The 401(k) is not inherently bad. It actually has a lot of potential to help a lot of companies and employees. But the model is broken.
The 401(k) comprises the main vehicle of retirement savings in America. It also has the potential to be a really successful vehicle.
However, the model upon which the 401(k) is built, doesn’t work. What’s more, most of the people affected, including both employees and employers, don’t know what the problems are.
Below are the four most serious problems that American employees face with the conventional 401(k) model.
1. Conflicts of Interest
Conflicts of interest are probably the most serious problem of the traditional 401(k) model because a large number of other issues derive from it. Such conflicts appear when a 401(k) provider (Advisor, Recordkeeper, TPA, Broker, etc.) is incentivized to act in their sole interest, rather than the employees'. This motive is derived from the following two factors:
- The model of reimbursement for the service provider
- Whether the provider is one of your plan’s legal fiduciaries.
Let's see an example:
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Imagine there is a financial advisor whose payments come from your plan’s mutual funds (indirect compensation) rather than from direct payments from the plan participants or the company. That person is now incentivized to propose funds from which he will receive a higher commission that’s the definition of conflict of interest.
What they should be doing instead, is to propose funds depending on their ability to help participants make proper retirement savings. Still, this is the case with most of the 401(k) plans in the country. And that’s not even all. If that advisor doesn’t belong to the legally named fiduciaries on your plan, they aren’t obligated to act on what’s best for the employee’s interest. This little detail means that you can’t hold them responsible for tending to their own interests, and that happens every day.
To get rid of these conflicts you simply have to change the provider’s payment method, or name them legal fiduciaries. It is your right to ask for these changes, as a plan sponsor. If they deny, change providers with someone who will accept your terms.
2. High Fees
Conflicts of interest are usually the cause of the next problem in line, high fees. Despite the high administrative fees, the majority of the 401(k) model’s fees are usually paid by the employees themselves via retailed priced, actively managed mutual funds’ expense ratios, since this is the payment method of service providers.
Small to mid-sized 401(k) plans usually have an expense ratio of about 1.3 percent. What’s more, another .4 percent is added to cover transaction and turnover costs, making a total of 1.7 percent in investment costs alone. If you add the administrative fees now, the total costs of your plan are elevating to somewhere between two and 3.5 percent.
At such rates, the contributions and returns of the employees are diminishing, dramatically decreasing their retirement’s nest egg size. For every one percent of fees added, there is a 20 to 30 percent decrease to retirement. This difference is immense. Conversely, employees should be given the choice to invest in index tracking portfolios or low-cost index funds (ranging from .05 to .30 percent). In such a case, their investment actually works to their benefit, instead of fueling the provider’s revenues via indirect compensation.
A recent survey showed that 17 percent of respondents really thought they paid no fees in their 401(k) plan. And they were completely wrong. Although new fee disclosure rules have rendered 401(k) fees more visible, it’s still almost impossible for employees and plan sponsors to find out where their money are going or how much they are being charged. It’s so complicated that the cost can’t be calculated by the providers themselves, in some cases. Let alone that they wouldn’t even want to calculate it for you.
3. Complicated Investment Options
Although sponsors have improved their investment lineup structuring, helping employees better understand the maze of available investment options, there are still a lot of companies that use their recordkeeper’s or financial advisor’s standard recommendations. Such lineups typically contain a list of 20 to 30 funds covering a wide variety of asset classes, while assuming that employees have the capacity to comprehend how a small-cap or a large-cap are different from a baseball cap, so they can spend their investment money rationally.
This is a difficult task even for seasoned investors, if they have to choose among 20 or 30 funds. Conversely, fund lineups should be built on risk-based model portfolios, age-based glide paths, or other pre-built and pre-diversified options, covering all major asset classes. Through these options, employees make informed decisions and pick investment approaches by understanding the terms that will help them save for their retirement with full confidence.
4. Fiduciary Risk
When the plan sponsor is burdened with the total of the fiduciary risk, the above factors are becoming even more of a problem. In as many as 95 percent of plans reported to BenefitGuard, the company plays both the fiduciary roles (administrative and investment-related) and carries virtually the total fiduciary risk. Plan sponsors typically act as the 3(38) Investment manager, the 3(21) Named Fiduciary and the 3(16) Plan Administrator.
Not only are they in charge of ensuring that the plan is administratively compliant, but it’s also their responsibility to select and monitor a fund portfolio of sensible investment options. So, if employees sue the company (which isn’t too rare), or if a government agency audit them (which is also not that rare), they are held responsible. Let’s be frank, the majority of companies with small to medium size lack the investment or administrative fiduciary expertise. So, assuming these roles along with their accompanying risk makes no sense.
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Summing up, the 401(k) model doesn’t work. But it can be fixed. From the plan sponsor’s view, you can get rid of conflicts, cut down investment expenses, use simpler investment options, and outsource your fiduciary roles and dangers.