A Glimmer of Hope for Costly 401(k) Plans

401 k plan
401 k plan

A recent proposal from the Department of Labor about how to evaluate retirement plans is drawing fire from financial advisors, according to an article in Investment News. The government agency suggested that computerized advice models for 401(k) plans should not consider historical performance for funds under review. Instead, the models should factor in only fees and expenses.

You can imagine the shock waves the mere consideration of this eminently reasonable proposal sent through the securities industry. If only fees and expenses are considered, the computer-based models would likely reach the same conclusion as hundreds of academic articles and long-term risk and return data: Few actively managed funds outperform index funds over the long term. As a result, there is no reason for an actively managed stock or bond fund to be in any 401(k) plan.

The objections to the Labor Department proposal are telling.

Robert L. Francis, Chief Operating Officer of National Retirement Partners, a broker dealer, offered this quote: "It's like saying that you should buy a Volkswagen over a Rolls Royce just because it's cheaper."

But that's a bad metaphor. Cars aren't retirement funds. With mutual funds, the less expensive option is the better performing one. It will provide you with superior returns over the long term, and it will do so at a much lower cost.

Buyer Beware

Jonathan Clements, the highly regarded financial columnist for The Wall Street Journal, found that, for the 10 year period ending 2001, active managers underperformed the S&P 500 index. He characterized the mutual fund industry as an "elaborate hoax" and referred to the "reams of statistics" that prove most actively managed funds fail to beat their benchmark index.

Another advisor noted that adoption of these regulations could mean less revenue sharing dollars, and that could increase costs to plan sponsors. That observation is at least half true.

If all 401(k) plans had only index funds as investment options, it would reduce or eliminate the insidious practice of mutual funds kicking back a portion of their fees to record keepers and advisors as the price for being awarded a coveted place as one of the investment options in the plan. Getting rid of this practice, to borrow from Martha Stewart, would be a good thing.

Costs to the plan sponsor and, more importantly, to plan participants, would decrease and not increase. The combination of significantly lower expenses of index funds in the plan compared to the expenses of actively managed funds, and the vastly improved performance of index funds, would dwarf any increase in record keeping costs.

'You Get What You Don't Pay For'

My favorite comment is attributed to Mr. Francis. He observed that any advice that doesn't take into consideration the past performance of funds isn't good advice. Really? Why then does the SEC require mutual funds to note the following in their advertisements?

"Past performance is not indicative of future results."

Perhaps because it's true.

An oft-cited study looked at the performance of the top 100 mutual fund managers for the twelve year period from 1996-2008. Only about 15% of the top 100 managers from the one-year periods repeated their top 100 performance in the second year. In 1999 and in 2007, 0% of the top 100 managers made the list in the following year.

The Department of Labor got it right. Anyone concerned about the well being of much beleaguered plan participants should support its proposal to focus on costs and fees of funds in a 401(k) plan. As John Bogle, the founder and former Chairman of the Vanguard Group stated: "...in mutual funds, you don't get what you pay for. You get what you don't pay for."

Originally published