Companies that sponsor 401(k) plans for their employees have attempted to reduce their fiduciary liability by allowing participants to choose their own asset allocation policy and their own investments from a variety of options. As employees retire, we will find out more about the success of employee investors and the impact of future litigation against employers for inadequate retirement nest eggs. I suspect the shift in investment decision-making to the employee from the employer has increased, rather than reduced, the potential liability.
Process over performance
Department of Labor regulations and case law under the Employee Retirement Security Act of 1974 support the premise that prudence revolves around "process," not investment results.
However, experience tells us that with 401(k) and self-directed plans, there is little documentation on the process for selecting the current provider or the process of monitoring and evaluation.
Fiduciaries for 401(k) plans seem to have the habit of choosing their provider and ending the process. But the standards for 401(k) plans are identical to that of a pension plan. The process of monitoring and evaluation is a fiduciary requirement.
Investment performance is also critical for fiduciaries. Recent stock performance, in particular, has been spectacular. When returns normalize or become negative, the "bad" market will become a catalyst for increased scrutiny resulting in many unhappy participants. Lawyers will become busier and the time spent by fiduciaries will increase. Strong market performance has masked numerous poorly performing 401(k) programs.
Some similar problems exist with many 401(k) programs:
Poor investment results
Even bottom quartile managers have produced astronomical results.
According to Callan Associates, the 75th percentile (the bottom 25%) of domestic core equity managers has earned nearly 17% per year in the past three years.
In comparing this return on long-term historical norms, nearly all managers look fabulous.
Relative performance comparisons are crucial and 401(k) vendors usually will attempt to put even poor performance in the best light possible.
Conflicts of interest
Independence is the key in ensuring objectivity.
Relying on providers of retirement plans to evaluate the current plan is like having the fox guard the hen house.
Additionally, understanding why investment options are recommended is crucial for fiduciaries. Platforms sponsored by insurance companies tend to have more participant dollars in their stable-value or guaranteed investment contract funds.
The problem is that for many participants the guaranteed option is a questionable strategy for a long-term investor, but the product also can be a much larger source of revenue for the insurance company.
Therefore, there is a disincentive to the vendor to encourage participants to structure long-term portfolios that are more aligned with their goals.
Poor participant investment decisions
The key determinant of investor results is the asset allocation of the portfolio. Some 401(k) plan sponsors pay little attention to this basic tenet of investing, and if they do, the education is so generic it might be useless to the participant.
When participants are provided an international equity option, for example, they need to understand why and how it is properly used in a portfolio.
If prudence calls for a change, many plan sponsors are forced to change the entire program or accept the problem.
As a way to increase flexibility, larger sponsors are looking to unbundling, or moving away from one investment organization providing record keeping, administration and money management services.
Each fund option, the custodian and the administrator would be separately accountable and detachable if necessary. With today's technology, administration can be very efficient in an unbundled structure.
For those that like the total integration of the bundled platform, many large fund families are providing the flexibility of adding outside mutual funds for a "quasi-bundled" approach.
Exit fees and surrender charges are becoming less common, but can still be a problem.
Frequently, these fees can be enormous and might increase as plan assets grow. These golden handcuffs are much more common with governmental and not-for-profit defined contribution plans.
Charges for administration, investment and custody vary immensely.
Some providers have a number of products with a variety of fee schedules. Many plan sponsors are not aware that some of the costs (depending on the product and size of the plan) are negotiable.
Because fees can be hidden in the fine print, 401(k) plan sponsors can overlook them. Often, the underlying investment products are available to the plan a la carte, but are marked up by the vendor.
Fiduciaries need to understand who is "selling" the product, and how they are compensated. Higher cost products negatively affect long-term results.
Consultants can be invaluable in assisting plan sponsors in understanding how their plan stacks up relative to literally hundreds of bundled providers and administrators, and thousands of mutual fund products.
Documentation is critical. Development of an investment policy statement, outlining the process and methods of evaluation are a fiduciary requirement.
Consistent and methodical performance monitoring and evaluation is a useful tool and can help keep problems at a minimum while significantly reducing fiduciary risk.
Additionally, some of the industry's largest consulting firms have little experience in the "self-directed" marketplace. With the number of expert consultants in the 401(k) arena, there is no reason to be a test case.
Making sure the current arrangement is fiduciarily sound and structurally competitive will make life easier when participants' questions arise.