The Sleazy Side of 401(k) Plans

US News

Most 401(k) plans are fraught with conflicts of interest and plagued with expensive, actively managed funds that typically underperform comparable index funds over the long term. Many funds included as investment options in these plans fork over revenue-sharing payments to brokers, advisors and record keepers as the price of admission. There is neither the appearance nor the reality of selecting funds that are genuinely in the best interest of plan participants.

While all this is bad enough, it gets much worse. A comprehensive study by three finance professors, aptly titled "It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans," exposes yet another conflict of interest negatively affecting the returns of hapless employees. The study investigated whether mutual fund families acting as trustees of 401(k) plans displayed favoritism toward their own funds. The conclusion is obvious: They did.

Initially, you have to wonder about the judgment of plan sponsors who permit mutual fund families to serve as trustees of 401(k) plans. This is akin to having the fox guard the hen house. How likely is it that these "trustees" will conduct a thorough and objective analysis of investment options and determine that funds managed by unrelated fund families should have a prominent presence? Clearly, there is a conflict of interest between the obligations of the trustee to select "suitable" investments for the plan and its economic interest in profiting from the inclusion of its own proprietary funds.

Sometimes plan sponsors and mutual fund trustees engage in an elaborate and useless ritual. Initially, funds are placed in the plan based on the recommendations of the trustee. Periodic meetings are subsequently held between the trustee and the investment committee of the plan to determine which funds should be added and which ones should be dropped. Stellar performers are added. Under-performers are dropped. These decisions are almost always made based on past performance, even though the Securities and Exchange Commission cautions that past performance is not predictive of future returns.

The study found an interesting exception to this process. Instead of the initial selection being based solely on favorable past performance, mutual fund trustees were "substantially more likely" to add their own funds to the menu of investment options, notwithstanding "lower prior performance than non-trustee additions." Mutual fund trustees were also more reluctant to drop affiliated funds from the menu, despite poor performance after they were added.

The self-serving decisions of these mutual fund trustees had a significant adverse impact on the returns of plan participants. The study found that participants were not sensitive to the poor performance of affiliated funds and "thus do not undo the trustee bias." The study also found that trustee funds that rank poorly based on past performance and were not removed from the menu of plan options "do not perform well in the subsequent year."

The impact on participants investing in these funds is staggering. The study found that participants investing in them generated subsequent abnormally negative returns of 2.9 to 3.6 percent per year. The study concludes that trustee bias "has important implications for the employees' income in retirement."

Given these findings, plan sponsors who appoint mutual fund families as trustees would appear to be at greater risk of lawsuits by participants for breach of their fiduciary duty. Perhaps the fear of liability will fundamentally change our flawed 401(k) system. It's obvious that Congress is no match for the powerful securities lobby.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.



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