Why most plans have too many fund choices

I recently looked up some information on my old dentist and saw he was on a news program called “Drilling for Dollars.”  The story was about how he diagnosed a patient with a bunch of cavities when another dentist who the patient sought a second opinion from said he didn’t have any cavities at all.  Needless to say, I was a bit disturbed after I just had a tooth drilled myself.

The more I thought about this issue, however, the more I realized that diagnosing patients with problems in order to provide unnecessary revenue-generating services was not unique to the dental profession.  This issue also applied to the retirement plan industry, as financial advisors (mostly commission-based brokers, but also registered investment advisors) will often recommend an excessive number of fund choices and asset classes in order to create unnecessary additional complexity to use as justification for their unnecessary additional fees.

Most financial advisors will justify this complexity with the argument that using a financial advisor to help participants navigate through a complex investment world is the only way to ensure that participants are consistently diversified and invested in a portfolio that is in line with the goals and risk tolerance.  However, what they fail to mention is that this same or often a greater level of diversification can be achieved by offering only five or six risk-based portfolio models (i.e. conservative, moderate, aggressive) consisting of two to five funds, which are automatically re-balanced at no additional cost and without the assistance of an advisor.  Because these models can potentially contain 9,000 securities or more, it is clear that diversification is not about the number of mutual funds offered, but the number of securities in each fund.   Furthermore, many of the additional and unnecessary mutual funds that are offered are actually very highly correlated meaning they move in the same direction and are therefore redundant.  With regard to the so called need to offer funds in each asset class, this is another deceptive practice because you can cover the small, mid, and large cap asset classes entirely with the Vanguard Total Stock Market Index Fund which costs only 0.05% while passively managed funds in each of these asset classes cost 0.24% or more.  Why spend more money on each pie slice when you can buy the whole pie at a much lower price?  And how do you know which area (small, mid, or large cap) will outperform?  These types of arrangements with excessive funds choices encourage redundancy, needless cost and complexity, and market timing.  Unfortunately, because participants tend to buy after a fund has gone up and sell after a fund has gone down, they tend to be very poor market timers.  Perhaps most importantly, having all of these different fund choices encourages participants to try and “pick the best funds” and chase returns rather than continually monitor their goals and risk tolerance.

In the case of offering solely risk-based portfolio models, however, the only responsibility participants would have is to periodically review a risk assessment questionnaire to ensure they are investing properly.  In fact, the federal government’s Thrift Savings Plan already uses this approach:

http://www.cbsnews.com/8301-505123_162-37741476/thrift-savings-plan—the-model-for-all-401k-plans/

Here are some highlights:

•   Simplicity – Five core investment options.

•   Diversification – Four of those five options give exposure to the entire U.S. stock market, most of the international stock market, and the U.S. aggregate bond market.

•   A special government fund that yields longer term bond returns without any loss of principal.

•   Ultra low costs – Less than 0.03 percent annual costs.

•   Lifecycle funds that own all five core investments, rebalance automatically, and become more conservative over time – all for no additional costs.

I agree with Walter Updegrave of Money Magazine that this is the retirement plan that Uncle Sam has right. It is the simplicity of this plan that makes it particularly effective, because studies show the more choices that are offered, the less likely people are to choose. And the diversification of this plan protects investors from chasing the part of the stock market that has recently gone up.

Costs really matter – the 0.03 percent annual expense ratio compares to the 401(k) industry average expenses of 2.00 percent, as noted by a recent LA Times article by fellow blogger Kathy Kristof. To put the costs in perspective, the average 401(k) plan costs 67 times the amount of the TSP, and even my own portfolio is about five times more expensive. Hence the envy I have for this plan.

As compelling as the TSP is, the final proof that this is the model for all 401(k)s is the fact that the financial industry hates it. The Investment Company Institute, the trade organization for mutual funds, published a paper questioning the TSP as a model for 401(k)s. You can bet that anything that threatens the mutual fund industry’s profits is probably a good thing for investors.

I’m with advisor and author Dan Solin that the TSP is the model to stop the great 401(k) rip-off. I’m not making a political statement when I say that I would jump into the TSP if I were offered the opportunity. It would simply lower my costs and increase my returns. It’s unfortunate that I’m not making a political statement, because getting elected to political office would be my only chance to get access to the TSP.

My advice to Federal employees is to keep your money in the TSP plan, in spite of many of my fellow planners telling you to dump it as soon as you can. I’m happy to say that, according to TSP spokesperson, Thomas Trabucco, that’s exactly what most former Federal employees are doing.

Consequently, because participants’ goals can be achieved with such simplicity, there is no need to pay a financial advisor excessive percentage-based “management fees”.  Instead, plan sponsors should be advisors a flat dollar fee based on the value of their time – which not surprisingly is always significantly less than a percentage-based fee.

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