Your 401(k) Consultant May Be Serving Two Masters

Who would pay such extravagant fees? Well, you do if the mutual fund firm accepts soft-dollar commissions. Briefly, soft dollars are revenue-sharing arrangements in which fund firms use investors' money to pay for services from the brokerage industry -- which can be fairly loosely interpreted. About four-fifths of all fund firms use soft dollars. In other words, you pay the fee that the fund firm pays to the consultant.

Mutual fund firms and managers are loath to discuss these arrangements on the record, for fear of alienating the consultants that are so vital to generating new business. Because managers are so dependent on consultants' recommendations, "criticizing them means running the risk of losing business," one fund manager said. Or, as another put it, "the asses that we kiss are all consultants'."

Others said the conflicts of interest among consultants are far less problematic than they were two decades ago in the pension industry, and that the potential for conflict isn't as great as it was, thanks to greater investor awareness. "In this age of disclosure about performance, the reality is if our numbers suck, a consultant isn't going to recommend us to clients even if we pay the $50,000 fee," said one fund manager whose firm does pay for some business with a major consultant.

However, a recent fracas over Hawaii's Employee Retirement System highlighted the potential problems with these relationships. An audit of the $7 billion program found the trustees failed to properly manage the $7 billion in assets and pointed out that the consultant to the plan, Callan, had disclosed business relationships with 87.5% of the recommended funds and with 100% of the funds chosen for the plan.

Callan took strong exception with the audit -- in part because it was conducted by rival consultant New England Pension Consultants, which lost out on the Hawaii contract to Callan. Callan said the audit didn't "consider the materiality or lack of materiality of any disclosed financial relationship between the investment managers and the investment consultant."

Callan declined to comment for this article. Mercer's McInerney, however, defended its institute as a vital, necessary function for its sponsors. "We think it's in the best interest of our sponsor clients to do this," McInerney said, who adds that the business relationships with managers has "no impact whatsoever on the [manager] search process."

Meanwhile, critics of such plans remain unswayed. "I don't like these institutes," said Meigs of the 401(k) Help Center. "Even if it's not the intent, it smacks of having to pay to play. These firms need to re-examine that practice."

Of course, the potential for conflicts of interest doesn't always translate into actual conflicts. Mercer Investment Consulting is owned by Marsh & McLennan(MMC), which also owns the Putnam fund company. However, Mercer has won high marks for not playing favoritism with Putnam funds in its proprietary search for mutual funds to recommend. "We have to treat every manager the same -- no better no worse, including Putnam," McInerney said.

Meanwhile, other conflicts remain with consultants who are part of a brokerage firm or an insurance firm that also sells investment products. Individuals need to be aware of the relationship its 401(k) consultant has with the firms that offer mutual funds or annuities.

There are a lot of people who call themselves consultants, but they work for Citigroup unit Smith Barney or Merrill Lynch(MER) or some other financial services firm," said Meigs. Are you hiring a truly independent consultant who has no connections to major investment firms, or are you hiring the local branch of a big national company? They still can help you, but "they are charged with selling product as well," Meigs said.

Likewise, if your consultant is an insurance firm, for instance, investors should ask themselves if the high-fee annuities in their plan are there because they are the best investment option or because they are profitable vehicles for insurers. "Nobody should buy annuities," said Sentinel's Lansing. "The fees are so high that it's prima facie breach of fiduciary responsibility."

>To order reprints of this article, click here: Reprints