BETA
This is a BETA experience. You may opt-out by clicking here

More From Forbes

Edit Story

Flawed 401(k) Plan Structures to Blame for Systemic Failure

This article is more than 10 years old.

Over the years I have conducted forensic reviews of hundreds of 401(k) plans, from the smallest to the largest. The closer I have looked, the more apparent it has become that the overwhelming majority of these plans have indefensible structures or features, which, at a minimum, contribute to their mediocre-to-dismal investment performances.

While high-priced ERISA lawyers counsel employer plan sponsors that 401(k) investment results don’t matter as long as plan fiduciaries follow acceptable “processes,” to me this advice has always sounded laughable. Remember the old joke: the doctors all agreed the operation was a great success … unfortunately, the patient died. Only lawyers could conclude that the results of a retirement plan investment program don’t matter. I can assure you that the results do matter to the workers that participate in these plans and rely upon them for retirement security.

I have identified three broad types of flawed 401(k) plan structures which are pervasive. Understanding these deficient structures goes a long way toward explaining why the great 401(k) “experiment” has largely failed to date.     

1. “Captured” plans: Over 90% of 401(k) plans involve the employer effectively “outsourcing” the entire administration and management of the plan. Financial vendors shape the investment program, including the mutual fund investment options to be offered, and divvy-up between themselves the compensation to be derived from the plan’s assets—all this with only superficial or illusory input from sponsors. Sponsors are permitted to choose Coke or Pepsi—i.e., any carbonated beverage (actively managed mutual fund) loaded with caffeine and sugar (fees permitting kick-back payments to gatekeepers).

There is a sucker in the room and it’s, for sure, the participants and often the employer as well.

Understandably, the overwhelming majority of 401(k) plan sponsors do not have sophisticated investment personnel charged with responsibility for overseeing the retirement plan and cannot afford to. (Recall that over 90% of plans are tiny—under $5 million.) Owners or human resource types dedicating, at best, a few hours a week to thwarting Wall Street sharks intent upon devouring plan assets, don’t stand a chance.

In my investigative experience, it is mind-blowing just how much money can be skimmed by Wall Street from even a single large plan—tens of millions—seemingly unbeknownst to employers.

While investment firms deliberately seek to capture or control plans so they can maximize the profits they derive from 401(k)s, the industry has successfully fought efforts to hold vendors responsible, as fiduciaries, for the plans they bilk. Given industry marketing pitches, it should come as no surprise that employers regularly lose sight of the fact that under ERISA, the sponsor remains responsible as the named fiduciary to the plan even when the sponsor delegates or outsources management of the plan.

2. “Conflicted” plans: Some of the largest plans have been structured with conflicts of interest at their core. The employer-sponsor has sought to derive a benefit from the retirement plan (which regulators have effectively sanctioned) and has tailored the plan to meet his objective. For example, operating companies such as American Airlines, Bechtel, Caterpillar, General Dynamics and General Electric all established affiliated money management firms to earn fees from managing the retirement assets of their employees. In other words, these operating companies built asset management businesses upon the backs of their employees’ retirement monies.

Whether that’s been good or bad for employees can be debated but there is no question that many employers have profited handsomely from managing their employees’ retirement plan assets.

American Airlines recently sold American Beacon Advisers, its wholly-owned asset management subsidiary, to two private equity firms for $480 million. To the best of my knowledge, none of that $480 million went to the employees whose retirement assets primed the pump, so to speak. Here’s what the company had to say about the relationship between the asset management subsidiary and the company’s retirement plans:

“American Beacon currently provides a number of services for AMR and its affiliates, including cash management for AMR and investment advisory services and investment management services for American's pension, 401(k) and other health and welfare plans. AMR anticipates that it will continue its relationships with American Beacon after the closing. However, to ensure that continuing relationships between American Beacon and American's pension, 401(k) and other health and welfare plans after closing satisfy the fiduciary duties and other rules that apply to these plans, an independent third party has been engaged to review and approve any such continuing relationships.”

How likely is it that the so-called independent third party mentioned in the press release would opine (at least prior to AMR’s final payout) that the relationship between the retirement plans and American Beacon was sub-par and should be terminated? In my opinion, not very.

Financial services firms are notorious for offering conflicted 401(k) plans. The fiduciaries of virtually all 401(k)s sponsored by money management firms have coincidentally concluded that hiring the employer-asset manager to manage plan assets, as opposed to any of the thousands of other registered investment advisers with competitive performances, is in the best interests of these plans. For years the Department of Labor has looked the other way, apparently recognizing that forcing money managers when acting as plan sponsors to acknowledge their weaknesses is unworkable—even if participants suffer.        

Including employer stock as an option in a 401(k) is another example of a plan structural conflict. Remember Enron? The company’s performance lagged, the value of the significant company stock in the 401(k) tanked, employees were laid off and ended up losing both their retirement savings and their jobs. Employers with publicly-traded stock almost always structure their 401k(s) to include company stock as an option and benefit when their stock rests in friendly employee hands. On the other hand, it is well known that when employees invest in company stock, it is often for the wrong reasons and at imprudent levels. 

3. “Smartest guys in the room” plans: A limited number of large plans I have reviewed suffer as a result of someone at the helm apparently having an inflated sense of investment acumen.  These plans are, in my opinion, needlessly complex and costly.

The $3 billion plus International Paper 401(k) plan is chocked full of customized investment options with, last time I looked, utterly incomprehensible long-term investment performance track records. For example, a 2000 statement I reviewed indicated that with respect to the 10 year performance quoted for the International Stock Fund offered within the 401(k), “Prior to June 1994, performance is that of … MSCI EAFE Index, a recognized benchmark for this Fund.” In other words, half of this actively managed fund’s ten year track record disclosed at that time was lifted or borrowed from an index. A participant would have had to weigh whether the fund’s 112 basis point active management fee was justified based upon historic passive rates of return not related to the actual performance of the actively managed fund offered within the 401(k).

A 2000 statement I reviewed with respect to the Small Cap Fund offered within the 401(k) indicated 1, 3 and 5 year performance as of December 31, 1999. A chart showed performance over 5 years since 1994. It was noted, “The inception date for the Small Cap Fund was September 1, 1997. Fund performance prior to this date is based upon a weighted portfolio of each investment manager’s actual returns. Performance prior to September 1997 excludes Arbor Capital; performance prior to March 1995 excludes Artisan Partners; performance prior to June 1994 excludes AXA Rosenberg Portfolio weights.”   

Yawza! Show me an employee capable of understanding and evaluating performance information presented in this manner.  

In my opinion, 401(k) plan sponsors should resist the temptation to create complex investment options (which inevitably involve higher costs) and performance track records that don’t exist for such investment options. Multiple "tiers" and dozens of investment options are unnecessary for even the largest plans, confusing to participants and counter-productive. 

In closing, when you look across the 401(k) landscape it's not difficult to identity pervasive structural defects and suggest ways to improve these retirement plans. To date there has been a dearth of critical insider commentary regarding the failings of 401(k)s. Participants in these plans still lack both sufficient knowledge as to the reasons these plans have largely failed (and indeed were doomed to fail), as well as an effective means of communicating their dissatisfaction.