Why 401(k) Plan Providers are the Biggest Threat to Retirement

The term “financial advisor” normally evokes the thought of a professional service provider who provides advice. If this belief were actually true, however, advisors would suggest that employers terminate their retirement plans or at least set them up so that service providers charge fees that are commensurate with the services they provide.

While participants can take advantage of an employer match and receive additional tax deferral through an employer profit sharing contribution, every dollar employers spend towards a match and profit sharing contribution is a dollar they could have spent towards employees’ salaries or training. Now employees often have no choice but to divert a part of their salaries into a retirement system that is rigged against them rather than receive a higher salary.

Employers may have the best of intentions, but rarely understand how service providers make their money, which results in fees being charged to employees that are far out of proportion to the services they receive. The service providers include financial advisors, record keepers, administrators, and custodians. To explain these terms, a record keeper provides a website, sends out participant statements, and keeps track of participant balances, an administrator handles compliance functions and prepares the plan tax form, and a custodian simply takes possession of the plan assets. As for the financial advisor, there are two types: Commission-based brokers and registered investment advisors. The former earn their compensation through percentage-based kickbacks built into the mutual fund expense ratios known as 12b-1 fees or revenue sharing while the latter charge based on a percentage of plan assets or a flat fee. Brokers dominate the industry, yet most employers don’t understand the difference between the two kinds of advisors, rarely have any idea that record keeping and custodial fees even exist, and often don’t even know who provides record keeping and custodial services for their plan because they don’t understand what these services are in the first place.

Record keepers and custodians who earn their compensation through revenue sharing also dominate the industry, which ensures that most funds are actively managed, as low cost passively managed funds (known as index funds) typically do not include revenue sharing. Consequently, most providers continue to deduct more money out of participants’ accounts as the plan assets increase without doing any more work.   Furthermore, participants are often primarily limited to choose only among actively managed funds that have kickbacks built in to pay the providers despite a mountain of evidence suggesting that the majority of broker-sold mutual funds do not consistently outperform the market.

The fee disclosure requirement was advertised to solve these issues, but it has had the opposite effect of raising compliance costs and creating more confusion rather than helping participants understand which providers are taking their money, how much they are taking, and how and why they are taking it. For example, some large providers include the fees explained above within the investment earnings on the participants’ statements instead of breaking them out and explaining them while separately disclosing the mutual fund fees. For this reason participants now falsely believe providers are disclosing all of their fees. Clearly providers believe it’s much easier to bundle all the fees together in order not to “confuse” anyone and ensure no more meaningful questions are asked.   Maybe this was the real aim of the fee disclosure requirement all along.