Your Broker (Not You) Will Retire on Your Retirement Plan

Your 401(k) is probably enriching the investment industry more than you.

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A study published by Demos makes a compelling case for something I have known for a long time: Retirement savings accounts like 401(k)s, 403(b)s, 457s, IRAs, Keoghs, and SEPs are a giant rip-off and a national disgrace. Demos is a non-partisan public policy research and advocacy group. Among its stated goals is “a more equitable economy with widely shared prosperity and opportunity.” It found some low hanging fruit with its analysis of retirement plans.

Here’s a summary of the findings of this study:

  • The average American household will pay, on average, almost $155,000 over the course of their lifetime in total 401(k) fees. In this economy, that would buy a pretty nice home.
  • The fees paid by 401(k) participants are 46 percent higher than fees required to manage the typical traditional pension plan.
  • Merely requiring the disclosure of fees, which new Department of Labor regulations effective on July 1, 2012 will do, will only “marginally reduce” excessive fees.
  • Employees believe that higher fees guarantee higher returns when the opposite is true. Lower fee index funds often have higher net returns than higher fee actively managed funds.
  • The conclusion of the authors of this study is compelling. They believe “wholesale reform” of the retirement system is needed if we want to ensure a comfortable retirement for American employees. They set forth core principles of a new system which include universal coverage and a steady lifetime stream of retirement income adequate to fund a retirement with dignity.

    Yet, even a firm as sophisticated as Demos is no match for purveyors of flawed 401(k) plans. In its study, it used its own 401(k) plan to illustrate the effects of costs on returns. Its plan has 22 investment options. All except three of these funds are actively managed. The expense ratios of its funds (representing management fees charged by the fund which are deducted from returns) range from 0.70 percent to 1.53 percent. Even its few index funds charge indefensibly high fees. Two of them have expense ratios of 0.70 percent and one fund charges 0.95 percent. It is particularly striking that it is incurring an expense ratio of 0.70 percent for the SSgA S&P 500 Index Fund. Vanguard’s S&P 500 Index Fund (VFINX) charges an expense ratio of only 0.17 percent.

    Demos is incurring expense ratios ranging from 1.14 percent to 1.32 percent for access to the Fidelity Advisor Freedom Funds, Class T. It could switch to Vanguard’s Target Retirement Funds where the expense ratios range from 0.17 percent to 0.19 percent.

    Few employees are capable of putting together a globally diversified, risk adjusted portfolio in a suitable asset allocation from a list of 22 investment choices. Even if they could, their returns would be crippled by the same high costs described by the authors of this study.

    Its employees would benefit by replacing this plan with one that offered a small number of passively managed portfolios (not individual funds), with risk levels ranging from conservative to aggressive. The blended expense ratio of these funds would be around 0.30 percent —a considerable reduction from the expense ratios it now incurs. Demos should eliminate all actively managed funds from its plan.

    While we are waiting for the politicians to adopt the recommendations in the Demos study (don’t hold your breath), plan sponsors have a responsibility to adopt plans that reduce fees and increase expected returns for plan participants. Demos should lead by example, and it is apparently headed in that direction. Robert Hiltonsmith, the author of the Demos study, told me that he was “shocked” by the high fees in the Demos plan. It is switching to a lower cost plan.

    Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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