Politics & Policy

Watch Out for the 401(K.O.)

High fees? Lousy track records? Conflicts of interest? What to do.

Finally, the SEC is cracking down on 401(k) retirement-plan providers that are taking advantage of individual retirement savers and corporate sponsors who really don’t have the tools or experience to manage their own portfolios or plans.


#ad#Investment News recently reported the imposition of a $9.3 million fine on a major fund provider. The basis for the fine was the complaint that one stockbroker mishandled the savings of three clients by “putting them in high-fee mutual funds.” The fine broke down as follows: $3.8 million for compensatory damages, $2.5 million for court costs and attorney fees, and $3 million for punitive damages.


As a portfolio advisor on such retirement-plan investments, I am struck by the combination of not only high fees but also the particularly poor selection of mutual funds that are offered in some broker-sponsored programs. Recently, one of my clients was considering participation in a new 401(k) plan that was being offered to employees. He asked me to help him select mutual funds that would make sense for his current financial situation. Unfortunately, such advice was not forthcoming from either the plan provider or the financial institution offering the plan. So, as a favor, I set about examining the elements of his company’s program, and was shocked by much of what I found.


The first abomination was conflict of interest. The investment manager of the program was a mutual fund company. The fund selections for the program essentially consisted of two mutual fund company funds: One set of funds was from the plan manager and the other was from the offering broker’s internal mutual funds. There also were three odd-ball funds from other fund companies, but these were immaterial. Overall, there appeared to be little if any due diligence on the funds chosen for the program.


After removing the cash-equivalent fund, there were twenty funds offered of which nine were from the program manager and eight from the broker. Given the fact that the majority of these funds had poor performance records, one would think that the costs of these funds would be reasonable — if not downright cheap. Unfortunately, the truth was the exact opposite.


The average fund expense ratio was in excess of 2 percent, with one expense ratio coming in at 3.35 percent. In addition, the selected share class included a 1 percent deferred load charge. As opposed to money-manager fees which decline with assets under management, expense ratios remain the same no matter how much money is involved.


Another danger was that the manager, in addition to offering poor fund selection, also offered no portfolio-allocation advice. Nor did the manager provide any financial analysis to help in the portfolio-building process. There also was no disclosure to participants of additional fees or charges associated with the program.


Ranking fund performance can be hazardous, so in aiding my friend I went for some basic measures. For example, Morningstar ranks funds from a high of 5 to a low of 1, taking into account performance and risk. In my friend’s fund-selection universe, the average Morningstar rating was 2.2, well below average, and there was not one 5-star-rated fund.


I also referenced Morningstar’s 5-year category rankings. The ratings here span from a high of 1 to a low of 100. The average for my friend’s grouping was 58, also below average. This measurement also produced four funds that were in the bottom 10 percent of all similarly structured funds.


Shifting to the fund-rating system of William O’Neil and Co., eight of the funds were graded “E,” the lowest of five ratings. Of the eighteen funds from the two mutual fund company selections, only one had an “A” rating.


Needless to say, the brokers offering this program provided little information about the historic performances of these funds.


Asset allocation is critical when weighting mutual funds in the process of building a diversified retirement portfolio. But among my friend’s offerings, while there were three global funds and two international funds, there were no domestic small-capitalization funds, a category that continues to do extremely well. Additionally, one new fund had no history and four funds boasted managers with less than one-year experience managing their respective funds.


I could go on, but I’m sure you get the point: Using brokers to structure 401(k) plans, in conjunction with mutual fund companies with lousy track records, no advice on portfolio structure, and high fees, can add up to a 401(K.O.).


If you see these inequities in your own 401(k) plan, you might want to take your company managers to task for making a bad choice, and then suggest they survey the field of competent 401(k) plan providers. If you meet resistance, you and your co-workers can always call a lawyer.

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