Did you happen to catch The Retirement Gamble on PBS on April 23, 2013? The Frontline documentary provided an hour-long, no-holds-barred look at the financial services industry. It detailed how traditional Wall Street brokerage firms and non-fiduciary “financial planners” have contributed to the erosion of 401(k) retirement savings for millions of Americans. If you missed the program, I highly encourage you to watch it via the PBS website.
The documentary concluded that the 401(k) retirement savings system is broken, but I have an easy fix: Plans should work with a fiduciary, and investment choices should include index funds. Yet, unfortunately, the 401(k) market is dominated by the same Wall Street players with the same conflicts of interest that exist in the individual space. Rather than operate 100% in the employees’ best interests, like a fiduciary does, these plan providers need only provide “suitable” investment options.
As Martin Smith, Frontline’s filmmaker, explains, “Big banks, brokerages, insurance companies and other financial service providers operate under something called a ‘suitability standard,’ which says they don’t have to give you the best advice, just advice that isn’t too egregiously terrible. Eighty-five percent of all financial advisers and financial planners are really just brokers or salesmen. Their incentive is to sell you a product that makes them a higher commission, not necessarily a product that maximizes your chances of saving more.”
Accordingly, these advisors, whether working with a 401(k) plan or individuals, often recommend mutual funds regardless of the high fees charged. And the difference in cost between mutual funds can be significant, especially over time. In 2012, for example, the average expense ratio for a large cap blend fund was 1.27%, versus just 0.63% for index funds. For emerging markets funds, the differential was even greater—1.69% for active mutual funds compared to 0.68% for index funds. And some mutual funds charge as much as 2%.
How might that add up? “The Retirement Gamble” offers this example from Jack Bogle, Vanguard’s founder: Assume you are invested in a mutual fund with a gross return of 7% and the fund’s cost, or expense ratio, is 2%. Over a 50-year investing lifetime, that 2% annual fee will erode 63% percent of what you could have earned without paying the fee. As Bogle puts it, “The investment magic of compounding is overwhelmed by the tyranny of compounding costs.” And yet, according to a recent AARP study, 70% of mutual fund investors are not even aware that they pay fees for the mutual funds they own.
Of course, it costs something to manage and administer mutual funds, so you can’t expect to invest for free. However, it’s important to understand what your options are and to actively look for low-cost funds. That’s equally true when it comes to 401(k) plans, where employees often believe that someone at the company has vetted the list of funds, selecting only the best performers at the lowest cost. That’s not necessarily true.
In fact, many plans do not offer index funds as investment options, even though they cost less and also tend to beat actively managed mutual funds over time. In fact, the Standard and Poor’s 2012 report comparing index funds to their actively managed counterparts found that index funds produced better returns than actively managed funds in 16 of 17 investment categories over the past five years.
So why don’t you find index funds on the 401(k) plan menus? Smith has the answer: “Even though an index fund might be a better option for you and me, a broker operating under a suitability standard has no incentive to sell it to us. He or she will make higher commissions by selling funds that have higher fees.”
Is there hope for change? It seems that after the financial crisis of 2008–2009 and Bernard Madoff’s Ponzi scheme, the tide may be beginning to turn in favor of the investors. Last year, the Obama administration proposed a rule to mandate that all financial advisors working with retirement accounts such as your 401(k) would have to adopt a fiduciary standard. Of course, it was no surprise when the financial services industry, with more than $10 trillion in retirement assets, pushed back. They argued this regulation would be too expensive to incorporate into their business, and the administration pulled its proposal last fall. However, the Labor Department plans to introduce a new fiduciary rule in July under the nearly four-decade-old Employee Retirement Income Security Act (ERISA).
What can you do in the meantime? If you work for a relatively big organization, you can look up your plan on Brightscope and see how its fees rate. You also might speak to the person at your company who controls the plan and ask him or her about adding low-cost investment options.
Watching “The Retirement Gamble” reinforced for me just how different our approach is from that of the 401(k) marketplace. One thing the Frontline documentary made very clear is that few company retirement plans work with conflict-free advisors like Bernhardt Wealth Management who utilize low-cost, passive investments and serve as a fiduciary, putting the client’s interests ahead of their own. In my mind, that’s something all investors deserve.