Grading Your Employer’s 401(k) Plan
When you head out each morning to work, you have an expectation that your employer
is providing a safe environment. There is no heavy object loosely dangling above
your desk, and the coffee in the break room uses water that has gone through some
filtration system. Employers provide this safe environment at work because they
have a responsibility to ensure the well-being of their employees. This responsibility
extends beyond your physical and mental health. If employers decide to offer you
benefits, such as a retirement plan, they must place your interests above all else,
otherwise known as fiduciary responsibility. The law has provided some guidance
as to what constitutes fiduciary responsibility in regards to employer sponsored retirement
plans. These are laid out in the Employee Retirement Income Security Act, or ERISA.
A Little History
Gone are the good old days of your parents’ pension plan. Funding your retirement
was so much easier back in the day. Your employer took out a portion of your earnings
from each paycheck, and along with a little extra money from their own pockets,
invested the funds for you and your colleagues. At retirement, the pension fund
would begin sending you a paycheck every month calculated using a formula that included
your years of service and salary. You should have noticed one important thing that
was missing in that calculation — investment returns! Investment returns were solely
the responsibility of your employer. Whether the investments in the fund performed
well or poorly, your monthly retirement check calculation would stay the same. Poor
investment performance just meant that your employer had to make up the short fall
to cover their obligation to you. This did not sit well with employers; they did
not want to assume the risk of poor market performance. Therefore, that risk was
transferred to the employees utilizing a long standing yet little used section of
the code known as the 401(k).
An Employer's Duty
Now the 401(k) is the norm, and the pension plan is, for the most part, non-existent
in private industry. Instituting a 401(k) plan may have transferred investment risk
to the employees, but the responsibility to act in the best interest of the employee,
or fiduciary prudence, still lies with the employer. The 401(k) plan must provide
a reasonable process for selecting investments. Which begs the question, what is
a reasonable process? Well, the Uniform Prudent Investor Act spells out that the
reasonable process must be rooted in Modern Portfolio Theory. This means the process
must take into account three important factors:
1. the trade-off between risk and return
2. offer investment products which provide broad diversification both within and across asset classes
3. charge fees appropriate relative to service
Unfortunately, it seems as though employers have misinterpreted their transfer of investment risk to the employee to also mean a transfer of fiduciary prudence.
Too many employer-sponsored 401(k) plans violate nearly all three of the above factors.
Investments are chosen based on recent outperformance (which has been proven overtime to be no indication of future performance) while ignoring risk,
investment options are narrow and often ignore many asset classes, and fees are excessively large and many times hidden.
The silver lining here is that employees are beginning to fight back. Lawsuits against prominent companies are mounting.
Names such as Wal-Mart, Caterpillar, Unisys, United Technologies, Honda, Boeing, etc. are all seeing their fiduciary prudence being questioned.
To be fair, each of these companies has been sued but not all have received a judgment against them.
That being said, the accusations tend to include the terms excessive fees, limited options, and even active management without similar passive options.
Grading Your 401(k)
Here are some important questions to research in your plan documents:
1. Do your fund expenses exceed the following:
0.35% for US Large
0.50% for US Small
0.50% for Real Estate
0.50% for International Large
0.80% for International Small
0.80% for Emerging Markets
0.35% for Fixed Income
2. Do the expenses include 12b-1 Fees (which are paid to the plan provider but only serve to lower your return)?
3. Is your plan missing one or more of the above asset classes?
4. Are you forced to choose from a menu of expensive actively managed funds without index fund alternatives?
5. Do funds tend to last only for a couple years in the plan, entering after recent good performance then leaving when they cannot replicate the performance?
6. Are you given little to no guidance on how to put together a risk appropriate portfolio using the fund selections available?
As a plan participant, employees should be unequivocally concerned with the asset
allocation of their retirement plan. As an employee, if your retirement plan is
unknown to you or poorly performing, a visit to your HR department is in order.
You should seek passively managed options through index funds with a low cost structure.
Here's a sample letter to
ask your Plan Sponsor for Index Funds.(PDF Format)
(MS Word Format)
Special Edition of IFA Radio!
Your Rights as a 401(k) Participant
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