Ask Lynn - This Week’s Column

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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Can you remember the last time you received a bill for your mutual funds? Think hard. Maybe you paid it when you wrote the check for the cable company and your credit cards. Or perhaps, the invoice is still stashed in your stack of bills.

Actually, don’t bother looking for it because you never received one. The fund companies automatically pull the cash out of your accounts to pay for your access. In fact, you pay the mutual fund managers about as frequently as you reimburse Visa or MasterCard.

The frequency isn’t what should gnaw at you. It’s the enormity of your price tag that should deserve as much of your attention as a case of untreated gallstones. Many investors are blithely sitting on a portfolio of expensive funds because they don’t know they’re being gouged. Surely shoppers who are patient enough to stand in a long line at Costco to save a few bucks on 48 rolls of toilet paper would be furious if they realized they were ponying up hundreds or even thousands of extra dollars for their mutual funds.

Unfortunately, the mutual fund industry long ago mastered the art of stealth fees by throwing Harry Potter’s cloak of invisibility over the entire affair. Consumer advocates, over the years, have clamored for personalized account statements that pinpoint what each of us pay for the privilege of being fund investors each year. The fund industry, however, has routinely squashed the idea. Obviously, if we don’t know what we’re paying, we lose the motivation to find better deals.

The closest thing to a fee disclosure can be found in each fund’s yearly prospectus. In this document, you’ll find a chart that projects what the costs would be for a hypothetical investor. Hardly anybody reads this ponderous handout and even if they did, it only provides an example. I wouldn’t be alarmed at Donald Trump’s credit card bill because I don’t have to pay it. I’m only interested in what my bill is.

If you don’t know if your fund company has shaken you down, make this the day you find out. It isn’t hard to do. What you want to obtain for each of your funds is something called the expense ratio. You can locate this number in the prospectus or you can call up the fund company or the advisor who convinced you to buy shares. Perhaps the easiest way to get this expense ratio is to visit Morningstar.com. Type in the name of your fund in its search engine and once it appears on the screen, click on the “Fees & Expenses” link.

This ratio tells you what percentage of your account is being siphoned out for expenses each year. For example, if you have $50,000 in a fund that maintains a 2% expense ratio, your tab for the year would be $1,000. A $500,000 retirement nest egg that’s invested in the same fund would be $10,000. It’s these sorts of number that will make the time you spend chasing toilet paper discounts look pretty inconsequential.

So what’s expensive? The average fund expense ratio, according to Morningstar, is 1.35%. Admittedly, that percentage standing by its lonesome isn’t going to look draconian. That’s especially true for those of us paying sales tax of 7.75% every time we pull out our wallets. But over time, your returns will erode dramatically even if you stick with average priced funds, much less the expensive ones.

Suppose, for example, that you invested $25,000 in a fund for retirement that charges the average rate and you hang on for 30 years. Assuming an 8% return, you’d end up with $167,326. The total cost of holding this average priced fund would be $31,720 in fees and $52,519 in foregone earnings. In contrast, if you sunk the cash in an index fund that charges .2%, you’d walk away three decades later with $236,902. You’d pay $5,880 in fees and $8,784 in lost earnings. Which one would you rather own?

When examining a fund’s costs, you should also check for a fee that I find particularly galling that’s embedded in the expense ratio. It’s called the 12b-1. The U.S. Securities and Exchange Commission signed off on this fee more than a quarter century ago to help struggling mutual funds attract investors through marketing. In theory, funds with all this extra cash could publicize their great track records and bring more investors into the fold. As they grew, these funds could become more efficient, cut their costs to investors and ditch their 12b-1 training wheels. Unfortunately, that didn’t happen.

Instead an increasing number of mutual funds began tacking on 12b-1 fees. In fact, today a stunning 12,366 mutual funds out of 18,914 have embraced these fees. Much of this money is no longer going to buy glossy brochures or other marketing materials. Instead, the fund companies use their windfalls to compensate brokers and investment advisors for recommending them to their clients. Because these fees technically aren’t a sale charge, a broker can tell his client that he’s recommending a fund that doesn’t charge a sales commission. The investor mistakenly thinks he’s gotten a fund for free and the broker gets to pocket a chunk of the 12b-1 cash. Now suppose, a broker recommends a fund with a 12b-1 fee, you buy it and then never see the guy again. The broker will continue to be reimbursed for advice — whether or not it was any good — for as long as you own the fund.

You don’t have to rely upon a stockbroker, however, to become entangled with 12b-1 fees. If you can buy these funds through discount brokerage supermarkets, such as the ones offered by Charles Schwab and Fidelity Investments. Typically, the funds that don’t charge a transaction fee when purchased are the ones that pass along the 12b-1 fee. The fund companies use their 12b-1 money to compensate the brokerage firms for giving them shelf space. Once again, investors think they are getting something for free, but they aren’t.

Even if you don’t rely upon a stockbroker, you could still get entangled with 12b-1 fees. Plenty of funds, which are offered through discount brokerage supermarkets, such as Charles Schwab and Fidelity Investments, contain 12b-1 fees. The fund companies use their 12b-1 cash to compensate the brokerage firms for giving them shelf space.

What’s the lesson in all this? Finding out what your funds cost is not only critical, it can also be an empowering exercise. That’s because costs are the one thing that you can control as an investor. While you may devote many hours to picking the right mutual funds for your portfolio, they could turn out to be turkeys. If instead more people paid attention to costs, fund prices would surely drop and that would benefit everybody. “The industry,” says Roy Weitz, the publisher of FundAlarm, free online mutual fund newsletter, “ takes advantage of the fact that people don’t pay attention to their pennies.”

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It’s just a hunch, but I’d bet that just about everybody who is reading this column today worries too much about their investments.

Sooooooo, let’s take a break. Stop thinking about the stock that you bought, which now stinks worse than the trash sitting out at the curb. And erase any thoughts of those mutual funds that have you ripping apart Alka-Seltzer packets.

Forget all about that bad investing karma for a moment. Instead, fill your diaphragm with a long cleansing breath. If I remember correctly, that’s the kind of breath a pregnant woman is supposed to take when she’s in the delivery room and it feels like she’s about to give birth to a side-by-side refrigerator. Okay, so maybe those don’t work.

My attempt at beginning a column with a Zen moment, however, comes from a good place. Study after study has shown that Americans obsess about their money. The obsession leads to questionable decisions, which leads to bad financial results, which leads to a partridge in a pear tree. Just kidding about the last part.

Actually, our irrational approach to investing tends to make us antsy. And that’s never a good place to be if you’re an investor. In fact, if you find it appalling that more than half of marriages in this country implode, check out how disloyal we are to our investments. According to a recent study by Dalbar, Inc., a financial markets research firm in Boston, the average investor holds onto a stock mutual fund for a measly 3.3 years. What’s even more surprising is the fickleness of the typical bond enthusiast, who we may think of as a rock-ribbed conservative investor, who greets any hint of change with furrowed eyebrows and a disgusted harrumph. These guys are dumping their bond funds after just 2.6 years.

Where does all this disloyalty get us? Not anywhere near the finish line. Our impatience, and some would say greed, actually eviscerates our performance returns. And I do mean eviscerate: picture a freshly caught trout that’s been reeled out of a lake and gutted for a barbecue. That could be your portfolio burning on the grill.

But don’t believe me. Instead take a gander at Dalbar’s depressing calculations. During the 20 years ending in 2006, the Standard & Poor’s 500 Index generated an annualized return of 11.8%. But look what kind of performance the typical investors were stuck with during this period. Their average annual return was a mere 4.3%. Gulp. And the figures are just as bleak for our fixed-income friends. In the same time frame, the Lehman Brothers Long-Term Government Bond Index produced an amazing 8.6% annualized return. Our stalwart bond investors, however, only eked out an average yearly return of 1.7%.

Sure, these are stunning performance gaps, but you don’t need a statistician to explain them. Understanding human nature is all that’s necessary. Plenty of people sabotage their portfolios because they only want them stuffed with gold medals. When investors discover a hot mutual fund or stock that’s generated breathless press clippings, many can’t resist the temptation to buy it. Right now! And they dump the funds that they consider worse than pound dogs.

Human nature, however, rarely appreciates the realities of financial cycles. The best way to describe the typical financial cycle is this way: What goes up, must come down. Yes, there are times when blue chip stocks perform fabulously. So do U.S. Treasuries, small company stocks, gold, foreign stocks and asset classes you may not even know existed, such as emerging-market debt and inflation-indexed bonds. But eventually the helium leeks out the balloon and any gravity-defying investment will fall to the pavement. Americans’ investment returns are typically mediocre because they buy high–when the hype is irresistible–and they sell low–when the performance stats have returned to sea level or worse. Obviously, this is a terrible investment strategy.

Our Keystone Kop investors aren’t messing up their portfolios single handedly. They’ve got accomplices handing them banana peels. In a police lineup, the guilty parties would be easy to spot. Among them are the media and the mutual-fund industry. Rather than encouraging people to invest responsibly, the fund industry cynically takes advantage of people’s dreams of becoming fabulously wealthy. They will launch new small-cap value funds or junk bonds, for instance, right when these asset classes appear ready to peak. People scramble on board during the final hairpin curve of the roller coaster ride that’s headed straight down.

What’s a better solution? For starters, you shouldn’t invest in the market if you can’t stay put for at least five years. Professionals will quibble about this number–some will suggest a longer time frame–but suffice it to say you need a time horizon of many years before you invest in the stock market. With time on your side, you should be able to better absorb the market’s ups and downs.

You should also ignore the hype blasting from CNBC, financial-talk radio and investing magazines, as well as from stock analysts and fund companies. If you can resist a child’s whining at the grocery store, this shouldn’t be too hard. Instead, diversify. While paying attention to your time horizon, investment goals and risk tolerance, you should spread your money across the main asset classes. Someone with a long time horizon, for instance, may want to invest in large and small domestic company stocks, foreign stocks and some high quality short or intermediate-term bonds. Preferably you will do this through low-cost index mutual funds.

The main goal of diversifying is to cut your risk by investing across the broad market. When your small-cap fund is doing well, for instance, your foreign stock and bond funds may be lagging. A year later, the roles might be reversed. But by spreading your money across the major asset classes rather than scooping up the fire crackers, you won’t have to anxiously check on your investments every day, or week or month. A couple of times a year should be plenty. And with a more balanced approach to investing, you will no longer go to sleep at night with the equivalent of a loaded gun hidden under your pillow.

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As students return to their college campuses this month, I’m sure it will never occur to them that getting stuck in the slowest line at the campus bookstore or eating dorm food that tastes as if it were prepared by Chef Boy-R-Dee are trifling annoyances compared to a potential danger that stalks them upon their arrival.

Every autumn, marketers stack tables with cheap bling on campus quads and wait for the kids to show up. To snag a free t-shirt, towel or maybe even a sandwich, a student simply has to fill out an application. Once signed, the kids walk away with a t-shirt made in China and their first credit cards. It’s right here that you could insert an analogy about lambs and lions or babes and woods.

Young adults surely spend little or no time contemplating the sort of powers that their new pieces of plastic holds. What’s particularly disquieting about this rite of financial passage is this reality: By the time the typical American teenager turns 18, he or she has seen more than 10 million ads. Combine young adults’ easy credit with their craving to be “merchants of cool,” a term used by a PBS documentary, and you’ve got the ingredient for a perfect credit storm. MySpace, Facebook and iPods will someday turn into quaint artifacts, but credit card debt will remain evergreen and ever a nuisance.

Debb Thorne, an assistant professor of sociology at Ohio University, who teaches an aptly named class called, Bling, Bling Blues, appreciates that many students spend more time reading a Chinese takeout menu than they do perusing a credit card contract. “The students are completely ignorant of the terms of contracts that they sign,” says Thorne, who has had several of her upperclassmen tell her that credit-card debt forced them into bankruptcy. “Almost without exception, they have no idea what the APR is and they have never hear of universal default. They are shocked when they learn that a cash advance costs them more in interest than a card purchase.”

I suspect that young adults are more likely to get mired in credit quick sand because they get introduced to temptation sooner. When I was in college, card issuers were as likely to hand a credit card to somebody like me, who was making minimum wage working in the student union cafeteria, as a guy doing 25 years to life for armed robbery. Even after graduating from the University of Missouri debt free with a full-time newspaper job, I discovered that obtaining a credit card was nearly impossible. My father, commiserating with me after hearing of my serial rejections — even Sears snubbed me! — cosigned for a MasterCard at his bank.

What young adults don’t realize is that treating their credit card as a plaything can sabotage their financial lives. An increasing number of employers are pulling the credit reports on college graduates, who are seeking jobs. If they spot too much debt or a history of late payments on a credit report, a prospect, who aced her job interview, might never know how she lost out. Lackluster credit scores will also prevent a college grad, or anyone else, from getting the most favorable interest rates when buying a car or home loan.

Thorne, who is a regular contributor on CreditSlips.org, an academic web site devoted to credit issues, says her students are furious when they learn how the industry jerks them around. For example, if a cardholder doesn’t pay his bill on time, the issuer can hit him with a late fee and raise his interest rate. But that’s not all. Other creditors, who are getting paid promptly, could also penalize the kid with a much higher interest rate. Imagine if schools adopted this universal default provision. If a kid got a “D” in calculus,” his other teachers could pile on and automatically give him the same grade.

How can college students handle credit responsibly? Thorne makes these recommendations:

* Unless it’s an absolute necessity, wait until you’re a senior to get a credit card. You won’t need a credit history until then.

* Get a card through a credit union, which often has more reasonable rates or through the financial institution where you have a checking and/or savings account.

* Obtain a card with the lowest credit limit possible. What’s more, tell the issuer that you don’t want the credit limit ever raised without your permission.

* Pay the bill as soon as it arrives.

* If you leave campus over the summer, make sure your card issuer sends the bill to your new address. If bills pile up over the summer, you’ll face a huge financial mess when you return to school.

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I begin each morning–whether I want to or not–at La Mesa’s dog park. Once the kids are out the door, Minerva, our golden retriever, knows that it’s her turn to chase tennis balls, wrestle with her pals and, if she’d like, hunt gophers.

The canine park regulars that Minerva hangs with may not be as indulged as Paris Hilton’s teacup Chihuahua, but they are a lucky bunch. One owner scrambles eggs for her Siberian Huskie every day. A hair stylist brings brushes to fluff the fur of any dog that sidle up to her. Many of the pooches enjoying the sunshine had been liberated from the pound.

But what happens, one park regular wondered the other day, if a dog loses its owner? It’s a question worth exploring since tens of millions of dogs and cats belong to somebody. The sad fact is that every year, more than 500,000 dogs and cats are euthanized at shelters in this country because their owners died.

In the media, you will occasionally hear or read about extravagant examples of post-mortem pet indulgences. Dusty Springfield, the singer, allegedly left behind instructions that her cat’s bed be lined with her nightgown and her recordings were to be played at the felines bedtime. Doris Duke, the tobacco heiress, whose ancestors started Duke University, left six figures to her dog. And the actress who played Lovey on Gilligan’s Island apparently instructed that all fortune be given to her pooches.

But what, realistically, can typical pet lovers do to insure that their rambunctious Labrador mix or furry Siamese princess doesn’t get dumped at the nearest shelter if tragedy strikes.

What you shouldn’t do is leave money or property to a pet in a will, advises Mary Randolph, an attorney and the author of Every Dog’s Legal Guide: A Must-Have Book for Your Owner, 6th edition (Nolo, Sept., 2007). Randolph recalls a case of an elderly California woman, who split all her possessions between her dog Roxy and a close friend. The woman’s niece essentially argued that Roxy couldn’t inherit a Milk-Bone, much less a bank account and the California Supreme Court agreed with her. The niece received half the estate even though her aunt had specifically stipulated that she didn’t want her relative getting her paws on the money.

What worked against Roxy was what some may consider an irritating legality: a dog is a piece of property. And one piece of property can’t inherit another. Try imagining a Honda Accord inheriting a diamond engagement ring. As a practical matter, you also couldn’t expect a standard poodle, who inherits money, to open up a checking account or monitor its investments online. When someone does leave IBM stock, municipal bonds or a stack of certificate of deposits to a pet via a will, the well-meaning move will backfire. The assets often end up with whoever is designated as the will’s “residuary beneficiary.” That refers to the person who gets everything not specifically left to others in the document.

There are other ways, however, that pet lovers can care for their animals after their own deaths. The most simple way is to ask someone who you trust if he or she would adopt your orphaned dog. If a friend or relative agrees, you could make your decision more official by including it in your will. You can make the same designation in a revocable living trust. In either case, you may also want to include a backup person if your original choice ultimately wiggles out of the obligation or simply can’t do it.

Because you are saddling a would-be guardian with a big responsibility–imagine someone else putting up with your dog’s chewing or digging issues–ideally you should throw some money in the pot to sweeten the deal. “If you trust them with the animal, hopefully you can trust them with the money as well,” Randolph says. It’s best to leave the money through a will or revocable living trust even if the pet’s new owner doesn’t need the money. “A dog who arrives with a full dinner dish, is likely to be more welcome than one who is on the dole.”

Establishing a pet trust is another alternative. If someone had walked into a probate court with a pet trust not all that long ago, he or she would have been laughed out of the building. But the National Conference of Commissioners on Uniform State Laws, which provides model laws for states, examined the issue of pet trusts in 1990 and said, “Why not?” Today at least 30 states, including California, New York, Florida, Texas and Michigan, allow them. With one of these trusts, you leave money or property for the pet and you designate someone else, called a trustee, to manage and spend it. Most people aren’t going to need one of these, but those who are interested may want to visit the web site of 2nd Chance 4 Pets, which is a nonprofit in Los Gatos, CA., which works to protect pet orphans and promote lifetime care for pets.

As a precaution, pet owners should also carry an animal card in his or her wallet. On the slip of paper, you should write the pet’s name, its location, special care instructions (i.e. the animal requires medicine) and the contact information of someone who could care for the animal at least temporarily if you become incapacitated.

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