My column last week probably prompted many readers to panic when I asked a simple question: Do you know how much your mutual funds cost? I should have mentioned that this is a two-part quiz. And here's the second question: How much are you paying for your 401(k)?
I've already guessed what the two most common answers will be:
A, I have no idea. Or B, my 401(k) is free.
If I had a red Sharpie in my hand, I'd mark both answers wrong. If you've got a workplace account, your chances of picking up the tab for your 401(k) is as likely as tomorrow's rush hour. What's more, the costs can be far higher than the price of a closet full of office supplies.
Those who read last week's column will already appreciate why so many people remain unaware that their 401(k) is a parking meter that must be fed. When you invest in mutual funds at your workplace or on your own, you never receive a bill - the money is deducted from your accounts. If you did receive an invoice, you'd be more likely to decide whether a fund with platinum expenses and leaden returns should be tossed.
It's understandable that people never ask about 401(k) costs, but what's inexcusable are the thousands of employers who are just as complacent. In fact, even the most well-intentioned companies don't necessarily know the cost of their employees' retirement plans.
I observed this phenomenon firsthand while I was at a corporate Christmas party a few years ago. During a conversation with the human resources director, I asked her about the employees' 401(k) expenses. At first she looked perplexed by the question before she assured me that the workers didn't pay anything. Yikes, I'm thinking to myself, as I tried not to choke on my chardonnay. How would she know if her employees were overpaying when she wasn't even aware that they paid anything at all?
What's alarming about corporate ignorance or indifference is this: With increasing numbers of companies shamefully ditching their pension plans, the 401(k) has become a financial firewall for many workers. If the firewall doesn't hold, millions of employees could be forced to work far into their retirement years, or live on peanut butter crackers.
And, unfortunately, workers can't go out and find a better 401(k) if the investment choices in their corporate plan stink. They can only hope that their superiors will select top-notch mutual funds with low costs for their retirement plans.
But here's where things get really perverse. Companies are often far more motivated to sign off on plans that offer mutual funds or annuities with bloated fees that employees must shoulder. Why? Because these expensive investment choices generate so much excess cash for the outside firms overseeing these 401(k) plans that workplaces have to kick in little or no money for the administration.
When companies are told they can pay for a variety of 401(k) costs or leave it to their employees, they tend to choose the latter without asking many questions.
The way that much of corporate America operates 401(k) programs is more than just a shame. It's possible that some of them are breaking federal law. Last month, Schlichter Bogard & Denton, a law firm in St. Louis, filed lawsuits against seven of the nation's biggest corporations alleging that their workers were charged millions of dollars in excessive 401(k) fees.
At the same time, New York Attorney General Eliot Spitzer is reportedly close to reaching a settlement with a major insurance company that sells and oversees 401(k) programs for taking undisclosed fees to promote certain mutual funds for a retirement fund for teachers.
What potential transgressions have attracted the interest of prosecutors and trial lawyers? A common 401(k) industry practice called revenue sharing is what's drawing fire. If you have a weird lineup of expensive and mediocre mutual funds in your 401(k), the culprit could be revenue sharing.
To understand what revenue sharing is, you have to appreciate how 401(k) plans are put together. Some guy in your human resources department didn't dream up your 401(k) menu. Nor does anybody in your company manage the plan. What typically happens is that a company selects a vendor to pull together a plan and then maintain it. The outside administrators include many of the nation's most recognizable mutual fund companies and brokerage firms, along with major insurance companies.
In pulling a plan together, the vendor often picks mutual funds that charge investors a 12b-1 fee, which I mentioned in last week's column. The 12b-1 fee was created more than 25 years ago to allow small mutual funds to generate money to advertise their existence. Today this pernicious fee is popping up everywhere, including 401(k) plans.
Here's a common scenario: The outside administrator will select more costly mutual funds with 12b-1 fees for a workplace 401(k) menu. In return, the anointed mutual funds will use their 12b-1 cash to, in essence, thank the administrator for picking it for a company's 401(k) lineup. Can everyone see the potential conflict of interest in these arrangements? With this undocumented 12b-1 windfall, the administrator can oversee the plan without billing the workplace for its services. That's the part many employers like.
But operating a 401(k) with hidden payments - and no accountability - should be unacceptable. In fact, the federal Employee Retirement Income Security Act, which oversees workplace retirement plans, requires that 401(k) fees be reasonable and fully disclosed. If the boss doesn't know who is getting what, how will he be able to say he's complying with this law? That's a question that I bet more trial attorneys are going to be asking soon.
Next week: More on 401(k)s.