(January 2, 2005 ) Explaining Poorly Designed 401ks |
Two separate articles are presented below.
The first is entitled, “Explaining Poorly Designed 401ks” and the second is an our letter (as a member of the Chamber of Commerce) to the President of the U.S. Chamber of Commerce regarding its highly publicized lawsuit against the SEC and criticisms of Eliot Spitzer, the Attorney General of New York.
Explaining Poorly Designed 401ks: A discussion between Fred Barstein, CEO of 401k Exchange, an online consultant to the 401k industry and Edward Siedle, President of Benchmark.
Siedle: The investigations we have undertaken involving defined contribution plans have uncovered that an alarming percentage of these plans are so poorly conceived, both in terms of excessive fees and poor performing managers, that it is virtually inconceivable that the participants in these plans will ever accumulate wealth over their lifetimes through them. If you agree with this observation, how would you explain this state of affairs?
Barstein: Fee and performance issues are rampant in the 401(k) market for a number of reasons. During the late 1990’s, performance across the board was so good that most sponsors, especially in the smaller market, did not pay close attention to the funds, fees and plan administration. As Warren Buffet opined after the market crash of March 2000, you don’t know who is swimming naked until the tide turns. The crash exposed the vast problems inherent with many 401(k) plans caused by:
• Participants who had thought they knew how to pick funds painfully realized that they were chasing hot technology equity funds that did not have real value. In addition there was very little, if any, re-balancing.
• Sponsors which did not have an investment policy statement or a process to monitor the funds
• Advisors/Brokers not experienced in the corporate retirement arena who left sponsors and participants to fend for themselves.
In addition, many providers loaded plans with expensive proprietary funds to pay the advisor and help lower administrative fees which sponsors were reluctant to pay. Insurance companies’ ability to charge wrap fees on variable annuities (which can be changed on the plan level) did drastically increase the fees that participants paid and significantly lowered returns. Today, in an era of single digit returns, expense ratios of 250-400 basis points commonly found in small plans severely hamper participants ill-equipped to beat the market.
But before we throw the baby out with the bath water, remember that all money put into a 401(k) plan is tax deductible and many companies match contributions.
Siedle: Do you believe that participants in plans that have costs of 3% or more have much of a chance of ever building a retirement nest-egg?
Barstein: Participants paying 3% or more asset based fees makes it difficult to envision significant growth of assets. Put another way, any significant reduction in fees substantially increases that amount of money participants will have when they retire. With only 20% of actively managed funds beating their index, you have to wonder if high priced mutual funds still make sense in 401(k) plans especially if participants are ill-equipped to make good decisions. Indexed funds, ETF’s and managed accounts all with lower fees seem to be more logical. There’s a systemic change that needs to happen but it will only be driven by proactive sponsors.
Siedle: A friend of mine who served as an expert witness in a lawsuit brought against a 401k plan sponsor came away from the experience convinced that any sponsor who did not include a low cost index fund as an investment option was asking to get sued.
Siedle: Do you believe that marketing practices of many high cost managers, which have recently come under fire from regulators, are a factor in explaining why so many plans have high cost, poor performing managers? I mean, higher fee managers generally pay finder's fees and enter into revenue sharing agreements with brokers to incentivize them to sell their funds. Doesn't that explain why lower cost alternatives are often conspicuously absent?
Barstein: The interesting fact about the broker sold 401(k) market is that only 3% of registered representatives have meaningful experience in the corporate retirement market yet 80% of all plans are sold by “blind squirrels” with little or no experience. Of those plans with more than $5 million in assets sold by a broker, only two thirds even receive service from that broker. These factors put a lot of pressure on providers who have to include higher priced load funds to pay the broker but also incur more costs in selling and servicing abandoned plans. While providers would prefer to deal with experienced retirement brokers who service the plan and have significantly higher satisfaction and retention levels than the norm, providers cannot ignore 80% of all sales opportunities. Again, sponsors have to be more careful about the broker they hire and should stay away from the “brother-in-law syndrome” where plans are placed with brokers because of personal or business relationships.
Siedle: We receive a lot of inquiries from participants in smaller plans that are outraged with the performance of their plans. Do you believe that smaller plans are more likely to be poorly conceived?
Barstein: Smaller plans have less choice and are more likely to hire inexperienced brokers or advisors so their performance will not match larger plans. In addition, they have significantly less buying power than larger plans. With that said, the sponsor can take action to maximize returns including:
• Hire an experienced retirement broker who actually services the plan.
• Get an agreement from the broker on what services they will perform and understand how much they are paid.
• Search for a high quality provider that has competitive pricing and funds.
• Create an investment policy statement.
• Monitor funds quarterly and conduct periodic due diligence to insure
that the provider is keeping up with the market.
• Offering meaningful advice to participants in the form of a proactive
broker who meets with the participants and rebalances the portfolios as opposed to online advice tools which very few participants use, understand or trust.
Siedle: Do you believe most plan sponsors have already or are seeking to re-evaluate their plans in response to the mutual fund scandals? Has there been a noticeable increase in the number of plans searching for or changing their investment managers?
Barstein: There has been a significant increase in the percentage of plan sponsors that are actively searching or thinking of changing over the past two years driven by the scandals and concern about costs and fiduciary liability. In 2003, there was a 20% increase in activity over 2002 and another 35% increase in 2004 across all markets. Plans with less than $1 million were especially active with a 40% increase in 2004 over 2003.
Siedle: Are there any trends in the 401k market that you've seen as of late?
Barstein: The biggest trend is that sponsors’ trust of providers and advisors has been severely tested because of the scandals. Sponsors no longer trust without question that their vendors will protect their interests. More sponsors have become proactive and take steps to make sure that their vendors are actually doing the right thing. Politicians in turn, seeing an opportunity to capitalize n this trend, will introduce legislation and regulations that give sponsors better protection and more power. It took people like Eliot Spitzer not anesthetized by corporate donations to get other politicians and regulators to move but that trend is evident.
Letter (as a member of the Chamber of Commerce) to the President of the U.S. Chamber of Commerce
Thomas Donahue President U.S. Chamber of Commerce 1615 H. Street N.W. Washington, D.C. 20062
January 10, 2005
Dear Mr. Donahue,
As the owner of a company that investigates financial fraud globally, which is a member of the Lake Worth, Florida, Chamber of Commerce, I am disturbed by the highly publicized positions your organization has been taking on matters of corporate governance and corporate wrongdoing.
As I testified before the Senate Banking Committee, it is now abundantly clear that the mutual fund industry has over the past twenty years been skimming from investor funds and using investor monies for its own benefit. Industry practices must change; we are not concerned here with the actions of a “few bad apples.” The efforts of the Attorney General of the State of New York, Eliot Spitzer, brought this wrongdoing to the attention of the American public and the safety of the American public’s investments has been strengthened from his actions. We still have a long way to go nevertheless.
Your organization has openly criticized Mr. Spitzer and is (unbelievably) involved in a lawsuit against the Securities and Exchange Commission regarding mutual fund board governance. Judging from the actions of your organization, I can only conclude that the majority of your membership suffers when enforcement of the nation’s laws is strengthened and when corporate boards are held more accountable for their misdeeds.
The views of the U.S. Chamber of Commerce are not consistent with those of this firm and I believe many responsible business leaders/ owners do not share your organization’s beliefs. Indeed I understand that local Chambers around the country are uncomfortable with many of the extreme positions espoused by the U.S. Chamber.
Leadership involves setting standards of conduct for the greater good of the country. Your organization appears to be more concerned with protecting the interests of unethical businesses than with furthering the interests of firms that uphold the highest commercial standards. If that is the reputation your organization seeks, then congratulations are in order.
Very Truly Yours,
Edward A. H. Siedle President Benchmark Financial Services, Inc.