By Daniel Solin

William Bernstein is one of the most respected financial minds of our time. His book, The Intelligent Asset Allocator, should be read by every investor. In an insightful commentary entitled What the Investment Industry Doesn’t Want You to Know, Bernstein observes that investors “can only positively impact one aspect of investment performance — your allocation of assets among broad asset classes.” Stock picking, mutual-fund picking and market timing are “irrelevant.”

Keep this advice in mind, since it is the primary reason why your 401(k) is probably a “clunker.” Here’s a checklist of others:

1. High costs: Low costs correlate directly to higher returns. The total cost of your plan should not exceed 1.50%. By “total cost,” I mean the expense ratio of mutual funds in the plan, record keeping, custody, administration fees and advisory fees.

2. No investment advice: Advisers to 401(k) plans are well compensated, yet most limit communications with plan participants to “education.” Your adviser should give investment advice. Most advisers won’t because of the potential liability. If the investment options in the plan were in the best interests of plan participants, they wouldn’t have this concern.

3. Revenue-sharing and hidden mark-ups: Brokers and insurance companies typically extract payments from mutual funds that want to be included as investment options. How objective can their advice be if they are receiving these payments? They also mark-up management fees charged by mutual funds. I reviewed a plan that included a Vanguard Target Retirement Fund, which Morningstar reported had an expense ratio of 0.18%. The plan was charged 0.93% for this fund. This difference comes out of your returns.

4. The plan adviser is not a “real” fiduciary: Brokers and insurance companies misuse the term “fiduciary” in describing their obligation to the plan and plan participants. The only real fiduciary is a 3(38) ERISA fiduciary. This kind of fiduciary accepts 100% of the liability for the selection and monitoring of investment options in the plan. I have never seen a 401(k) plan where a broker or insurance company agreed in writing to be a 3(38) ERISA fiduciary. Any other designation of “fiduciary” is meaningless.

5. Retail share classes are in the plan when institutional classes are available: I recently reviewed a plan that had thirteen mutual funds as investment options. All of them were retail shares. Every one of these funds had institutional shares available. What’s the difference between the two share classes? The retail shares have higher management fees. Otherwise, they are exactly the same. The only reason to include retail shares when less expensive institutional shares are available is to increase fees and lower returns. This practice is indefensible.

6. The money market fund has high fees: In many plans, the money market fund is the default where assets are placed if the plan participant does not make another choice. The management fees charged by money market funds can really impact your returns. If the money market fund in your plan has an expense ratio higher than 0.25%, it should not be in the plan.

7. The mutual funds in the plan have high fees: Brokers typically populate fund options with high-cost, actively managed funds (where the fund manager attempts to beat a given benchmark). The fees charged by these funds range from 1.5% to 2% (or more). A blend of comparable index funds has fees under 0.50%. The difference comes right out of your returns.

8. Mutual funds in the plan underperform their benchmark: Most actively managed mutual funds underperform their benchmark index. I looked at a plan where over 70% of the funds failed to equal their benchmark. Why are those funds in the plan when low-cost index funds will equal their benchmark 100% of the time (less low expenses)?

9. Funds drop in and out of the plan: A charade takes place at most companies with 401(k) plans. The investment committee meets periodically with brokers advising the plan to decide which funds will be dropped and which ones will take their place. This makes everyone feel they’re doing something useful, but it’s a useless activity. Past performance is not an indication of future performance. Poor-performing funds may or may not outperform in the future. Stellar-performing funds typically underperform in the following five years. It also ignores a key issue: If the broker really had the expertise to pick superior funds, why is this exercise necessary at all?

10. Many investment options: Many fund options confuse plan participants. Few participants know how to put together a risk-adjusted portfolio in an asset allocation suitable for them. Instead of offering a boatload of funds, your plan should have a limited number of pre-allocated, globally diversified portfolios of stock and bond index funds, ranging from conservative to high risk. Plan participants should fill out a simple asset-allocation questionnaire to determine their risk level. They should then select the portfolio suitable for them. If all 401(k) plans followed this practice, returns would increase significantly.

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