All posts by Paul Sippil

Paul Sippil is a former auditor, recovering CPA, and independent registered investment advisor who uncovers the fraud, corruption, conflicts of interest in the retirement plan industry. He moonlights as a community organizer and advocate for connecting people with one another through a farm-to-table community dining and wellness club promoting sustainable farming, conscious food choices, stronger social bonds, and meaningful conversations that he started in March of 2015.

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.

 

Mesirow Financial vs. Mesirow Financial

Mesirow Financial has two different areas that provide services to group retirement plans:  The Retirement Plan Advisory Group and the Investment Strategies Team.   Here is more information:

http://www.mesirowfinancial.com/retirementplanadvisory/

http://www.mesirowfinancial.com/investmentstrategies/

There is a significant overlap of services at the plan sponsor level, including:

1.  Developing an investment policy statement.

2.  Providing fiduciary services.

3.  Performing ongoing due diligence of investment managers.

4.  Creating a diversified investment menu.

These areas are completely separate and do not interact with each other, but it would be helpful if they did.  For example, clients can obtain 3(21) or 3(38) fiduciary services (which include the other additional services listed above) on Vanguard’s platform through Mesirow Financial’s Investment Strategies team for a total cost of 3 and 6 basis points for ERISA 3(21) and 3(38) fiduciary services respectively (2 to 5 basis points for Mesirow and 1 basis point for Ascensus who partners with Vanguard) with no required minimum asset level.

One difference between Mesirow Financial’s 3(21) and 3(38) fiduciary services is that while the responsibility for the selection and monitoring of plan assets remains with the plan sponsor with Mesirow’s 3(21) services, Mesirow takes discretionary control over the selection and monitoring of the plan assets with their 3(38) fiduciary services which would save time for both the advisor and plan sponsor.  However, if the advisor is recommending a line-up consisting of passively managed funds, there should be little time spent on the selection and monitoring of plan assets anyway.  Another difference is that there are not only far more funds available with Mesirow’s 3(21) services, but the plan sponsor also has the flexibility to add and remove whatever funds it wants within Mesirow’s broader offering of hundreds of funds, while the plan sponsor would not have this flexibility with Mesirow’s 3(38) services.  Furthermore,  the legal protection is identical for both 3(21) and 3(38) services, so there isn’t much of an advantage of paying any more than 3 basis points for this type of fiduciary service.  Because this team provides such extensive and cost-efficient services, it would seem there is no need for an outside advisor, but they do not provide participant education services, so there is room for an advisor to the extent that plan sponsors need this type of service.

Consequently, plan sponsors should consider how much of an advisor’s fee is for fiduciary and investment selection and monitoring services vs. participant educational services.  Typically, advisors don’t break down what their fee is for, but if plan sponsors are primarily using an advisor to select and monitor investments rather than for participant education services, they should seriously consider either significantly lowering the advisor’s fee or not having this type of advisor at all and simply using Mesirow’s low cost Investment Strategies Team.

In further reference to what an advisor’s fee should be and how it should be charged, it really depends on what type of services the advisor is providing.  If advisors are charging for participant educational services, then they should only act as a registered investment advisor rather than a broker and charge a flat fee based on how much actual work they are doing rather than an asset-based fee.  I have elaborated here and here.

Granted, Mesirow’s Investment Strategies Team does charge asset-based fees, but my criticism of this type of fee arrangement has been largely on the basis that fees should only increase in proportion to the increased liability an advisor faces – and a fee of only 3 to 6 basis points is far more proportional to the cost of increased liability than an asset-based fee of 25 basis points or more which is what most advisors and brokers typically charge.  The other problem with asset-based fees is that it causes a conflict of interest when advisors give advice to participants (technically a broker can’t even legally provide advice), but as noted above, Mesirow’s Investment Strategies Team does not provide advice to participants, so this conflict would not apply.

It has been my experience as a financial advisor providing services to group retirement plans that participants hardly ever contact the advisor or broker and/or the plan sponsor is simply too busy to spend much time having participant educational meetings.  Furthermore, once participants are set up in a risk-based model or target date fund, there should be little if any changes made to the funds, especially in the short term.

Advisors may argue, however, that they do more than simply provide investment due diligence and participant educational services.  They also claim to provide valuable fee benchmarking studies to provide plan sponsors with assurance that their fees are “in-line” with so called industry averages.  Because most plans pass on asset-based fees (including record keeping, custodial, and sometimes even administration) to participants, their costs are not commensurate with the level of services provided either, which makes a comparison to other plans misleading and meaningless.  For this reason, there is little need for benchmarking services.  All plan sponsors need to do order to ensure their fees are reasonable is offer a line-up of passively managed funds and use a provider who charges flat dollar fees regardless of the plan asset level for advisory, record keeping, and administration services that are commensurate with the level of work and risk involved – and there are many firms who do charge this way without necessarily sacrificing their service offering as I have explained here.

Mesirow’s Investment Strategies team can be used by any financial advisor and should be viewed as an additional resource that can be utilized to provide services more efficiently than financial advisors can provide on their own.  However, advisors whose business models are not competitive may view this kind of service more as a threat than as a resource as it will shine light on the inefficiencies of their services.  Consequently, plan sponsors and participants need to make more of an effort to understand how the group retirement plan industry works rather than simply rely on service providers.  Unfortunately, this isn’t going to change any time soon as participant level fees dominate the industry, so plan sponsors will always view the retirement plan as a low priority because it does not affect the bottom line and most participants lack the financial expertise to even know what to ask, which causes them to primarily do nothing, as suggested by Mesirow’s own survey:

“Participant interest in fee disclosure, however, is surprisingly low, with more than 83% of plan sponsors indicating that employees have had very few questions as a result of 404(a) participant fee notification.”

Participant interest in fee disclosure, however, is surprisingly low, with more than 83% of plan sponsors indicating that employees have had very few questions as a result of 404(a) participant fee notification – See more at: http://www.mesirowfinancial.com/retirementplanadvisory/ebulletins/plan_sponsor_survey_results_2013.jsp#sthash.4envQQM2.dpuf
Participant interest in fee disclosure, however, is surprisingly low, with more than 83% of plan sponsors indicating that employees have had very few questions as a result of 404(a) participant fee notification – See more at: http://www.mesirowfinancial.com/retirementplanadvisory/ebulletins/plan_sponsor_survey_results_2013.jsp#sthash.4envQQM2.dpuf

http://www.mesirowfinancial.com/retirementplanadvisory/ebulletins/plan_sponsor_survey_results_2013.jsp

Participant interest in fee disclosure, however, is surprisingly low, with more than 83% of plan sponsors indicating that employees have had very few questions as a result of 404(a) participant fee notification – See more at: http://www.mesirowfinancial.com/retirementplanadvisory/ebulletins/plan_sponsor_survey_results_2013.jsp#sthash.4envQQM2.dpuf

Risk-Based Asset Allocation Models
Our risk based asset allocation models are designed to help our clients manage risk and maximize return by diversifying across a comprehensive set of asset classes.

Fiduciary Partnership
The Mesirow Financial Fiduciary Partnership service can help to make your plan sponsors’ fiduciary duty more manageable.

Custom Target-Date Portfolios
Target maturity portfolios provide a simple investment strategy for retirement plan participants who are unsure about how to best select investments that provide diversification across asset classes.

Retirement Income Solution
The Investment Strategies Division at Mesirow Financial has developed a retirement income framework that seeks to optimize both the product allocation and asset allocation for traditional investment products and advanced retirement income products.

Manager Search and Due Diligence
Institutions often look for assistance in finding appropriate funds from independent third parties like Mesirow Financial’s Investment Strategies team.

Alternative Allocation Strategies
Mesirow Financial Investment Strategies has developed an alternatives optimization procedure that does not rely on some of the key assumptions that limit the usefulness of traditional methods when dealing with alternatives.

Stable Value Product Due Diligence
The independent due diligence experts at Mesirow Financial provide a detailed due diligence report on various stable value products used widely in retirement plans.

Precision Fund Insight
Precision Fund Insight provides direct access to Mesirow Financial,s due diligence data, supplying a roadmap for DCIO sales, national account and retail sales teams with the information they need to better target their efforts and empower retirement plan advisors to garner assets.

– See more at: http://www.mesirowfinancial.com/investmentstrategies/services.jsp#sthash.XdGCeJ1w.dpuf

No, Your Broker Does Not Provide Advice!

It’s truly unfortunate that so many plan sponsors I talk to insist that their broker gives advice.  “Why is the broker’s name listed as the contact for all of their participants to call?”, one plan sponsor continued to ask me in spite of my continued attempts to explain the difference between a broker and a registered investment advisor, the basic concept that when you are a service provider whose compensation depends on receiving a kickback from a third party, it’s not advice, and the fact that he could have independently verified my claim by contacting FINRA (Financial Industry Regulatory Authority) or simply asking his broker.

This article further explains:

Conflicts of Interest Cost Retirement Plan Investors Billions:

http://www.benefitspro.com/2013/04/09/conflicts-of-interest-cost-retirement-investors-bi?eNL=5166db72140ba03f7900005d&utm_source=RetirementAdvisorPro&utm_medium=eNL&utm_campaign=BenefitsPro_eNLs&_LID=80852648

•   By using affiliated mutual funds, brokers are not acting in the client’s best interest. This is the focal point of the fiduciary standard. Eliminate the conflicts of interest in terms of giving advice, and investors will immediately benefit. It doesn’t mean eliminating brokers, it just means eliminating the claim that brokers are giving advice. They are not. Advice requires a fiduciary duty. Brokers don’t (and shouldn’t) have to operate under the regimen of a fiduciary duty.  Brokers don’t give advice. They trade.

This article makes the distinction between selling securities and providing advice clear as well:

Brokers

What they are: While many people use the word broker generically to describe someone who handles stock transactions, the legal definition is somewhat different—and worth knowing. A broker-dealer is a person or company that is in the business of buying and selling securities—stocks, bonds, mutual funds, and certain other investment products—on behalf of its customers (as broker), for its own account (as dealer), or both. Individuals who work for broker-dealers—the sales personnel whom most people call brokers—are technically known as registered representatives.

Who regulates them: With few exceptions, broker-dealers must register with the Securities and Exchange Commission (SEC) and be members of FINRA. Individual registered representatives must register with FINRA, pass a qualifying examination, and be licensed by your state securities regulator before they can do business with you. You can obtain background information on broker-dealers and registered representatives—including registration, licensing, and disciplinary history—by using FINRA BrokerCheck or calling us toll-free (800) 289-9999. You can also contact your state securities regulator. To find your regulator, check the government listing of your phone book or contact the North American Securities Administrators Association at http://www.nasaa.org or (202) 737-0900.

What they offer: Broker-dealers vary widely in the types of services they offer, falling generally into two categories—full-service and discount brokerage firms. Full-service firms typically charge more for each transaction, but they tend to have large research operations that representatives can tap into when making recommendations, can handle nearly any kind of financial transaction you want to make, and may offer investment planning or other services. Discount broker-dealer firms are usually cheaper, but you may have to research potential investments on your own—though the broker-dealer Web sites may have a lot of information you can use.

Registered representatives are primarily securities salespeople and may also go by such generic titles as financial consultant, financial adviser, or investment consultant. The products they can sell you depend on the licenses they hold. For example, a representative who has passed the Series 6 exam can sell only mutual funds, variable annuities, and similar products, while the holder of a Series 7 license can sell a broader array of securities. When a registered representative suggests that you buy or sell a particular security, he or she must have reason to believe that the recommendation is suitable for you based on a host of factors, including your income, portfolio, and overall financial situation, your tolerance for risk, and your stated investment objectives.

Investment Advisers

What they are: An investment adviser is an individual or company who is paid for providing advice about securities to their clients. Although the terms sound similar, investment advisers are not the same as financial advisers and should not be confused. The term financial adviser is a generic term that usually refers to a broker (or, to use the technical term, a registered representative).

By contrast, the term investment adviser is a legal term that refers to an individual or company that is registered as such with either the Securities and Exchange Commission or a state securities regulator. Common names for investment advisers include asset managers, investment counselors, investment managers, portfolio managers, and wealth managers. Investment adviser representatives are individuals who work for and give advice on behalf of registered investment advisers.

Who regulates them: The SEC regulates investment advisers who manage $110 million or more in client assets. Advisers who manage less are regulated by the securities regulator for the state where the adviser has its principal place of business. Because they primarily engage in the buying and selling of securities, broker-dealers and registered representatives typically do not have to register as investment advisers. But some do, which is why it is so important to find out exactly which services a professional who wears multiple hats will provide for you and what they will charge for their services.

You can get background information on both SEC- and state-registered investment advisers by using FINRA BrokerCheck or calling us toll-free (800) 289-9999.You can also get background information by visiting the SEC’s Investment Adviser Public Disclosure database.

What they offer: In addition to providing individually tailored investment advice, some investment advisers manage investment portfolios. Others may offer financial planning services or, if they are properly licensed, brokerage services (such as buying or selling stock or bonds)—or some combination of all these services.

http://www.finra.org/Investors/SmartInvesting/GettingStarted/SelectingInvestmentProfessional/P117278

And if the information above isn’t enough, here are more articles that explain:

Broker Versus RIA

http://www.oldfatherfinancial.com/new/oldfather-financial/content.asp?contentid=2016403506

Here are some highlights:

The vast majority of people you would normally think of as a “financial advisor” are Registered Representatives of a Broker-Dealer. But there are actually three kinds of advisors.

THE FIRST is a Registered Representative of a Broker-Dealer. Known as “A Broker”. Sales and product driven advice. A Broker cannot charge you just for advice. They can only make money on the investments they sell to you.

THE SECOND is a Registered Investment Advisor (RIA). You pay an RIA only for investment advice.

THE THIRD– is the hybrid broker. Brokerage firms now have their own affiliated RIA firms. Brokers can now be both a broker and an RIA and jump back and forth between them. Since many people prefer fee based accounts, brokers can set up these arrangements. But with hybrid firms the conflicts of interest are massive and the fees are very high.

Broker? Adviser? And What’s the Difference?

http://www.nytimes.com/2010/02/18/your-money/financial-planners/18TRUST.html?pagewanted=all

Investment advisers vs. brokers: Know the difference

http://www.bankrate.com/brm/news/BoomerBucks/20050427a1.asp

Fee-Only Financial Planner: What’s the Difference?

http://www.forbes.com/sites/davidmarotta/2012/06/11/fee-only-financial-planner-whats-the-difference/

 

Why do 401(k) Plan Advisors get Paid Comparable to Brain Surgeons?

After doing a bit of research, I learned that brain surgery can cost anywhere between $30,000 and $150,000 and can take between 1 and 12 hours.  On average, it takes about 8 and a half hours.  So if you take the average cost of $90,000 (($30,000 + $150,000)/2), and divide this number by 8 and a half, you get $10,588 per hour.  That’s not a bad day’s work.

As for 401(k) plan advisors, they typically earn anywhere from $1,000 to as much as $100,000 per year per plan, but the vast majority of advisors earn far closer to the lower end.  While some advisors may spend up to 20 hours a year, there are many advisors that literally don’t do anything at all.  So I would estimate that on average, advisors spend about 1 hour a year and earn approximately $3,000.  Granted, a brain surgeon still likely earns more than three times the compensation of a 401k plan advisor, but given what it takes to be  brain surgeon vs. the 4 to 6 weeks of exam preparation it takes to become an advisor, this difference should be much larger.

Furthermore, there are plan administrators who also earn about $3,000 per year per plan, yet they are required to spend far more than 1 hour per year of their time.  So the obvious question is:  How can financial advisors possibly continue to earn so much money while doing little if any work – and without necessarily having any expertise?

The simple answer is that nobody understands or even thinks about how advisors get paid or how the industry works.  But the deeper question is:  Why don’t people understand and think?  I have attempted to answer this question in an earlier post.

The Myth of Saving Money Because of “Switching” Providers

I have now lost track of how many times a plan sponsor has told me, “We now have lower fees because we just switched providers.”  This response naturally leads me to ask, “Which fees are lower?  Unfortunately, the next response I normally receive is stunned silence by the insistence that “we have everything taken care of” and then of course the click of the phone.

The reality, however, is that lower overall fees don’t necessarily mean that the plan sponsor actually saved any money.  First, the broker often earns a 0.5% to 1% upfront commission in the first year of the provider change – an amount much greater than the annual compensation trail at the previous provider.  Furthermore, the plan sponsor often changes from one record keeper and custodian who charges based on a percentage of plan assets to another provider who charges the same way (as opposed to a flat dollar fee), so there is no change to the underlying fee structure.  So how can the overall fees then be lower with the new provider?  The answer is that the advisor and/or record keeper simply helped the plan sponsor select lower cost mutual funds which gives the appearance of lower fees even though the fees the new service provider(s) charges are either the same or greater.  What plan sponsors don’t realize is that most or perhaps all of those lower cost mutual funds were available in their former provider’s platform.  Consequently, these plan sponsors could have incurred the same savings without changing providers, so the decision to “change” serves no purpose whatsoever.

Furthermore, this article clearly demonstrates that simply choosing lower cost actively managed funds doesn’t necessarily lead to better performance:

http://fiduciarynews.com/2012/10/a-401k-must-read-mutual-fund-expense-ratio-myth-busted/

 

Plan Sponsors Continue to Put their Personal Relationships Ahead of their Fiduciary Duties

Margaret Thatcher once said that “The trouble with socialism is that eventually you run out of other people’s money.”  Our retirement plan system isn’t quite socialism, but it does allow plan sponsors to pay their friends and relatives primarily with participants’ money.  When I ask these plan sponsors (and I’ve asked hundreds of them) if they are willing to cut their “close friend or relative” a check instead paying them with other people’s money, they always say “No.”  It’s funny how suddenly these relationships turn out not to be so close when the question of plan sponsors paying with their own money arises.  It’s also funny how there is a direct correlation between the amount of money an “advisor” (often a broker who cannot even legally provide advice or act as a fiduciary despite the fact that brokers refer to themselves as advisors) makes and how close the relationship is – meaning the closer the relationship, the less scrutinizing plan sponsors are and the more they allow the “advisors” to take from participants’ accounts.  So one might ask:  “What can be done about this?”  The answer is nothing if you view solving problems through the lens of central planning as this means of oversight would make it impossible to effectively monitor the extent to which personal relationships influence plan sponsor decisions on a consistent basis.   However, as retirement plan participants, we can ask questions and raise awareness to put a stop to these conflicts of interest that are costing us so much money.

Do the Most Expensive Retirement Plan Providers Necessarily Provide Better Services?

“You get what you paid for” is a common expression, and often this expression is true because when you pay more for something, you’re supposed to get more in return.  However, it doesn’t quite work that way in the retirement plan industry for a few reasons.  First, unlike the lower cost providers, the most expensive providers primarily charge for their services based on a percentage of plan assets, so as the assets increase, the fees in absolute dollars increase in spite of the fact that the percentage declines.  Consequently, these providers will continue to charge more without providing any additional services in return.  Second, the large providers include most of their ongoing fees within their “all-in” percentage-based fee whereas the lower cost flat dollar fee-based providers tend to provide an a la carte pricing structure where plan sponsors can choose to purchase additional services if they need them.

Overall, all providers basically provide all of the same services.  They just price these services differently.  However, large providers who charge asset-based fees still argue they offer more comprehensive services.  This claim is simply false.  One example is bilingual education services.  While these services are clearly important for companies with a non-English speaking population, they are not unique to large providers.  In fact, some large providers actually outsource bilingual education services to outside firms even though these services are still branded as being provided by the large providers.  Because these same outside firms can partner with any provider, there is no advantage to using a larger more expensive provider.  The only difference is that plan sponsors would have greater flexibility in choosing which services they want to pay for with a lower cost provider.  Another example is the ability to offer more default investment options.  This offering actually harms participants more than it helps as explained in an earlier post entitled Why Most Plans Have too Many Fund Choices.

This flexibility is especially important because almost all plan sponsors wind up paying for services that participants don’t ever use – which occurs mainly because plan sponsors have little understanding of what they are actually paying for as well as how to compare pricing of plans.  While providers may tout their statistics on how much participants contribute and how often participants use the website, the bottom line is that participants normally through their money into a fund (or multiple funds) and leave it there without having any idea of what they are doing in spite of the wide array of “educational” services which wind up confusing participants more than helping them.  In fact, participants shouldn’t be making many changes to their portfolio anyway, as evidenced by the fact that low cost portfolio models (i.e. conservative, moderate, aggressive) are available at a cost of less than 0.10% and can automatically be rebalanced by any record keeper as often as quarterly at no additional cost.

Open Letter to John Mackey

I admire your commitment to conscious capitalism and your ability to effectively articulate the principles and virtues of the free market.  I agree that our healthcare system, for example, as you have stated, would be much more innovative and competitive without burdensome government regulations.

However, you may not be aware of the stifling regulations in the 401(k) plan industry.  As a result, we have a far less flexible and transparent retirement plan system that benefits the politically connected retirement plan providers at the expense of the participants and embodies the very crony capitalism you have decried.  This lack of transparency prevents companies like yours from applying the same level of scrutiny to your 401(k) plan costs and design as you have applied to your health insurance plan.

To illustrate, you have written in your Wall Street Journal op-ed that Whole Foods Market has established a combination of high deductible health insurance plans and health savings accounts in order to create an incentive for your team members to spend their money more carefully.  Similarly, becoming more informed about the inner workings of the 401(k) plan industry will help you develop innovative methods to encourage your team members to invest their money more carefully.

You have also written that you allow your team members to vote on what benefits they most want the company to fund.  Unfortunately, however, most plan participants have little if any understanding of the costs and benefits of their plan and how almost all plans are set up for them to fail.  Consequently, by learning how to more effectively set up your plan and communicate its features to your team members, you can help them make more informed decisions.

For example, two of the largest holdings in your plan are target date funds through Vanguard.  While Vanguard does offer competitive target date funds, were you aware you could have offered risk-based portfolio models (i.e. conservative, moderate, aggressive) with the same holdings at approximately half the cost?  And are your participants aware that because the target date funds are meant to be stand-alone options, they may be unwittingly creating unnecessary additional costs and redundancy by choosing additional funds?

As a second example, you have 18 additional fund choices, most of which are likely highly correlated meaning they move in the same direction.  Consequently, while you may have the appearance of a diversified investment offering, your plan simply has too many choices, which not only create needless investment costs, complexity, and duplication, but also serves to make participants less likely to contribute because of the confusion that this vast array of choices creates.  As evidence to support this claim, Brightscope, an independent retirement plan rating service, has graded your participants’ salary deferrals and account balances as below average and poor compared to other companies in your peer group.

The Vanguard Total Stock Market Index Fund, on the other hand, which is the main component of each Vanguard target date fund, actually contains 3,644 securities, so you can clearly offer a diversified and comprehensive array of investment options without offering so many.  In fact, the federal government employee’s Thrift Savings Plan (which has over $400 billion) does just that, offering a total of 10 options including 5 Lifecyle (target date) funds.  In a free market, consumers would be more aware of these issues and would therefore have far more simple and lower cost plans.

In summary, I am writing you because I believe that together we have the power to vastly improve and expose the true nature of the 401(k) plan industry by spreading the message of voluntary and mutually beneficial exchange.  I have written a research paper entitled The Retirement Plan Racket that focuses on the issues I described above and that I believe will help you provide the best possible benefits to your team members.

https://www.paulsippil.com/The_Retirement_Plan_Racket.html

Please consider reading my research paper and joining me in promoting conscious capitalism in the 401(k) plan industry.

Sincerely,

Paul D. Sippil, CPA

Why the Retirement Plan Industry is Doomed to Fail Unless Plan Sponsors and Participants Start Paying Attention

The retirement plan industry, despite the pronouncements of the financial service providers and organizations who support it, is a complete disaster.  It is dominated by service providers who not only subject participants to significantly excessive fees and investment complexity, but who also have major conflicts of interest because of the kickbacks they receive from the mutual funds.

However, it actually gets worse because the people who are in charge of the plans either don’t have the aptitude to understand how the plan works, don’t care to understand how the plan works, don’t have time to understand how the plan works, or in many cases, all of the above!  Furthermore, there is often a relationship with a close friend or family member that precludes any sort of critical evaluation of the plan because the main goal of the plan is to simply direct business to the friend or family member – at least when the plan sponsor gets to pay these people primarily with other participants’ money (which is how it almost always works).

But what’s most disturbing are two psychological factors which prevent plan sponsors from acting in participants’ best interests.  The first is the fact that despite some vague notion that there are costs, the actions plan sponsors take indicate a belief that everything is free.  Because of this belief, plan sponsors and participants don’t even bother to consider what plans cost and make irrational decisions.  To illustrate, professor Dan Ariely in his book Predictably Irrational, provides an example of how the concept of “free” causes people to behave irrationally.  He cites an experiment where people had the choice between purchasing a Hershey Kiss for 1 cent or a Lindt truffle for 15 cents.  About 73% of people chose the truffles.  However, when the price of each candy was reduced by 1 cent – making the Kisses free – 69% of people chose the Kiss!  As Professor Ariely says:

“What is it about “FREE!” that’s so enticing?  Why do we have an irrational urge to jump to a “FREE!” item, even when it’s not really what we want? 

I believe the answer is this.  Most transactions have an upside and a downside, but when something is “FREE!” we forget the downside.  FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is.  Why?  I think it’s because humans are intrinsically afraid of loss.  The real allure of “FREE!” is tied to this fear.  There’s no visibility of loss when we choose a “FREE!” item (it’s free).  But suppose we choose the item that’s not free.  Uh-oh, now there’s a risk of having made a poor decision – the possibility of a loss.  As so, given the choice, we go for what is free.”  (Predictably Irrational, p. 54, 55)

Consequently, we always tend to buy things we don’t need when we get something for free.  In the retirement plan industry, plan sponsors make decisions to purchase retirement plan services that participants don’t need and don’t use because they think they’re free (this happens because most participants simply throw their money into a fund and leave it there meaning they don’t wind up using many of the services they’re paying for).  What’s worse is that these plans are actually not free, but very expensive – at least in proportion to the utilization of the services.

The second factor has to do with a phenomenon known as the bystander effect which refers to the idea that fewer people will help a person in distress the greater amount of people that are present.  Granted, retirement plan sponsors are not in a position to help people in distress in the way they would if they were witness to a car accident.  However, they are in a position to help participants protect their retirement savings, yet despite my consistently calling many plan sponsors (often over a period of years!) with the simple request of doing nothing more than picking up the phone and calling their provider to negotiate their fees, they often refuse to take any action whatsoever.  I believe the reasons are that they believe that everyone else is doing the same thing and that if nobody else is taking any action, then there must not be anything wrong.  So many times have plan sponsors said to me:  “Our fees are in line with other plans in the industry.”  Statements like this one perfectly exemplify plan sponsors’ abdication of responsibility as a result of feeling proportionally less responsible because of the belief that their actions are visible to others who are behaving the same way.

What ultimately has to change is not making new rules that represent more “reform” that so many people clamor for, but the mindset of central planning which ultimately results in plan sponsors serving the goals of politically connected service providers rather than the participants who they have a fiduciary obligation to protect.  As a consequence, plan sponsors spend most of their time and energy following a set of arbitrary bureaucratic rules instead of looking for ways to fill the unique retirement needs of each participant.

Unfortunately, those in power who benefit most from this system won’t give up their power any time soon.  To stimulate change, we need to strike at the root which perhaps can only be done with a full scale consumer rebellion.

What’s Wrong with Asset-based Fees? Pretty Much Everything!

Asset-based fees are the predominant model of the group retirement plan industry.  For this reason, nobody seems to question this arrangement.  Plan sponsors simply say “Everybody has to make money.”  The simple response to this assertion is “No they don’t!”

If there is no value to a service, then the service provider doesn’t deserve any money.  This idea should not be debatable.  However, because plan sponsors don’t understand what service providers actually do (and don’t do), they are in no position to determine the value of the services they are receiving.

The very nature of asset-based fees obscures the plan sponsor’s ability to effectively understand, compare, and effectively negotiate them.  Due to the cash flow and time constraints of running a business, most employers prefer to pass on most or all of the fees to the participants and do not have time to sufficiently understand the details of the retirement plans they offer.   As a result, plan sponsors tend not to look at the fees as closely as they would if they were writing a check instead, meaning they become less price sensitive, just as the withholding tax made us less sensitive to the taxes we pay because we no longer write a check.  This lack of price sensitivity becomes even more apparent when the plan sponsor either has little personal money in the plan.  Yet there are some plan sponsors who do not only have the means to write a check, but also prefer to do so. In these instances, plan sponsors suddenly become far more price sensitive and put more thought into whether the services they are receiving are commensurate with the fees they are being charged. However, the large plan service providers generally do not make it known that plan sponsors can write a check (and some do not even allow for writing a check) for all of the fees because these providers know their fees and services would then face far greater scrutiny.

From a psychological standpoint, plan sponsors also do not question the value of the services when the fees are based on a percentage of assets because this percentage gives the appearance of a good deal. Getting an entire package of services for only 1% doesn’t sound like much, but with an account balance of $2 million, that comes out to $20,000, which can be quite excessive for plans with few participants and little work to do. And is it fair if another plan has the same number of participants, but has $5 million in assets and therefore allows the provider to take significantly more money out of the participants’ accounts despite the fact that the plan doesn’t require any more work?  Clearly there is reason to question the fairness of this fee structure, yet plan sponsors rarely feel they have the power to negotiate lower fees and do not realize that some providers are willing to offer a flat dollar fee structure.  On the other hand, plan sponsors who do negotiate often feel they have competitive fees after receiving a reduction in the percentage their participants are being charged when in reality, they are just being ripped off a little bit less.  Less excessive fees are still excessive. When put in terms of hard dollars, however, a plan sponsor may be more inclined to scrutinize the fees instead of being so easily satisfied.

Providers often argue that their fees are reasonable by providing fee benchmarking studies showing that a client is paying fees that are in line with other companies of comparable size.  These comparisons are misleading because they simply indicate that fees are similar to other companies, but that does not mean other companies’ fees are reasonable either.  They also primarily disclose fees only terms of percentages rather than hard dollar costs and as a result, do not provide a true understanding of whether or not the fees being charged are reasonable in proportion to the level of services provided.

Providers may further argue that all plan sponsors need to see is the total cost and that delving into each component has less importance by pointing out that people only care about the total cost when they buy a car.  Unlike a retirement plan however, you aren’t going to buy the wheels and seats separately from another company – you are getting everything from one place.  With retirement plans, while there are some bundled providers who provide a one-stop shop for all investment advisory, record keeping, administration, and custodial services, many plans have multiple companies performing these tasks with different levels of expertise.  Therefore, only by comparing the cost of each service offering for each part of the plan in hard dollars can a plan sponsor obtain meaningful benchmarking information.

Another means providers use to keep plan sponsors and participants in the dark is to charge a flat fee for administration directly to the business and decrease this fee as the assets increase so as to make it appear that they are reducing the fees.  The reason they can reduce the fees is because the revenue sharing or percentage-based fee in absolute dollars increases as the account balance increases.  Plan sponsors don’t think much about this arrangement.  All they see is their fees being reduced, and for this reason they think they are being “taken care of.” A second form of deception some providers employ is to have plans set up so participants receive a credit, which gives the appearance of a refund.  This credit is often simply a return of the revenue sharing payment that a record keeper or financial advisor would have received has they decided to earn their compensation through revenue sharing.  Additionally, the providers who actually charge hard dollar fees may take the revenue sharing payment and issue a credit against the fee they are charging which also gives the appearance that the plan sponsor is getting some kind of discount, but this credit simply means the provider is not charging twice. In many cases, the record keeper and financial advisor often charge a percentage of the account instead which is usually either equal to or more than the revenue sharing payment itself.  This credit often creates confusion because plan sponsors believe providers are discounting their fees. In reality, however, the plan sponsor could have simply purchased the same funds (or very similar funds) without the revenue sharing fee in the first place, so the credit is nothing more than an accounting gimmick.  Furthermore, as previously mentioned, both record keepers and financial advisors often reduce the percentage payment as the assets increase, which also gives the plan sponsor the appearance that they are receiving a discount, when in reality their fees are still increasing, just at a decreasing rate.  In fairness to the providers, some of them may not even be trying to trick the plan sponsors, yet the plan sponsors rarely have a full understanding of how the fees are charged.  As a result, when a competitive provider displays honesty by openly charging a flat annual fee, plan sponsors often view this arrangement as more expensive because they believe their current services are “free” or “discounted” since they either don’t see any fees or see they are receiving a credit.

The idea of paying down debt also becomes an issue under asset-based fee arrangements.  While this idea may sound counter-intuitive, the last person to ask this question to should be a financial advisor who has an incentive to advise against paying down debt, as an advisor’s compensation is increased as a result of an increase in plan assets.  Another common participant question is how much to save each year.   Financial advisors tend to advise participants to contribute the maximum affordable amount for the same reason they suggest not paying down debt.  However, participants may already be in a comfortable financial position without having to contribute the maximum affordable amount, so financial advisors’ advice can cause needless sacrifices to their current living standards.  Granted, advisors could argue that they need to raise their fees because their professional liability insurance premiums increase as the plan assets increase.  However, the increase in premiums is generally based on each $1 million of coverage, while the advisors’ percentage-based compensation increases with each dollar in plan assets.  And yes, some advisors do decrease their percentage-based fee as the assets increase, but their fees in absolute dollars still ultimately increase as the assets increase.

As a whole, the fees service providers charge bear no relationship to the services they offer. Instead, fees for the providers who dominate the industry are based on factors such as average participant account balance and annual plan contributions rather than the amount of time involved.  This pricing model helps these large providers generate more revenue, but they do not necessarily provide higher quality services in return for this additional revenue. As a result, plan sponsors cannot effectively use providers’ pricing as a means to determine the quality of their services, which is extremely important because providers who lack sufficient expertise can make costly mistakes.  To elaborate, some providers of investment advisory, record keeping, and administration services actually possess a greater level of sophistication than other providers in spite of being able to offer services at a lower price, which suggests that the pricing of retirement plan services is completely distorted.  Until pricing models change to more accurately reflect the value of services provided and plan sponsors and participants gain an understanding of the cost of the services they are receiving, the retirement racket will continue.