The Seven Deadly Sins of 401(k) Plans

The use of soft dollars has mushroomed since Congress first enabled it in 1975. Typically in these transactions, fund firms use investors' money to pay for services from the brokerage industry -- research services and such that theoretically benefit the individual. Many of these soft-dollar arrangements aren't even recorded on paper, according to Bradley. The costs of these services typically turn up in trading commissions: The average commission rate is more than 5 cents a share, compared with the 0.85-cent cost of trading electronically, according to Greenwich Associates. What are participants "paying for" via these soft dollars? Research, yes. But also, according to a list compiled by Bradley, soft dollars may pay for a fund firm's accounting services, telephone bills, computers -- even membership at the tony Standard Club of Chicago. The overwhelming majority of 401(k) plan participants have no idea what their money is used for, because these deals aren't disclosed. "They're soft dollars because it's not their money they're spending -- it's yours," said McHenry's Harris.

"The entire system is based upon picking the investor's pocket -- it is a round robin of kickbacks where you get left out," Gensler said. (A forthcoming article in our 401(k) series will delve further in to the many fees -- disclosed and hidden -- they eat away at investors' retirement plans.)

During the roaring 1990s, with 15% annual gains in the stock market and 10% gains in the fixed-income market, individual investors paid precious little attention to fees, and that clearly led to excessive fee payments. "It's time to revisit excessive costs," Siedle said.

Sixth Deadly Sin: Bad or Inadequate Choices

A few years ago, the fund choices offered in many 401(k) plans were fairly straightforward. If Vanguard ran the plan, it offered Vanguard funds. If Oppenheimer ran the plan, it offered Oppenheimer -- the same held true for Fidelity, T. Rowe Price(TROW Quote) and so on. Then a funny thing happened: Janus(JNS Quote).

"When Janus funds exploded in the 1990s, investors saw the performance and started asking, 'Why can't I get Janus? Why am I stuck with these dogs in my 401(k)?" said an official at one consulting firm. "So the company providing the plan sponsor asks the consultant or the fund firm, 'Yeah, why can't we have Janus?'"

This led to "open architecture," through which firms began including funds outside of their stable of offerings -- from Janus and a host of other outside fund firms. "Open architecture has become the sine qua non of 401(k) plans," Greenwich's Wechsler said. Indeed, firms such as Charles Schwab(SCH Quote) have had great success offering access to a "supermarket" of hundreds of mutual funds for 401(k) plans.

Despite the abysmal postbubble performance of many Janus funds, a wider array of fund choices has been a positive development -- even though experts say too many fund choices can pose a problem for uninformed participants. Still, a great many 401(k) plans still have inadequate fund options that make it nearly impossible for investors to build a diversified portfolio of low-cost funds.

Even with the funds from outside the plan provider's roster, the fund firm still has an interest in recommending its own funds because they collect much higher fees. "There still needs to be greater diversity of brand names," Trone said, adding, "access to a few index funds is a good litmus test to see if the 401(k) plan isn't conflicted."

Indeed, the American Law Institute in 1992 refashioned its Prudent Investor Rule to state that actively managed funds have additional costs and risks and that index funds are a practical investment alternative.

However, in part because of a lack of education among employers and participants, "the participant is paying for the plan, but they have no control over the funds or the costs -- all they know is, they're stuck with crappy funds," said McHenry's Harris.