that the average fees for actively managed funds significantly exceed those for index funds.

The numbers reported by the ICI show that, in 2012, the average expense ratio for an index equity fund was 13 basis points compared to 92 basis points for an actively-managed equity fund.  The comparable costs for bond funds were 12 basis points for index funds and 65 basis points for actively managed funds.

At least on the equity side, active management does not produce higher returns.  The academic literature clearly shows that the majority of actively managed funds underperform index funds and that returns are significantly lower for actively managed funds after accounting for fees.”

Munnell would like to see actively managed funds banned in 401(k)s and replaced with index funds. I don’t think that’s necessary, but I would like to see a cap on fees that matches what the government’s Thrift Savings Plan charges federal employees.  Last year, the plan charged employees 0.027%. While that percentage varies from year to year, it’s ranged from 0.015% in 2007 to 0.102% in 2003.

I can’t imagine private mutual fund managers and brokerage houses willing to go for this modest proposal. If they’re fleecing employees for 1 percent a year or more, why would they want to move their fees two positions to the right of the decimal point?

Other than legislation mandating a rock-bottom expense ratio for 401(k) funds and adequate, customized risk adjustment, every employee who is being gouged should be outraged.

Check to see how much you’re paying and compare it to the TSP expense ratio. Do you even come close?

If you’re being overcharged, pretend that you’ve had a wretched meal in a restaurant — there were bugs in your soup and salad. What would you do? Would you wait 30 years to complain? [/EXPAND]