This is my first post in a new series which will analyze the retirement planning industry. I will cover 401(k), 403(b), and other (less popular) vehicles in my discussions. My hope is to unravel to some extent the cost structure of these plans and help corporate executives, business developers, and plan participants to gain a stronger understanding of how their retirement funds are being handled. It’s no secret that retirement plans are a huge mystery, even to those who administer them and preach about their benefits. Much of my research is my own, and stems from reading hundreds of retirement plan documents and speaking to people who invest their hard earned money in these plans. The other portion of my research comes from Matthew Hutcheson, an authority in the field of unmasking qualified retirement plans. I’d like to thank him in advance for his extensive knowledge and research in this area. His paper on hidden fees in qualified retirement plans is outstanding and can be found, along with other interesting materials, at the 401k Help Center.
In this first entry, I’d like to talk about what, exactly, the problem is. I’ll follow up in a few days with a post on the details of how retirement plans are structured and where you can find these hidden fees. Finally, I’ll jump into potential solutions to the problem.
Let us note that the issue of corporate retirement plans, especially those which we self-direct, is becoming increasingly important. A pattern is emerging in which corporations are shifting their benefits structure from the old line “defined-benefit” (i.e. pension) plans, to more modern “defined-contribution” (i.e. 401k) plans. This is a crucial distinction to understand. In the old days, 30 years of service to a major corporation may have been rewarded with checks which could support you and your family into your late years. Companies have been discovering that making these promises can be a financial disaster. If revenue and profits don’t keep pace with the promised level of benefits, a company can go bankrupt while trying to make these payments to retired workers. The solution, which should make sense, is to avoid these somewhat unpredictable financial obligations. Rather, have employees re-focus onto current, self-directed retirement plans. Employers can motivate their workers by offering a match (free money) as an incentive. Understanding this transition within the retirement arena is very important. It creates a sense of urgency to the problems surrounding costs and fees within the plans.
There are other factors, such as increasing life-expectancies and decreasing government benefits which add fuel to the debates about self-directed retirement savings.
Let me take a moment to answer a question which I commonly field at this point. “Russell, why do we focus on fees, costs, and structure, rather than on investment options? Who cares about costs and fees if you can select the best funds in the right sectors? The answer to this question is quite simple. Over the long-run, on average, very few people outperform the major indexes (i.e. the S&P 500). In the short-run, managers might pick the right sectors and look great, but if you study their performance over five-year, ten-year, and longer periods of time, things looks a little different. In fact, statistics show that people who chase performance come out way behind over the long-term. If you’re interested in pure speculation, do it with a portion of your money which you can afford to lose. Don’t do it with little Meg’s college savings fund. Thus, we focus on costs and fees because these are items which we can actually control. If we reduce our average expenses from 2% to .5%, we’ve effectively improved our return by 1.5% per year.
So, now that we’ve established why the 401k and other defined-contribution retirement plans are important. We’ve also mentioned why we focus on costs and fees, rather than on performance. Now let’s get back to the problem. Americans aren’t getting their fair share of market returns! Part of the problem is the debatable fact that the average American may not be knowledgeable enough to manage his or her own retirement plans. We’ll talk about this in a moment. The other, larger issue is that financial professionals, namely brokerage firms and plan advisers, may not be adequately disclosing all the fees and expenses associated with the plan. What’s particularly ironic is that plan participants–the same people who are paying these hidden (and often superfluous) fees, and taking on the market risk–are totally unaware of the problems.
•The average American may not be capable of managing his/her own retirement plans – If you think about it, what’s so great about having a self-directed retirement plan? In practice, it encourages a majority of people–who don’t know much about investing and personal finance–to make important decisions regarding their long-term financial security. Ultimately, that translates into a lot of confusion. You could easily ask three people the best way to invest retirement funds and get three completely different answers. Also, I’ve noticed that individuals tend to switch in and out of funds more frequently with self-directed accounts, resulting in lower performance and higher expenses. This doesn’t sound like an advantage, does it? In theory it could be a good thing, but only once investor education becomes dramatically better.
•A few financial professionals may not always place your best interests first - There is a long list of people who get in between an investor trying to buy an investment. At the most obvious level, retirement plans, like non-retirement investments, often involve commissions and fees paid to the representatives who help implement the plan. Often these representatives help “educate” the participants about details of the plan. They also host enrollment meetings, field questions, etc. There is certainly some value to these services, but the extent of that value, and the price tag on it, may be questionable. These guys sometimes receive ongoing commissions and fees as well, something we’ll get more into in the next post. At a deeper level, there are more costs and fees involved with the fund itself picking and choosing investments. This includes trading costs, paying rents, paying research analysts, etc. The stuff you never think about gets sucked out in the form of expenses which ultimately reduce your return.
The follow-up post will discuss what these fees, costs, and expenses are in more detail.
As always, feel free to e-mail me with questions or comments.
Premier Financial Advisors
14 E. 60th Street, #402
New York, NY 10022
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: NASD & SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.