As a financial planner, I’ve seen many a 401k plan in my day, and I’m here to tell you that the vast majority of them are not pretty, while some are even downright ugly. Admittedly, that’s a mighty broad brush full of awfully harsh words, and I’d surely prefer to be la-la-la’ing about instead, all chipper, sprightly espousing what-a-wonderful-world bromides, but I feel irresistibly impelled to instead write of the truth I’ve seen. And that truth is that the typical 401k plan — in which a decent part of the wealth of most Normal Folks resides — falls quite a bit short of being beautifully designed.
Please allow me to explain.
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The Design of 401k Plans.
401k plans are all alike in some ways, and all one-off’y in others — all of them generic appendages and overall precipitation, but each unto itself a one-of-a-kind fingerprint and snowflake.
The basic design of most plans — the chassis let’s call it — is quite standardized. That chassis emanates from the documentation establishing the plan, which contains a lot (100-plus pages usually) of mumbo jumbo legalese, most of it included there to help the plan obtain the IRS’s blessing of the plan as a legit 401k plan, capable of providing the 401k tax advantages that we all know and (sometimes to the point of rote obliviousness) love. That documentation creates a legal entity — a very specific sort of legal entity — that is the 401k plan.
Supplementing the chassis is something I call the plumbing, which consists of the virtual pipes that tap into the company’s payroll process, through which a just-right amount of each participating employee’s payroll dollars are siphoned away, pronto, from going to the employee’s bank account to help support his or her current lifestyle, to instead go to the employee’s 401k account to be used later on to help support the employee’s future lifestyle, and in the meantime to stew and marinate as investments.
These components of a 401k plan are all highly standardized one plan to another and, for all but the most curious and activated plan participants, entirely out of sight.
Riding on top of those components and also mostly standardized, but very much something that even the most apathetic and lethargic plan participant butts up against, is a set of decisions which any company offering a 401k plan must make about how generous it wants to be, such as (a) which employees are eligible to participate in the plan (e.g., those who are at least 18 years old, have at least one year of service, and work at least half time), (b) what kind of employer match to provide, if any (e.g. 50% of each dollar the employee contributes, up to a max of 3% of any given paycheck) and (c) how long an employee has to be with the employer before the employee is entitled to those employer match dollars even if the employee stops working for that employer (e.g., three years, with the turn of phrase being, “the match dollars vest in three years”).
Within each of these decisions, employers have a range of generosity to consider, with the constraint on the miserly side coming from tax law (go too miserly and the plan will not qualify as a 401k plan for tax purposes) and, on the saintly side, the constraint coming from general economics and business self-preservation motivations (go too saintly and the 401k plan could suck enough cash out of the business to kill it).
So those are the standardized components: the chassis and the plumbing, out of sight and out of mind, plus the generosity decisions riding on top, creatures, all, of the taxation and retirement systems we as a country have created via our government.
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The FSIC Part of 401k Plans.
Once those mostly standardized components are in place — the chassis, the plumbing, the generosity decisions — you end up with a socket into which an entirely different component must be plugged. The component that plugs into this socket is not at all standardized, and, for plan participants, is the most salient part of the plan because it’s where their decision-making most comes to the fore. And rather than being a creature of the tax and retirement systems we as a country have created via our government, this component is very much a creature of the part of our world often short-handed as Wall Street, which I call the Financial Services Industrial Complex, or the FSIC for short.
I refer here to the investment menu of the plan, i.e., the limited number of investments, primarily mutual funds, that plan participants are allowed to purchase with the dollars they contribute to their 401k plan.
Every 401k plan has but a single menu, and that single menu might have, say, as few as a dozen to as many as a handful of dozens of investments to choose from, with most menus these days falling in the middle of that range (depending on how you count . . . ). For every single 401k plan, then, there is, somewhere out there, a person or a committee responsible for selecting those dozens of mutual funds appearing on the 401k plan’s investment menu from among a universe of many thousands of mutual funds.
So how do you suppose those selections get made?
Hmmmm . . .
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Assessing the Design of a 401k Plan at the Investment Level.
The first thing I look at when getting to know a client’s 401k plan is whether the investing menu looks like it was designed with the interests of the plan participants in mind, or was instead aimed at furthering the interests of the person or people designing the investment menu of the plan. The former sort of menu tends to contain mutual funds that charge relatively low management fees (less than, say, 0.75% per year), while the latter tends to contain mutual funds that charge high management fees (more than, say, 1% per year). Those fees, which come straight out of the employees’ investment holdings via lower prices of their mutual fund shares, tend one way or another to lead back to someone’s pocket — often the person who sold the plan to the employer, who is often also the person most or entirely responsible for deciding which funds are on the menu.
The second thing I look to is how easy it is for the participants in the plan — who, by and large, are NFs (Normal Folks) with neither the time nor the inclination to get deeply involved in ongoing investing decisions — to be smart when making investment decisions using that menu. Does the menu nudge, at least a little bit, plan participants to dial in investment selections that are smart and apt to increase their overall financial health regardless of their level of attentiveness? Or does it instead nudge them towards choosing investments that are apt to come back to bite them, such as investing their contributions big-time in their employer’s stock (Enron be thy name) or some mutual fund that is both wicked expensive to own and full of super-concentrated risk (Janus be thy name)? Or, more idiomatically: does the menu make it easy for participants to shoot themselves in the foot, or would they have to walk a mile to do so? Or, more coarsely: how idiot-proof is the menu? It’s a long way to retirement, after all, and some sorts of investments are much more likely than others to need to be jettisoned sooner or later, so mightn’t it be a good idea for 401k plan investing menus to emphasize investments that are likely to work well as simple buy-and-hold investments?
The third thing I look for, related to and in many way subsuming the two characteristics above, is whether the menu allows plan participants to pursue a well-diversified passive investing approach — over and above the target date funds most funds offer these days (a target date fund is a mutual fund designed to auto-pilot an investment portfolio from mostly stocks to mostly bonds, to fit well with a targeted retirement year, e.g., a 2020 Target Date fund is designed for people planning to retire in 2020). To receive a positive review from me on this characteristic, the 401k investing menu must offer, at minimum, two stock index funds — one that tracks the entire US stock market and the other that tracks the entire non-US stock market — plus one bond index fund that tracks the entire US bond market.
I just about never see menus with this third characteristic. In this day and age, what with passive investing now being totally mainstream and Vanguard, its long-term proponent, the biggest mutual fund house of all, why is this? Also, given that many (most?) money managers assert that smartly managing an investment portfolio requires the services of an expert actively attending to the portfolio and the overall investing world on the day-to-day level or at least week-to-week level, and given that nearly all 401k plans are managed by the plan participant without nary a glance from anyone with anything even approaching investment expertise, why then do folks putting together investment menus often shy away from mutual funds that take the passive approach to investing?
Hmmmm . . .
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The Selling and Pricing of a 401k Plan.
Every 401k plan is sold. For every single 401k plan, then, there is, somewhere out there, a person who was primarily responsible for selling that particular 401k plan, and someone, within the particular employer, who was primarily responsible for buying that particular 401k plan.
Let’s first look at the buyer. In large companies, the person buying the plan is usually part of a multi-person department focusing on group benefits, and has some, or a lot, of expertise. We can assume, then, that the buyer in a large company can for sure negotiate a great deal for the company and, if the company so wishes, a great deal for the plan participants as well (the same sorts of employer motivations that play a role in the generosity decisions mentioned above come into play here as well).
In the SMB market, though (SMB = small and medium business, a new, to me anyway, abbreviation making the rounds these days), the person inside the company responsible for buying the plan is usually an office manager or a human resources generalist or a controller, so the buyer in the SMB space sometimes (oftentimes?) has little or no expertise, and therefore might not be able to negotiate a good deal for the employer, let alone for the employees.
Now let’s look at the seller. People who sell 401k plans ran the gamut from young stockbrokers just starting out and struggling to make a living, to Wall Street interests already quite gargantuan. All along that spectrum, though, asset gathering is the seller’s main goal, and assets under management fees the seller’s main economic motivation, because, any which way you slice it, the more dollars inside a 401k plan, the higher will be the fees it generates (since assets under management fees are calculated as a percentage of assets).
It happens, then, that many (most?) sellers of 401k plans dial in what I would call an override — a vig, a slice — on top of all the other expenses the employer and the plan participants pay, mostly as compensation for the sale itself, and also for helping out a bit with the ongoing participant education piece that companies providing 401k plans are obligated to provide, plus steering the investment menu plus helping the employer be smart about offering the 401k plan. That override might be, say, 0.25% to 0.5% (sometimes more) and typically lasts forever.
Presumably employee headcounts increase over time, as do investment values, so it is easy to imagine that, ten years down the road, the asset base against which that override is calculated has increased three- or four-fold. Indeed, if headcount and asset prices both double over that time (about a 7.2% annual rate of increase), you’re looking at a double-double, which is a four-fold increase of the asset base inside the plan. Assuming that the override percentage stays constant, then ten years later that override has grown into a four-fold larger payday. At that time, though, the closing of the sale is a distant memory, and the ongoing services required of the seller of the month-to-month sort are essentially nil, while the annual services have probably stayed roughly constant (though increased headcount can increase the eduction burden).
I, for one, have a hard time seeing any alignment between, on the one hand, the value being delivered by that seller ten years out, and, on the other, the compensation the plan is generating for the seller. I also think it’s wrong for Normal Folks to be footing the very real bill stemming from that misalignment. Wall Street, the FSIC and the world in general, as currently constituted, do not, however, agree with me.
Indeed, that’s business as usual; the rock star coveted by the microwave oven salesman in Mark Knopfler‘s Money for Nothing is an absolute piker by comparison.
It’s actually even a bit worse than I’ve mentioned so far, because I’ve only talked here about two kinds of fees (the internal costs of the mutual funds inside the 401k, and the seller’s override); quite often there are other fees layered on and spirited away as well.
And, yes, all you politically oriented folks out there who’ve been wondering: these layers of fees and costs and big-numbers-for-not-very-much-value compensation and pricing arrangements were indeed one of the main arguments against privatizing social security back in 2005.
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The Beauty and the Ugly of 401k Plans.
401k plans can be beautiful things. They mostly play to our strengths and submerge our weaknesses.
That’s important, because we human beings are fallible things, and nowhere more so than when it comes to squirreling money away for a later time. As a result, the you-can’t-spend-what-you-don’t-have mantra underlying all 401k plans — the siphoning away of our wages, away from our bank accounts and towards our long-term retirement investments — is a stupendously helpful thing for most people’s financial health.
Into that beautiful thing, though, a sometimes very ugly other thing comes, which is the part of us human beings that just loves to get paid for nothing, the more the better, period, the end. It is sometimes the case (often the case?), then, that 401k plan investment menus tilt heavily towards investment choices that are on the menu at least in part (in large part?) on account of the rich compensation they kick out, year after year, to a bunch of people plan participants never know. It is also sometimes the case (often the case?) that, on top of that fund-derived compensation going to a group of people, there is an override to boot, compensating the person or people who sold the plan to a buyer who, especially in the world of small to medium business, might not have been all that sophisticated and might have gotten a not-good-at-all deal.
Put it all together and you have this beautiful structure helping people save for their later years, but sometimes within it (oftentimes?) an ugly core sucking the good out of that structure — an ugly core in which dozens of folks within a single 401k plan (or hundreds or even thousands) pay a lot of money for something that has little or no value to any of them, with some of that money (a lot of it?) sometimes going to a single person (oftentimes?). So it’s from the many to the one, where the “many” are Normal Folks and the “one” is some human being well ensconced within the FSIC.
It needn’t be this way.
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Towards Better 401k Plans.
Our collective self, in the form of our government, has recently lent us a hand, by requiring a greater level of disclosure from 401k plans about the expenses and fees built into the very structure of the plan itself. My impression, which many share, is that the new requirements are mostly a swing and a miss. For one data point, I haven’t talked with a single 401k plan participant who has read, let alone understands, these disclosures. This might be because the disclosures tend to be quite opaque and because they tend to obscure a lot of the good stuff, e.g., who is getting paid, and in exchange for what.
The FSIC as a whole loves it best when people pay for stuff without even knowing that they are paying for it, and, absent that, will settle for leaving people with the impression that, sure, they’re paying for something, but, hey, it’s all good, because they’re getting fair value in return.
My hope is that in the coming decade more and more folks responsible for buying 401k plans in businesses — the HR folks, the office managers, etc. — will make sure that their plan participants have better access to passive index funds in their 401k plans, and will also nail down the services the plan will receive, over the long-run, in exchange for any override the seller of the plan is getting paid. My hope is also that participants in plans will come to know, more and more, that by buying index funds, they have the power to keep more of their hard-earned retirement dollars for themselves, while at the same time de-powering, at least a little bit, the beastly part of the FSIC — the part of the Financial Services Industrial Complex that relies on salespeople to get unknowing people to pay too much for far too little, and pays a handsome ransom to those salespeople in return.
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In a much discussed Senate subcommittee hearing on April 16, 2010, during the depths of the Great Recession/Little Depression, Carl Levin, a six-term Democratic Senator from Michigan who will be retiring on January 3, 2015, made the 24-hour news cycle big-time when he confronted Daniel Sparks, head of the Goldman Sachs mortgage department and the person within Goldman primarily responsible for, and presumably most directly benefiting from, the selling of CDOs.
If you haven’t the foggiest idea what CDOs are, then you’re normal; Normal Folks have never heard of these things. Luckily, for our purposes here, you really don’t need to know anything about what collateralized debt obligations are, other than to know that they’re rocket-science sorts of financial products — derivatives riding on top of derivatives riding on top of mortgages, and, yes, that is two layers on top — that were emblematic of many of the excesses that led to the financial crisis of September the 15th, 2008.
The particular CDO in question during that hearing, named Timberwolf I, lost 80% of its value within half a year of being sold — an outcome, it appeared upon investigation, not at all surprising to some within Goldman Sachs (many?).
Senator Levin’s newsworthiness came primarily from his repeated use of the phrase “shitty deal”, as he repeatedly sought Mr. Sparks’s thoughts about an email he received from another manager at Goldman Sachs, which included the sentence, “Boy, that timeberwof [sic] was one shitty deal.” Without getting into the meaning of that email or the extent of Goldman’s culpability, I can, quite neutrally I believe and hope, say that, ever since then, the term “shitty deal” has taken on a life of its own, reinforcing the idea that there are some financial services professionals out there (many?) who will sell anything to anybody in order to make any number of dollars.
To paraphrase, then, and to add just a pinch of Midwestern innocence dressed up in appropriate business attire, so to speak, when I look at all too many 401k plans, I find myself shaking my head and muttering, Gosh, that’s one rotten deal.