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The Conspiracy For Failure in 401(k) Plans
August 23, 2013

The Conspiracy For Failure in 401(k) Plans

Academics are a quiet bunch. They don’t make waves too often. They stay in their towers. They do their research.  Once in a while they descend into nits picking amongst themselves.

What they don’t do is declare war. But that is exactly what Yale Law School professor Ian Ayres did last month when he sent out 6,000 letters to 401(k) plan sponsors threatening to name companies with high-cost plans. Plan sponsors were outraged. Industry figures opined that the professor had overstepped the boundaries of polite behavior. They didn’t like his threatening tone.

Since then Professor Ayres has back-pedaled a bit, saying that no “company specific” data will be released. And that’s too bad, because this information really needs to be out there.  Employees need to know how much their 401(k) plan costs and what high costs might mean, long-term, for their retirements. As I have pointed out a number of times, you might be better off in a low-cost employer plan that has no employer match than in a high-cost employer plan with a generous match— that’s how destructive high costs can be.

Unfortunately, those in the industry— mutual fund companies, insurance companies, consultants and others— have a vested interest in keeping fees high because our retirements are their lunch. The result amounts to a conspiracy to support failure.

Yes, that sounds pretty harsh. So let me explain with an actual example of a typical small 401(k) plan. Here’s what happens. The financial services firm offering to provide the plan to the company might charge 0.5 percent a year of plan assets for the machinery of the plan. The plan offers a menu of mutual fund choices. The majority of those choices are managed funds. The managed funds, in turn, may have an expense ratio of 1.5 percent that includes a 0.2 percent 12b-1 charge.

The 12(b)-1 charge is credited against the financial services firm’s 0.5 percent charge. This makes them look like heroes of cost saving. In fact, they’re still getting paid 0.50 percent. More important, the choice of the managed fund adds a net cost of 1.3 percent. So the all-in cost is 1.8 percent. This makes the plan expensive, but the funds have been “screened” by the financial services firm offering the plan for their “good management.”

What’s the alternative?

Offer the plan at a charge of 0.5 percent, but provide a rich selection of low-cost index funds. As I’ve pointed out in many columns, it is now possible for you and me to manage IRA investments for less than 0.20 percent. So we ought to be able to have 401(k) plans, even small 401(k) plans, that cost no more than 0.7 percent.

Note the cost difference. About 1.1 percent a year. And you’ll pay that for as long as you save and are employed, simply because your plan is part of the conspiracy of failure— the conspiracy that supports the idea that managed funds are a good choice.

In fact, managed funds are a lousy choice. They are more expensive, for one thing. And the size of those expenses generally means that about 70 percent of all managed funds will trail the index fund in the same category. Actually, the fail rate is often higher.

You don’t have to take my word for this. It has been documented by research studies going back half a century. The most complete and regularly updated report today comes from Standard & Poor’s. It’s called the SPIVA report, for “S&P Indices Versus Active Funds Scorecard.”  The most recent report, for the year ending 2012, shows results that essentially duplicate the results of the many earlier reports.

And what does that mean?

Just this. When we are investing for retirement we should have a choice. If we want a 70 percent chance of better results, we should be able to choose index funds. If we want a 30 percent chance of better results, we should be able to choose managed funds. The choices put in 401(k) plan menus favor the more expensive managed funds— and a lower chance of better results.

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