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.

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


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.

The $37,109 Commission Payment to a Broker that a Plan Sponor Insisted was “Free”

Mark Twain once said “It’s easier to fool people than to convince them they have been fooled.”  Too bad more retirement plan sponsors don’t heed his words.  If they did, it might one day occur to them that broker’s commissions are not free.  Unfortunately, I don’t see this happening any time soon.

To illustrate, I recently had a conversation with a woman in charge of overseeing a company’s 401(k) plan.  I tried explaining to her that the $37,109 commission payment that her broker received in 2012 was paid for by the participants despite her insistence that the mutual funds paid this commission and that it was free to the participants.  I tried explaining the concept of a share class to her which is the means by which a broker determines the level of compensation.  Plan sponsors have no idea what this means, so brokers always have complete control over the compensation they take from participants’ accounts.  The reason for the availability of different share classes is to allow the broker and plan sponsor to discuss different levels of compensation.  Of course this never happens nor does the broker ever remember (or perhaps conveniently forgets) to reduce the percentage-based compensation as the assets increase.

So this situation naturally begs the question:  If mutual fund payments to brokers are free, and the broker has the ability to select the share class without asking permission from the mutual funds, why would mutual funds bother offering different share classes?  Since everything is free to the participants, why wouldn’t every broker just continue to select the share class that pays the most?  And why would the Department of Labor bother having a fee disclosure requirement?

If any plan sponsor ever bothered going on the Department of Labor’s website in order to verify what should have already been obvious, they would find the following:

“Mutual funds also may charge what are known as Rule 12b-1 fees, which are ongoing fees paid out of fund assets. Rule 12b-1 fees may be used to pay commissions to brokers and other salespersons, to pay for advertising and other costs of promoting the fund to investors and to pay various service providers of a 401(k) plan pursuant to a bundled services arrangement. Some mutual funds may be advertised as “no-load” funds. This can mean that there is no front- or back-end load. However, there may be a 12b-1 fee.”

Sadly, the plan sponsor’s only response to this was:  “I need to do more research.”  Even more sadly, this response was not the exception, but the norm.  If common sense requires research, a broken and corrupt retirement plan system is the least of our worries.

How Conversations with Plan Sponsors Typically Go

Here is a typical interaction I have with a plan sponsor:

Financial Advisor:  I’m calling to quickly figure out if some of the research I’ve done and work I do is relevant.  If not, you’re welcome to hang up on me.  I just wanted to see if you had a minute.

Plan Sponsor:  What kind of research?  If it’s about the 401(k) plan, we’re all set.  We’ve done an extensive amount of due diligence recently.

Financial Advisor:  I am not concerned with whether or not you are “all set.”  I am simply trying to change the way in which the industry does business and help plan sponsors understand what’s actually going on without their knowledge.  More specifically, I am trying to explain to plan sponsors that they should only be passing on flat dollar fees to their participants for all record keeping, administration, and advisory services.

Plan Sponsor:  We just addressed what you mentioned.  We have a broker and XYZ Company and only pay flat fees.

Financial Advisor:  A broker by definition can only earn a percentage-based kickback paid by the mutual fund companies to retirement plan service providers and ultimately coming out of the participants’ pockets, which means a broker can only make money by directing you towards certain funds and investment platforms and away from others.  And yes, you may be paying a flat fee for the administration, but administration is the smallest portion of the fees.  XYZ’s business model is primarily based on revenue sharing, which by definition is also a percentage-based kickback.  If they reduce their fee, it only means they reduced the percentage, and that percentage only gets reduced once the account balance grows, so paying a lower percentage on a higher balance is NOT a reduction in fees at all.

Plan Sponsor:  Our broker does a good job.  He comes out regularly to meet with the participants.

Financial Advisor:  As I just mentioned, a broker can’t make any money unless he steers you towards certain platforms and funds.  Furthermore, a broker cannot legally provide advice.  Only a registered investment advisor can provide advice and charge a flat fee that is commensurate with how much actual work there is to do.  Consequently, you need to keep him as far away from your participants as possible.

Plan Sponsor:  I understand what you are saying, but we’re happy with our arrangement.

Financial Advisor:  How can you be happy knowing that your providers are consistently getting significant raises (and therefore subjecting participants to continually higher fees) without doing any more work?  And do you realize what administration and record keeping services actually entail and the difference between the two services?  Administration is nothing more than giving plan design advice, preparing a tax form, and performing discrimination testing and other compliance services, while record keeping is nothing more than sending out statements, providing a website, and keeping track of participant balances.  Can you honestly tell me that any advisor, broker, administrator, or record keeper is actually doing more work simply because the assets have increased?  How can you justify any provider taking more money out of participants’ accounts just because the assets are greater?

Plan Sponsor:  We have a good handle on things.  We understand how our fees work.

Financial Advisor:  Did you know that your provider’s primary pricing structure is a percentage-based fee or kickback based on cash flow contributions and the average participant account balance?  What do any of these factors have to do with how much actual work there is to do?  Did you know that there are many providers such as Vanguard, Ascensus, Aspire Financial, and Alliance Pension who only charge a flat dollar fee for all record keeping and administration services solely based on how many participants there are in the plan or how much actual work there is to do regardless of how much the plan has in assets?

Plan Sponsor:  I’m really busy.  I don’t have time to address this now.

Financial Advisor:  I don’t doubt you are busy, but unfortunately, based on the fact that the vast majority (or perhaps all) of the fees retirement plan service providers charge are deducted out of participants’ accounts and therefore don’t affect the bottom line, the retirement plan will likely always be a back burner item which dis-incentivizes plan sponsors to scrutinize fees as closely as they would if they were instead writing a check.

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:—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.

Why companies should never use a broker to “manage” their plan

A broker cannot legally provide advice or act in a fiduciary capacity.  Rather, a broker can only earn percentage-based kickbacks known as 12b-1 fees from mutual funds which creates a major conflict of interest because some mutual funds don’t have any kickbacks – which means a broker can only make money by recommending certain funds.  Only a registered investment advisor can act in a fiduciary capacity and provide actual advice because this type of advisor does not receive any kickbacks.  This short video also illustrates the difference:

Butchers v Dietitians Brokers v Advisors Suitability v Fiduciary:

This article further explains:

Conflicts of Interest Cost Retirement Plan Investors Billions:

•   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.

 Furthermore, many plan sponsors are actually under the impression that a broker somehow helps them meet their fiduciary responsibilities.  This is simply not possible, as a broker is not only not a fiduciary, but a party whose very existence inherently places plan sponsors at greater risk.

First, a broker can only get paid a percentage-based kickback that is deducted out of participants’ accounts, so if plan sponsors wanted to limit their expose to excessive participant fees by writing their broker a check, they would not be able to do this.  Second, a broker can typically only make money from more expensive actively managed funds (or index funds which are significantly more expensive that the least expensive available index funds such as the Vanguard Total Stock Market Index Fund – VTSAX – which has a cost of only 0.05%) which require significantly more monitoring than less expensive passively managed index funds.  This additional required monitoring makes an investment policy statement (a written description of a plan’s investment related decision making process) more difficult to follow.  Third, because a broker can only charge a percentage-based fee rather than a flat fee based on how much actual work there is to do, there is a greater chance that the broker’s fees will not be considered reasonable in light of the services provided.

Unfortunately, everyone still continues to falsely believe that a broker is “free” because the mutual funds pay the broker.  This belief isn’t true as explained below:

“The first form of revenue sharing, 12b-1 fees, is used for the cost of the sale, or distribution, of investments. The fee is deducted from the assets of the mutual funds and thus is charged directly to the participants invested in that fund. The fee is ordinarily paid to a broker-dealer as a part of the distribution of the mutual fund. However, for small plans funded with group annuity contracts, it may be paid to subsidize the recordkeeping costs.

The second form of revenue sharing, subtransfer agency fees (or sub-TA fees), are also deducted from the mutual funds’ assets. A mutual fund must maintain records of its shareholders and may properly pay for that service. Where an intermediary, like a record keeper, maintains those records, the mutual fund pays the record keeper for that service. Sub-TA fees are typically fixed fees on a per-participant basis or asset-based fees, or a combination of both. [Pozen, Robert C., The Mutual Fund Business. Boston: Houghton Mifflin Company, 2002.] The transfer agent also provides other shareholder services, such as administration, compliance, communications, and other operational services; the fees for these services, in the aggregate, are referred to as shareholder servicing fees.

The third form is that the mutual fund investment management firm, or an affiliate, may pay a portion of its management fee to a third party as a form of revenue sharing. For example, a mutual fund manager or affiliate may pay a bonus payment to a broker/dealer based on a specified sales goal or total volume of business retained. The source of this money is the fee for managing the portfolio of securities held by the mutual fund that is charged to the fund by the investment manager. Management fees are also charged directly to the mutual fund’s assets, thereby reducing participants’ benefits.”

“Mutual funds also may charge what are known as Rule 12b-1 fees, which are ongoing fees paid out of fund assets. Rule 12b-1 fees may be used to pay commissions to brokers and other salespersons, to pay for advertising and other costs of promoting the fund to investors and to pay various service providers of a 401(k) plan pursuant to a bundled services arrangement. Some mutual funds may be advertised as “no-load” funds. This can mean that there is no front- or back-end load. However, there may be a 12b-1 fee.”

Why most plans should not have an investment policy statement

An investment policy statement (IPS) is a written description of a plan’s investment related decision-making process.  While not required, the prevailing view is that any company offering a retirement plan should have this document in place because it will help provide protection from fiduciary liability.  In fact, the Department of Labor will regularly ask for this document in the event of a plan audit.

However, it is actually a bad idea for most companies to have an IPS because they likely will either not follow it or not sufficiently document the process.  The reason is that most companies have a large number of asset classes and fund choices, most of which are actively managed.  As a result, the process becomes extremely complicated to follow.  Here are some examples of questions that come up:

  1. Under what circumstances will the fund managers be replaced?
  2. What happens if the style of the fund changes?
  3. How should the performance standards of the fund managers be determined?
  4. How should these decisions be documented?

There are likely many more questions that companies need to answer, but the idea should be clear:  most plans are set up in a way that makes it extremely difficult to follow and document the steps in an IPS.   Consequently, it’s safer not to have one at all.