Ask Lynn - This Week’s Column

During the past two Sundays, you’ve read a lot about why 401(k) costs matter. You now understand that your 401(k) isn’t free, but how much is it costing you? Here’s how you can find out:

Do your own price check. Every mutual fund sitting in your 401(k) has its own price tag. You should find out what each one is. Here’s a frame of reference:  Today’s typical retail mutual fund sports an expense ratio of 1.4%. That means, for example, if you’ve got $25,000 invested in an average-priced fund, you’d pay $350 for that investment for the year. Your goal should be to find funds in your 401(k) lineup that cost less than that–if there are any. At the same time, you’ll want to avoid the 401(k) scalpers lurking in your workplace menu.

Paul Yossem, an advisor with Wheeler/Frost Associates, Inc., in San Diego, provided me with a great example of the kind of nasty surprises that can be stinking up your 401(k). Yossem, whose fee-only firm puts together 401(k) plans, was invited by a company in Escondido to evaluate its workplace program.  Yossem determined that the average fund in the company’s 401(k) lineup was 1.80%, which isn’t great. But several funds cost over 2% a year and one hideous option charged 3%, which I think qualifies it for the armed-robbery category.

You can check a fund’s costs by looking at its prospectus, which you can easily obtain by visiting the mutual fund’s web site and downloading it. If you don’t have Internet access, contact your 401(k) provider. You should also be able to obtain key facts about your fund by visiting Morningstar.com. Because funds can offer different share classes, which charge varying fees, you’ll want to make sure you have the right fund ticker symbol.

Locating a fund’s expense ratio won’t necessarily reveal all your charges. You’ll need to look further, for instance, if you invest in a lifestyle fund, which provides a one-stop mix of stocks, bond and cash that’s packaged for conservative, moderate or aggressive investors. Lifestyle funds are often slapped with an extra fee that may range from an additional .25 percent to one percent.  You might not uncover this cost unless you hunt for the footnotes in a prospectus.

You also should check to see if you are paying a wrap fee with plans that are arranged by stockbrokers, commissioned financial advisors and insurance companies.  If you’re unlucky enough to invest in a 401(k) that relies upon an insurance company annuity, you will certainly be paying more than just the expenses for the mutual funds, which are called sub accounts in annuity lingo.  In some 401(k) group annuity plans, Yossem has uncovered expenses that have reached as high as five percent! I gasped when he told me that.

You should, by the way, be just as price conscious if you’re investing in a 403(b) plan, which is the type of account that teachers use. Educators enjoy one advantage over the working stiffs that are chaffing at their employers’ ragtag 401(k) lineups. Teachers aren’t locked into one 403(b) provider.  They are free to find a 403(b) on their own, but this responsibility comes with its own perils.  Despite the ability to choose lower cost plans, millions of teachers select those pesky variable annuities with their high fees, unnecessary insurance charges and generally miserable returns.  Teachers get stuck with these dogs because they trust the salesmen, who corner them in the faculty lounge or finagle an invitation to their homes.  The lower cost options, such as those provided by Vanguard Group, T. Rowe Price, TIAA-CREF and Fidelity Investments, don’t dispatch people to schools to drum up business. Enterprising teachers must contact these firms by telephone.

Take a hike. What happens if your 401(k) is grotesquely expensive?  You may want to consider bailing from your 401(k) after you’ve sunk in enough cash to secure your employer’s yearly matching contribution. An excellent alternative is an Individual Retirement Account. For almost everyone, the best IRA choice will be a Roth IRA. If you are at least 50, you’re free to contribute up to $5,000 into an IRA this year. Younger investors can chip in $4,000. If you can afford to kick in even more money after maxing out an IRA, I’d recommend putting the rest of your cash in low-cost, tax-efficient mutual funds in a taxable account.

Of course, you’ll be in worse shape financially if you stop your 401(k) contributions and never bother feeding your backup IRA. To prevent this nightmare from happening, here’s a better alternative:  Before you cut back or eliminate 401(k) contributions, make sure you’ve set up an automatic deposit feature for your IRA.  You can have money taken out of your savings or checking account on the same day every month.

Scatter your money. Of course, costs aren’t the only reason you need to remain alert. Too many employees think that they’re investment geniuses if they’ve divided their money amongst a handful of mutual funds. But they may or may not diversified. You won’t know unless you understand what the investment mission is of each of your mutual funds. Once again, you can turn to the prospectus or Morningstar to investigate a fund’s mission.

Ultimately, what you want to own is a basket of investments that includes the major investing categories. A typical investor should own funds that invest in large-cap stocks, small-cap stocks, foreign stocks and a bond fund. And if they are low cost, all the better.

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Last week, I asked readers if they knew how much their 401(k) plan is costing them. Since then, I’ve heard from irate readers, who suspect that they’re being ripped off. So far, however, only one guy, who has contacted me, thinks he’s pinpointed how much he’s paying.

During the past 16 months, this reader figures he’s paid close to $7,000 in 401(k) fees. When he complained to his company about what he considered to be a bloated tab, here’s the response he got: “Suck it up. There is nothing you can do about it.”

In one respect, this candidate for employer of the year is right. In the 401(k) arena, workers are about as powerful as a bunch of kindergartners storming Chuck E. Cheese. Employees don’t get to select the mutual funds that end up in their 401(k) menu and they don’t have a say in what their workplace retirement plans cost them. While the employer holds all the aces, it’s the voiceless workers, who have the most at stake.

And that’s why it’s infuriating when stuff like this happens all too frequently: A boss chooses his old college roommate, who is a stockbroker, to put together a 401(k) plan for his firm or replace an existing one. The lucky broker is careful to only choose mutual funds that will, in turn, reward him financially. Some of these guys can make tens of thousands of dollars, and in some cases hundreds of thousands of dollars, a year for pretty much being in the right places at the right times. And it’s the workers who are picking up the tab. Every time they sink money into their 401(k) mutual funds, the worker’s investment returns are eroded by higher fees that are assessed, in part, to cover the broker’s reward plan.

So what does the broker have to do to justify his windfall? In some cases not much. Even if the broker does little more than annually entertain the firm’s owner with dinner and a round of golf, he’ll continue to be paid handsomely year after year.

Employers, however, can’t immunize themselves from completely botching their 401(k) responsibilities. Employers, both big and small, are supposed to be following the Employee Retirement Income Security Act of 1974, better known as ERISA, that mandates that they act as fiduciaries for their workers’ retirement money. One of ERISA’s requirements is that every employer with a 401(k) plan must establish a prudent management process to oversee their retirement plan providers. And that means they have to know what the heck is going on in plain sight and under the table.

As part of this oversight duty, an employer needs to know what the retirement plan is costing and where the money is going. In my lucky broker example, it’s highly doubtful that the boss understands how much his 401(k) point man is pocketing from the fund fees versus what his expenses are. And this same lack of knowledge can be true for much larger companies that depend upon major 401(k) players such as Fidelity Investments, Vanguard Group, T. Rowe Price, Merrill Lynch, Principal Financial Group and Hartford to run their plans.

What a workplace should be doing is monitoring how much cash is being generated for 401(k) expenses and where it is going. Companies should also compare how the costs and the services stack up to other 401(k) vendors. When companies aren’t vigilant, it’s more likely that workers will be gouged. “A missing prudent management process will almost always lead to excessive costs,” observes Ronald E. Hagan, chief executive officer at Roland/Criss Fiduciary Services in Dallas, which advises workplaces on their fiduciary responsibilities.

What is an unreasonable cost? It depends upon how big a workplace plan is. If a company has less than $1 million in assets the costs are going to be much higher than for employees who work at a place that has at least $10 million in the 401(k) kitty. Little plans are often stuck with insurance company providers, which typically assess among the stiffest fees.

With insurance plans, the mutual funds and/or variable annuities will typically be expensive and they will often be slapped with dubious wrap fees. Most 401(k) annuities will also stick investors with onerous mortality insurance fees, which are unnecessary. Companies should be looking for alternatives as soon as the plan acquires $1 million in assets, suggests Hal R. Schweiger, a fee-only advisor at Capital Financial Advisors, LLC in La Jolla, which puts together 401(k) plans. Actually, companies of any size should be seeking bids from 401(k) vendors every three years or so in an attempt to lower costs and obtain better services.

If you’re feeling helpless right about now, here is something you can do: Ask your company if it has documented your plan’s fees and costs. Chances are it won’t know and that’s partly because of a phenomenon I wrote about earlier called revenue sharing. Outside 401(k) administrators and commission-based financial advisors often pick mutual funds for a workplace menu that includes 12b-1 fees that originally were supposed to be used by funds for marketing. In the 401(k) universe, the funds use this cash to pay the 401(k) administrator or plan advisor for picking it. Of course, you don’t have to be a cynic to ask if the funds being selected are the best of show or simply the ones with the deepest pockets.

Typically, the administrator uses at least some of this money to cover such costs as the bookkeeping responsibility. But as the assets in a 401(k) plan grow over the years, few employers ever ask if this revenue sharing has gone beyond paying the basic expenses and mushroomed into a huge cash cow for the administrator. This can happen since expenses like bookkeeping and maintaining a toll-free number are pretty much fixed costs, or vary by number of employees not by the dollars in the account. The revenue sharing money, however, can continue mushrooming thanks to stock market gains and workers’ weekly contributions.

While it’s standard practice, workplace retirement plans don’t need to rely upon revenue sharing to pay costs. Companies can use low-cost mutual funds for their employees that don’t generate revenue-sharing cash. When going that route, employers can pick up the tab for administrative costs or pass them along to their employees. The big 401(k) players can set up these types of plans, as can fee-only investment advisory firms that routinely make sure all expenses are transparent.

For employers who blow off ERISA, here’s something that might get their attention: Dozens of lawsuits have been filed against employers for failing to live up to their 401(k) responsibilities. CEOs might assume that it’s the outside 401(k) administrators that risk getting clobbered in court, but they are wrong. The targets of these employee lawsuits, which should continue to multiply, are the workplaces and their executive officers. Gulp.

Next week: One more week on 401(k)’s.

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Last week, my column probably prompted many readers to panic when I asked a simple question: Do you know how much your mutual funds cost? I should have mentioned that this is a two-part quiz. And here’s the second question: How much are you paying for your 401(k)?

I’ve already guessed what the two most common answers will be. It’s either:

A) I have no idea. Or B) Isn’t my 401(k) free?

If I had a red Sharpie in my hand, I’d mark both answers wrong. If you’ve got a workplace account, your chances of picking up the tab for your 401(k) is as likely as tomorrow’s rush hour. What’s more, the costs can be far higher than the cost of a closet full of office supplies.

Those who read last week’s column will already appreciate why so many people remain unaware that their 401(k) is a parking meter that must be fed. When you invest in mutual funds at your workplace or on your own, you never receive a bill—the money is automatically taken out of your accounts. If you did receive an invoice, you’d be more likely to decide whether a fund with platinum expenses and leaden returns should be tossed.

It’s understandable that people never ask about 401(k) costs, but what’s inexcusable are the thousands of employers, who are just as complacent. In fact, even the most well intentioned companies won’t necessarily know what the costs are of their employees’ retirement plans. I observed this phenomenon first hand while I was at a corporate Christmas party a few years ago. During a conversation with the human resources director, I asked her about the employees’ 401(k) expenses. At first she looked perplexed by the question before she assured me that the workers didn’t pay anything. Yikes, I’m thinking to myself as I tried not to choke on my chardonnay. How would she know if her employees were overpaying when she wasn’t even aware that they paid anything at all?

What’s alarming about corporate ignorance and/or indifference is this: With increasing numbers of companies shamefully ditching their pension plans, the 401(k) has become a financial firewall for many workers. If the firewall doesn’t hold, millions of employees could be forced to work far into their retirement years or live on peanut butter crackers. And unfortunately, workers can’t go out and find a better 401(k) if the investment choices in their corporate plan stinks. They can only hope that their superiors will select topnotch mutual funds with low costs for their retirement plans.

But here’s where things get really perverse. Companies are often far more motivated to sign off on plans that offer mutual funds or annuities with bloated fees that employees must shoulder. Why? Because these expensive investment choices generate so much excess cash for the outside firms overseeing these 401(k) plans that workplaces have to kick in little or no money for the administration. When companies are told they can pay for a variety of 401(k) costs or leave it to their employees, they tend to choose the latter without asking many questions.

The way that much of corporate America operates their 401(k) programs is more than just a shame. It’s possible that some of them are breaking federal law. Last month, Schlichter Bogard & Denton, a law firm in St. Louis, filed lawsuits against seven of the nation’s biggest corporations that allege their workers were charged millions of dollars in excessive 401(k) fees. At the same time, New York state’s Attorney General Eliot Spitzer is reportedly close to reaching a settlement with a major insurance company that sells and oversees 401(k) programs, for taking undisclosed fees to promote certain mutual funds for a retirement fund for teachers.

What potential transgressions have attracted the interest of prosecutors and trial lawyers? A common 401(k) industry practice called revenue sharing is what’s drawing fire. If you have a weird line up of expensive and mediocre mutual funds in your 401(k), the culprit could be revenue sharing. To understand what revenue sharing is, you have to appreciate how 401(k) plans are put together. Some guy in your human resources department didn’t dream up your 401(k) menu. Nor does anybody in your company manage the plan. What typically happens is that a company selects a vendor to pull together a plan and then maintain it. The outside administrators include many of the nation’s most recognizable mutual fund companies and brokerage firms, along with major insurance companies.

In pulling a plan together, the vendor often picks mutual funds that charge investors a 12b-1 fee, which I talked about in last week’s column. The 12b-1 fee was created more than 25 years ago to allow small mutual funds to generate money to advertise their existence. Today this pernicious fee is popping up everywhere, including 401(k) plans. Here’s a common scenario: The outside administrator will select more costly mutual funds with 12b-1 fees for a workplace 401(k) menu. In return, the anointed mutual funds will use their 12b-1 cash to, in essence, thank the administrator for picking it for a company’s 401(k) lineup. Can everyone see the potential conflict of interest in these arrangements? With this undocumented 12b-1 windfall, the administrator can oversee the plan without billing the workplace for its services. That’s the part many employers like.

But operating a 401(k) with hidden payments—and no accountability–should be unacceptable. In fact, the federal Employee Retirement Income Security Act, which oversees workplace retirement plans, requires that 401(k) fees be reasonable and fully disclosed. If the boss doesn’t know who is getting what, how will he be able to say he’s complying with this law? That’s a question that I bet more trial attorneys are going to be asking soon.

Next week: More on 401(k)’s.

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