Whether a corporate 401(k) plan or an educational 403(b) plan, these plans include high fees, bad funds, and little prospects for the investor to put money away in a sensible and low-cost fashion for retirement.
No small amount of effort is required to invest using “workarounds,” to avoid the problems of bad funds, high costs and poor choices in these plans.
Therefore, I've put together a post which could I hope be useful to investors faced with bad investment choices in a tax deferred plan. It could be used to help form a letter, suited to particular circumstances, to convince management to offer better and less expensive fund choices, and to make other plan expenses transparent to employees. It could also be used to generate a fact sheet, with an appendix of news articles on 401k plan fees, to leave with an "HR person" after you've had a talk about the company plan.
I am very hopeful that posters here, more knowledgeable than I, will chime in with suggestions and revisions.
The argument can be made that employees should be responsible for the administrative costs of tax deferred plans, if employers decide not to make paying that a benefit. That said, I think employees have a perfect right to demand transparency, that fees and expenses should be clearly stated, and that at least two or three low-cost, preferably index, funds should be available.
While there have been lawsuits filed over plan fees, and noises made in Congress about fees, it’s more than likely that little will happen.
The two key concepts for investors are these: One, that tax deferred investing is a very long-term proposition, and that costs matter, because every small cost compounds over long periods to sizeable amounts of money at retirement. And second, that even a few decent choices in a tax deferred plan can help the employee out.
I think for a bad plan, simply adding the “big three” could make a difference: Total Stock Market, Total International and Total Bond. With a short bond index and Tips also included, the plan would be excellent.
I am not trying to start an argument over lumpers vs. splitters (total markets investing versus slice and dice value investing), or to debate the perfect tax deferred plan. The idea is with several additions to a bad plan, employees would be able to save and invest appropriately.
Sample Letter on Company Tax Deferred Plan
Dear (company plan administrator):
I am appreciative of the company’s providing a tax deferred plan to help employees prepare for retirement by long-term investing.
However, after studying the investments available in the plan, I am concerned that there are few options for employees who wish to invest efficiently for the long-term.
Most, if not all, of the fund choices in the company tax deferred plan are high cost actively managed funds which will not do the job of retirement investing. Over long periods of time, fees of one and two percent will add up, through compounding, to very large sums of money at retirement.
Because many employees are counting on this plan to see them through a lengthy retirement, I believe the company has a fiduciary duty to provide adequate fund investments.
That fiduciary duty could be easily met by the addition of just a few index funds to the company plan. Such funds are available from Vanguard, such as Total Stock Market, Total International, and Total Bond Market. Fidelity also offers such funds at a low cost, with its Spartan index funds.
Given the number of lawsuits that have been filed over the issue of fund expenses in 401k plans, and recent Congressional hearings, I believe further that the company could insulate itself from legal problems by offering funds that resembled the Federal Thrift Savings Plan, which includes just a few lost-cost funds.
That this would be an excellent benefit to employees is not just my opinion, but has been stated very succinctly by Warren Buffett:
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
--Warren Buffett
Berkshire Hathaway Annual Letter, 1996
Buffett’s advice is in line with the great majority of those academics who study the market, that actively managed funds cannot beat the market average, and in fact, run several points, at least, behind the market. In is also in line with the 1992 restatement of the Prudent Investor Rule by the American Law Institute.
Looking at the funds available within the company 401k plan, here are several comparisons:
(Note: The fund names, other than Vanguard are fictitious. The expense ratios, however, are taken from actual funds in 401k programs listed by posters on the Bogleheads board.)
Funds ard Expense Ratios:
Vanguard Total Stock Market Fund -- .19
Large Cap Core Fund -- 1.92
Vanguard Total International -- .25
Large Research International -- 2.11
Vanguard Windsor II (actively managed) -- .33
Vanguard Large Value Index -- .21
Large Cap Strategic Value -- 1.94
Vanguard Total Bond Market -- .20
Intermediate Bond Fund -- 1.15
I am hopeful that the company will consider these facts, and offer employees a small number of low-cost index funds in our company plan.
I have attached a small number of articles on tax deferred investing and index investing.
Sincerely yours,
___________________________________________________
Following are a collection of links on 401k investing:
About index investing
This link, from an article originally published in the Wall Street Journal, now available online at Marketwatch, may be convincing to management:
http://www.marketwatch.com/News/Story/Story.aspx?guid=%7BF047C5E4-3F49-451A-9A69-FD8FBF2D3A15%7D&siteid=google
Fees and Expenses
Employees should attempt to get a copy of the Summary Plan Description (SPD), and to determine what the fees and expenses of their plan are. These come in terms of expense ratios for individual funds, and overall administrative fees, which are likely hidden. Many vendors sell management on a “free” tax deferred plan, and then bill the employees for it by inserting costs into expense ratios for funds.
For an excellent explanation of how the fees and expenses for most 401k plans are established, go to the Asset Class Newsletter, February 2007 edition. It can be downloaded (in two parts) at:
http://www.equiuspartners.com/pdf/assetclass/feb07ac2.pdf
http://www.equiuspartners.com/pdf/assetclass/mar07ac2.pdf
Hewitt Associates notes that in 1988, 87% of employers paid all administrative costs for tax deferred plans. As of 2005, only 25% paid these costs.
House hearing on 401k plans, expenses
Link below: http://hr.cch.com/news/pension/032007a.asp
Excerpts from report on Congressional hearing on March 6, 2007 to determine whether hidden 401(k) fees are undermining the retirement security of American workers
Fees can significantly decrease retirement savings over the course of an employee's career. Barbara D. Bovbjerg, Director Education, Workforce, and Income Security Issues for the Government Accountability Office (GAO), for example, noted that a 45-year old employee who changes jobs with a $20,000 401(k) account balance, will realize $70,500 at retirement 20 years later, assuming an average annual net return of 6.5% (7% investment return minus 0.5% fee charge). However, if fees increase to 1.5% annually, the average net return will be reduced to 5.5%, decreasing the participant's retirement account at retirement by nearly 17 percent to $58,400.
Note the real life consequence of the fee assessments illustrated above is that employees will typically be required to work a longer period of time and/or not have sufficient income to maintain the desired lifestyle in retirement.
Investment and recordkeeping fees are the primary fees associated with 401(k) plans. Plan participants and sponsors may be aware of many of these fees. However, there are various hidden fees that are not disclosed to plan participants, although they can significantly erode retirement savings. These fees, which were detailed in the testimony of independent fiduciary, Matthew D. Hutcheson, include: undisclosed trading costs, SEC Rule 28(e) excess commissions, sub-transfer agent revenue sharing, non-fiduciary 12b-1 commissions, variable annuity wrap fees, and administrative pass-throughs.
Note a central current running through Mr. Hutcheson's testimony was the belief that the reduction of net returns through unnecessary and excessive brokerage expenses is an imprudent practice that runs counter to the fiduciary standards of ERISA. In addition, he cautions plan sponsors that, by allowing plan assets to be spent on services that may be imprudent and/or excessive, they invite suit for breach of fiduciary duty.
Disclosure requirements provide for limited fee information
Many fees remain hidden because, while plan sponsors must provide participants with summary plan descriptions, account statements, and a summary annual report, ERISA does not require these documents to include information on the fees incurred by individual participants. In addition, the GAO notes, plan sponsors provide fee information in a piecemeal fashion or in a way that makes a comparison of fees among investment options difficult. Particularly problematic is the fact that employers, other than sponsors of ERISA §404(c) plans, are not required to provide expense ratios to participants, although such fee measures are the best way to compare fees among investment options.
Other Links
It could be useful for employees considering asking their employers to state the fees and expenses associated with their plan, and to add several low-cost funds, to consult the following links:
http://www.fundadvice.com/401k-help/401k-plans.html
The Fund Advice website is interesting and useful, but Paul Merriman's suggestions for 401k plans suits his own business plan more than it does that of investors. He recommends offering a wide variety of funds, and most research shows that offering a multitude of choices hurts rather than helps the average investor.
http://efmoody.com/gripes.html
(I haven't been able to make the Moody link work directly. Go to efmoody.com, click on the menu item for 401k, and go to the link on the right side of the site for fund analysis.)
Here are some excerpts from the EF Moody letter (circa 1995):
..I have conducted a review of the mutual funds your company utilizes for their 401(k) plan in conjunction with the requirements and fiduciary obligations as identified in ERISA code section 404(c). I addressed the issues of performance, fees and current teachings in securities applications. Unfortunately, it is my opinion that the use of these funds could subject XXXXXX Training Corporation and its selection committee and officers to liability due to the lack of diversification, onerous fees and expenses as well as the sole use of managed funds. I will address these issues as follows with the first area focusing on established teachings in the field...
...So, since a 401(k) plan offers normally just a few funds from one fund family, the odds of one of those funds consistently outproducing an index, on a risk adjusted basis, is relatively remote. It again reinforces the necessity of the offering of some index funds....
...it is necessary to relate how the overall fees compare to industry standards. I have included several performance reports for Vanguard since they are the industry gauge for low costs. The difference in fees is most notable on bond funds. Merrill's High Income management fee is 1.29%- Vanguard is .35%. Merrill's Intermediate portfolio fee is 1.04% while Vanguard charges .18%. There are other issues that could substantiate the higher fees- service is one- but they still must be viewed in terms of performance....
...It is my opinion that the 401(k) portfolio should contain at least two basic index funds (S&P 500 index fund and probably an Intermediate Bond Index fund) that an employee can read with some relative degree of understanding and be able to address risk and reward. Further, employees should not be subject to onerous fees unless they have been completely forewarned of such fees and have accepted the consequences thereof- a fact that I do not believe has been disseminated to date. Under the guidelines of 404(c), it is a requirement that XXXXX Training Corporation accurately reflect the risks of these funds and offer a presentation of basic investment concepts (assuming it does not wish to retain further liability for inadequate retirement accounts of the employees). I do not think that these funds will attain basic comprehension by employees nor, upon proper notice, will they willingly accept the high 12b-1 fees- which are an anathema in current investment teachings....
Expenses for representative funds
Vanguard fund fees can be found here:
https://personal.vanguard.com:443/VGApp/hnw/FundsByType
The expense ratios of representative Vanguard funds are:
Total Stock Market (VTSMX) .19
Total Bond (VBMFX).20
Total International (VGTSX).32
Developed Markets (VDMIX) .27
If Fidelity funds are available in your tax-deferred plan, you should definitely consider trying to obtain their Spartan Index Funds. Fidelity offers its Spartan class of index funds in investor and advantage classes with different ERs, but most of the ERs are at 10 or 20 basis points (100 basis points equals one percentage point). Spartan funds include total markets, developed international, SP 500, Extended Market, and short and intermediate treasury indexes. Adding just two or three to a 401k list would help investors immensely.
Additional Links
http://www.401khelpcenter.com/
http://www.bizforum.org/whitepapers/bta001.htm
http://www.pbs.org/wgbh/pages/frontline/retirement/interviews/wray.html
http://www.latimes.com/business/la-fi-retire23apr23,0,6166250,full.story?coll=la-home-headlines
Quote from the LA Times links above:
As many employers scrap their traditional pensions and doubts grow about the future of Social Security, Americans' hopes for a secure retirement depend more than ever on their 401(k)s. About 44 million workers have more than $2 trillion invested in these accounts.
Yet unknown to many of them, obscure fees and deductions are quietly eroding the value of their nest eggs. In many cases, employers could bargain for lower charges, but don't.
Mutual fund management fees are the biggest expense. But they are prominently disclosed, have attracted wide publicity and have been declining as fund providers compete for customers.
Administrative fees are another matter. They usually don't show up on quarterly or annual statements. Brochures touting the benefits of 401(k) investing rarely mention them. Employees have to work hard to find out how much they're paying — for instance, by scouring their plan's website for a record of all activity in their accounts.
Some 401k plans aren't worth shooting
http://assetbuilder.com/blogs/scott_burns/archive/2003/04/17/Some-401_2800_k_2900_-Plans-_2700_Aren_2700_t-Worth-Shooting_2700_.aspx
...some plans are so poorly constructed they aren't worth shooting. Your husband's plan is a good example. The combination of high fees and low employer match is deadly.
In my opinion every plan should have the option of a low cost equity index, a low cost fixed income index, and an inflation protected option such as a Treasury Inflation Protected Securities fund. He should stop contributing immediately. He should let his employer know why. In fairness to his employer, small company 401(k) plans tend to be expensive.
Tim
(I'm sure that there is a lot that people here could add. Thanks.)
