The Big 401(k) Rip-Off May Be Ending

The end may be in sight for a common investment industry practice that robs millions of 401(k) plan participants of higher returns by choosing funds with expense ratios that are some 40% greater. This is how the rip-off works.

Say you want to buy a new car. You see two Ford Fusions in the dealer's showroom. They're the same in every respect, down to the color. The only difference is the price. One is $5,000 more than the other. Which one would you buy?

Dumb question, right? No one would purchase the more expensive car.

If you're a 401(k) plan participant, you don't get to select the investment options. They're put there by the broker or the insurance company. The adviser to the plan can often select from two classes of shares for each mutual fund -- retail and institutional shares.

As with the cars, everything about these two funds is the same -- except the cost. The retail shares have a much higher expense ratio (the amount deducted by the funds for fund expenses) than the institutional shares. To qualify for institutional share purchases, you typically have to meet a minimum purchase requirement. The minimum varies from fund to fund, but it's typically $500,000.

Kickbacks to 401(k) Plan Advisers

401(k) plans often qualify for the minimum because they can aggregate the purchases from plan participants. Even if they don't qualify, many funds will waive the minimum for these plans because they want to remain as investment options.

The difference in returns to plan participants can be significant over time. In one 401(k) plan I reviewed, there were 13 mutual funds offered as investment options. All of these funds were retail classes. There were institutional share classes available for every one of these funds. The expense ratio of the institutional funds averaged almost 40% lower.

Why would an adviser select higher cost funds when the same funds are available at a lower cost? To find out, just follow the money.

Retail share classes kick back a portion of their fees to the plan advisers. Institutional share classes do not. In effect, it's the plan participants who subsidize these kickbacks (known in the industry as "revenue sharing"). It's also the returns of plan participants that suffer due to this shameful practice.

Decision's Potentially Far-Reaching Impact

A recent federal court decision may stop this nonsense. In Tibble v. Edison International (CV 07-5359), Judge Stephen V. Wilson ruled on a class action brought by participants in Edison's (EIX) 401(k) plan. The case was brought in the District Court for the Central District of California.

Judge Wilson ruled that the selection of three retail share classes for inclusion as investment options in Edison's 401(k) plan violated the company's "duty of prudence" because lower cost institutional share classes of the same funds were available.

In reaching this conclusion, he stated: "In light of the fact that the institutional share classes offered the exact same investment at a lower fee, a prudent fiduciary acting in a like capacity would have invested in the institutional share classes."

The ramifications of this decision could be far-reaching. Judge Wilson concluded the plan participants had suffered significant damages to be determined by computing the difference in cost of the two share classes over the relevant time period and the "lost investment opportunity" caused the participants having less money to invest.

The Edison 401(k) plan is not an anomaly. In well over 90% of the 401(k) plans I have reviewed, retail shares are included as investment options, even though institutional shares are available at lower cost.

Blow Against Excessive Fees

To make a further point, there's no reason why any share class of any actively managed mutual fund (where the fund manager attempts to beat a designated benchmark) should be included as investment options in 401(k) plans. Index funds typically have only one class -- the costs are lower than either the retail or institutional classes of actively managed funds --and they'll likely outperform actively managed funds over the long term.

Nevertheless, if your 401(k) plan has retail funds in it, and institutional funds are available, your employer might be responsible for the difference.

To paraphrase Neil Armstrong, this is a small step for 401(k) plan participants and a big blow against the excessive fees and avarice that's so harmful to participants in these plans.