Murky 401(k) fees siphon savings away

Think about this: You’re a 401(k) participant with $100,000 in a combination of funds from a popular financial institution, and you receive an annual bill from that fund company for $800 — 0.8 percent of your account balance.

They ask you to write a check within 30 days. It seems excessive, you think. What are they doing for that much money? In a few more years, with earnings and future contributions, it will be $200,000 and the annual bill looks like it will become $1,600 at that 0.8 percent rate.

Furthermore, they are demanding that you subtract the money from your retirement fund and only use that source for paying the bill. For someone with a larger balance, the fee amounts to half of what they can contribute in a year.

This is a disaster. Your retirement plan constitutes the most efficient asset management tool you have. Funds can compound and be traded and rebalanced without triggering any taxable events. This valuable, irreplaceable money represents the last dollars that anyone should be forced to use when paying a bill.

What I just described is everyone’s current billing relationship with the financial institution managing their 401(k)’s, IRA’s and other retirement plans. The billing procedure is baked into the cake and not subject to negotiation. What the industry needs is the mutual fund that charges no internal annual expense ratio, but that sends a bill to the participant for money management and recordkeeping services.

In the case of 401(k) plans, the client is the company sponsoring the plan for its employees. Any company could pay all of those costs as a tax deductible business expense. What would this simple sea change mean for all employee participants over time? How about one-third more money by the time they reached retirement 30 years later, assuming the same underlying investment products.

Why doesn’t this happen? Because it’s more convenient for the mutual fund industry to just collect money from the accounts. The nuisance factor of having to send a bill and collect it, not to mention calling attention to it, is anathema to an industry that thrives in an environment where clueless buyers are not price sensitive.
In the current environment, it’s easy for company retirement plans to pay for the costs of operating a 401(k) and offer their participants investments that can charge as little as 12/100ths of one percent per year.

The cost to the company (but not to the plan) can be, on average, about 1 percent of plan assets which they would pay just like rent or phone bills. In smaller companies, where company owners and key management personnel have large portions of the money in the plan, Machiavellian interests hold sway. In most cases, these plans set a standard for how all plans ought to be operated by choosing more cost-effective vendors.

In larger companies, by comparison, plan decision-makers can often be management people whose own accounts are a relatively small portion of total plan assets. Here, the imperative is to reduce costs to the company — usually at a cost of higher expenses to employees.

Last year, according to CFO magazine, companies electing this approach paid $1.7 billion in legal settlements across the country for violating a fiduciary obligation to make “all decisions in the sole interest of plan participants.”

For IRA money, the same billing format could be conducted on an individual basis. IRA accounts could be billed on a periodic basis with the understanding that if the bill went unpaid for over 90 days, the money would be rolled out into the same investments that have the current annual expense ratios automatically deducted. In other words, back to square one for those who don’t “get it.”

That extra 1 percent so many of us pay under the current entrenched system is brutally punishing. In a case where underlying investments earned an average of 10 percent per year on a $10,000 annual retirement plan contribution, the damage done by an “internal charge of one percent” amounts to $75,000 in 20 years and $350,000 in 30 years.

It’s the “magic of compound interest” working against us when we pay bills with money that could otherwise be compounding tax-free. The same bill paid out of a checkbook or as a tax deductible business expense would have amounted to about one-quarter of this opportunity cost.

In spite of television’s ill-informed expose on “60 Minutes” that trashed 401(k) plans, we should not be deterred. Retirement plans (many up 30 percent since March 4th) still represent by far the best opportunity to accumulate wealth, even if they have become the Rodney (no respect) Dangerfield of financial tools.

Too many “wanna-be experts” are trying to throw the baby out with the bathwater.

Meanwhile, not letting a good crisis go to waste, U.S. Representative George Miller’s efforts to improve fee transparency may be bear some fruit before the end of the year.

If better transparency leads to a more cost-effective fee structure, we could be rocking in retirement with a lot more money.

Sun filtering through our dark clouds

READING ALL the economic prognostications just makes my head hurt.

Nobody strikes me as being that convincing either way, so it’s really an exercise of hedging bets and gripping the arms of my chair as tightly as possible.

My fellow Americans are saving money like it’s going out of style. One report showed that we have saved four times more in the first quarter as we saved in the equivalent quarter last year. That’s not good for the consumer-based economy, necessarily, but it is a reflection of sanity at some level.

And there’s more where that cash is going. We already have $4 trillion dollars sitting on the sidelines, and what could be better news for the 8,000 regional banks that were otherwise small enough to fail. Fortunately, the FDIC has only had to close 20 of those banks so far this year. That’s only a few more than the number being closed in a normal year, so let’s count this as good news.
 
So, what will happen next? And when? Considering a combination of the economy, the investment markets, and the labor market, we are coming to terms with a three-legged stool. Of the three legs, most of us reading this column are preoccupied with the investment market, so here are some fundamentals that could be reassuring.

First, the unemployment rates are high, no question, but when firms in the financial services industry lay off thousands of people, they suddenly become more profitable.

Goldman Sachs has laid off 4,000 employees (of their 27,000) for a 15 percent cut in workforce. Considering that the financial services industry toward the end of the recent bubble was contributing over 20 percent of all profits of the S&P 500 companies, a major cut in headcount, especially if it’s in middle management, can quickly help to boost lagging profits.

I’m not surprised to hear that a number of these banks, starting with Goldman Sachs and Wells Fargo, are suddenly anxious to pay back their TARP money. Their emissaries are walking around the halls of Washington waving checks and trying to get us taxpayers to take the money back.

Why should we hesitate? Well, for one thing, it should be the last money we take back because the TARP money allows us to limit bonus payments and executive compensation.

First, we should make these major financial institutions return the money they received from AIG — the then-secret money with no strings attached that backed up their derivative bets. Pay us back that money and then they can return the TARP money and refill the compensation feeding troughs. If Goldman Sachs is currently reported to be sitting on $600 billion in cash of which about $300 billion is borrowed, the money they received from AIG and TARP combined is just chump change.

I’m reasonably optimistic that government stimulus money will be paid back sooner than most people think for reasons like the one just cited. This would trigger a national psychological lift and set the stage for a resurging economy. Speaking of a psychological lift, we shouldn’t ignore the value of our current energetic leadership. Who knows for certain if they’re doing the right thing, but at least they’re not sitting on their hands back there.

Meanwhile, for those still investing, it’s an opportunity to be buying low and collecting relatively high dividend rates as a reward while being patient. For those looking for investment income, it’s not a bad time to consider some of the high yield corporate bond funds for a portion of fixed income portfolios. Capital values have declined temporarily and rates of return are up in the 10 percent range as a result.

As a general rule, the stock market recovers first — by about six months — ahead of the economic upturn, and the job market recovery then lags that of the economy. For those of us preoccupied with the investment markets, there is plenty to be optimistic about, and some of it we’ve seen in the form of exhilarating market gains over the past few weeks. As a general rule, the more rapid and substantial the decline, the more powerful and sustained the rebound will prove to be.

As for the economy as a whole, and the job market in general, we could be in a v-shaped recession, a U-shaped recession, or just a flat-lined funk. As for the latter, I see it as the least likely when we consider $5 trillion in stimulus from governments around the world, what seems to be the bottom of the housing market, a swift recovery of the banks, a rise in exports and the overall history of resilience in the world economy.

Throughout it all, there will always be rewards for the investor who filters out the noise and stays true to a long-term strategy that history demonstrates will prevail through thick and thin.

Look under hood of your investments

While unfortunate events in our investment portfolios may have prompted some anxiety, the vast majority of us can at least enjoy some smug satisfaction at having avoided a wipe-out from the Bernie Madoff Ponzi scheme. Bernie offers, however, a lesson for all of us. We need to lift the veil of our investment packages (mutual funds, annuities, etc.) to see what they hold as their underlying investments. How can we be sure the money is actually there?

With mutual funds, the evidence is clear and well-regulated. Mutual funds produce annual and semi-annual statements that list every asset and that spell out what the income and expenses were for the fund. Officially, a mutual fund is known as an investment company, so investors can expect the same reporting they would receive from any company whose stock is sold to the public. The monitoring and auditing of these requirements is dictated by the SEC and a new entity, FINRA, which took the place of the former NASD.

When it comes to annuities, which are life insurance products, the lines of responsibility are a little less clear. Life insurance companies are only monitored by the states in which they operate. A 100-year-old law (McCarrun Fergusen Act) actually prohibits federal oversight. When life insurance companies fail, some states have funds that protect investors, but getting the money paid out can take years if it happens at all.

In the case of Executive Life, investors like the Pacific Lumber Co. retirement plan participants got next to nothing. Then, Mutual Benefit Life was the 14th largest life company in the U.S. when it failed about 15 years ago. After its assets were slowly unraveled, investors got their money back, but with no interest several years later.

That company beside the freeway in Davis, Pacific Standard Life, failed in 1994, and its assets were then taken over by Hartford Life. Unfortunately, Harford assets have been downgraded to junk which means it could follow in Pacific Standard’s tracks. All in all, this amounts to pretty shabby treatment of insurance industry investors.

By comparison, on the day a bank fails, an army of FDIC auditors arrives in a fleet of limousines and descends on the hapless institution. It is a show of force as impressive as a presidential motorcade according to those who have seen it first-hand. As for mutual funds, none have ever failed.

For those whose money is in insurance company products of any stripe — annuities, 401(k) plans, guaranteed investment contracts (GIC’s), etc. there is at least some basis for being concerned. Some of the largest companies in these markets have seen their stock prices drop by 95 percent. Hartford, Lincoln Financial, Prudential and a number of other companies are showing signs of financial distress. Moody’s bond rating for Hartford has dropped to Baa3 according to the March 31st Wall Street Journal. More downgrades are probably on the way.

Stable asset funds, or Guaranteed Investment Contracts, invest in bonds and derivatives and then guarantee an interest rate to 401(k) participants for whom this is a popular investment choice (especially recently.) To create any profit beyond what they have guaranteed to investors, the underlying investments have to generate higher yields — which means taking more risk. The average, industry-wide value of the underlying investments right now is 95 percent of the principle amount guaranteed by the insurance company. So, how good is your guarantee if you’re just the general creditor of an institution whose investments (according to the rating agency) are now ranked as candidates for default.

The question for 401(k) trustees, fiduciaries, and the participants they represent is, “Who backs up the pool of money that is invested in what I thought was my guaranteed account.” A stable asset GIC is a mandatory investment offering in an insurance company 401(k) product, because this is where the company covers most of its costs.

The “spread” between investment yields and the guaranteed payment amount is buried and not available for disclosure. It’s not a Madoff- level catastrophe when the insurance company, possibly under water, stalls for time. However, to the former employees of bankrupt Mervyn’s who have been waiting since last October for their 401(k) money; it is a nuisance that could have been avoided.

Butler: Speedy recovery will inflate stocks

What a bummer. I was hoping the stock market would go up, but not this soon.

Having just finished Warren Buffett’s 900-page biography “Snowball,” the main recurring theme is the extent to which he made most of his money by buying stocks when they were down — in many cases, really down.

Early in his career, this investment strategy was referred to as “picking up cigar butts.” Then, we learn the extent to which Buffett managed to fold his tent when stocks in general were overpriced. There have been times when his annual stockholders’ letter bemoaned the fact that he saw no values out there. This would have been when the rest of us were basking in the euphoric glow of irrational exuberance.

Growth

Well, “this time it will be different,” for me at least. I have kept on investing methodically in stock-oriented mutual funds right through the downturn. I like the fact that the 401(k) deposits I made on Feb. 28th and March 15th, for example, were settling into mutual funds that were reflecting values of General Electric at $6 a share and Citibank at about $1. Citi has since tripled in a few weeks and GE has almost doubled. Stocks like that explain why many 401(k) accounts gained about 20 percent in just two weeks’ time.

Hopefully, this isn’t the beginning of another great bull market. I want the opportunity to keep buying in at these fabulous prices so I can reduce the average cost of all the mutual fund shares I own. The longer share prices stay down, the more I get to feel like a like some Warren Buffett clone.

A rule of thumb, if the last five crashes mean anything, is that the first few weeks of a major market updraft are critical. They make up a large part of what has been an average 38 percent increase in the first 12 months following the bottom of a crash. We have just seen what can happen in two weeks’ time for those who need a reminder.

Positive future

For many reasons, the rebound this time around could be explosive and substantial. Unlike the ’80s when interest rates and inflation were in the double digits, our current situation offers rates at 3-4 percent and inflation is in the negative.

We have unemployment figures that are rising, but some of this number reflects a record number of people who are leaving the workforce for retirement. Most companies were overstaffed (especially financial services firms) during the recent fat years. Going forward, companies still in business after this unpleasant economic experience will have undergone much profitable course correcting.

For one thing, their CEOs will probably not be paid as much, and this has the effect of lowering compensation expectations all the way down the management food chain.

It may take until 2013 before we actually reach the equivalent of 2007’s peak, but what’s magic about that number? In 2007, it represented the product of a 10 percent annual average return over a 20-year period, but we may not need that much going forward.

Stocks generally yield about 7 percent more than the rate of inflation, and inflation at an average of 3 percent contributes to that magic 10 percent. If inflation is next to nothing, we only need a 7 percent “risk premium” to meet inflation — adjusted retirement goals.

But here’s where the Warren Buffett magic comes into play. If stocks (mutual funds) in our 401(k) plan remain at half their 2007 prices for about two years and then slowly start returning to “full price” by 2013, our annual 401(k) deposits will be investing in cheap stocks with a weighted average cost of about two thirds the 2013 recovery price. The difference between two thirds and full price is a 50 percent return.

Meanwhile, our original Sept. 30, 2007, account balance that we all remember so fondly will have returned to its original value — plus five years of reinvested dividends (about 4% per year) that we had completely forgotten about.

If the market snaps back, we’ll feel better sooner, but let’s be careful about what we wish for. After all, a little foot-dragging on the part of what Buffett calls “Mister Market” would make us a lot richer by the time we really need the money.