How You're Doing Your Retirement Wrong

By Liam Fox

NEW YORK ( MainStreet)--Amid pervasive skepticism about standard 401(k) accounts in light of hefty management fees and low yields, some folks are getting hip to the value of low-cost index funds and classic pension plans.

So is it out with the old IRAs and 401(k)s?

This question has been the subject of heated debate lately, with some experts contending that the creation of these retirement accounts unfairly shifted the burden of investment management to those who are least qualified for the task - ordinary employees. Because of their inexperience, many employee retirement fund "investors" are losing tens of thousands of retirement dollars by filling their accounts with costly, actively-managed mutual funds. However, many individuals are recognizing the importance of educating themselves about investments, and are taking on the job of actively managing their own retirement accounts. This represents a sea change that is threatening a major source of revenue for the investment community.

Index-fund guru John C. Bogle, founder and former CEO of Vanguard Group, Inc., claims that fees charged by managed mutual funds are eating away at retirement accounts, reducing the likelihood that employee retirement savings will ultimately be adequate. Bogle recommends that individuals invest their 401(k) accounts in low-cost index funds, such as those offered by Vanguard. But this is not just self-serving advice - it's a matter of simple math. According to an April 23, 2013 Frontline report on "The Retirement Gamble," actively-managed funds charge average annual fees of 1.3% compared to 0.2% for index funds. This means that, over the course of a career, investment fees can cost an ordinary employee more than $100,000- a huge amount considering that the average 401(k) balance reached a "record" of $74,900 in the first quarter of 2011.

For so many American workers to willingly part with $100,000, they must believe that mutual fund managers do a lot better job of investing than they could. Certainly the banks, brokerages, insurance companies and other financial service firms who offer mutual funds do a great job of touting their expertise.

Unfortunately, that expertise generally doesn't translate into better returns. A 2012 report by Standard and Poor's concluded that managed funds outperformed indexes over the prior five years in only one out of seventeen investment categories. Likewise, Mark Kritzman, an MIT senior lecturer in finance who is also CEO of an investment management company, found that over 20 years an index fund's average 8.5% after-expense return would beat out both an actively-managed fund with an annualized return of 10% and a hedge fund earning 19%.

Although the average employee doesn't necessarily understand the true cost of investing in mutual funds, there is a growing trend among professionally managed pension funds to seek higher returns through index-fund investing. For example, the Wall Street Journal reported that the pension trust for employees of Montgomery County, Penn. has decided to move 90% of its assets into stock and bond index funds. Interestingly, this decision was based on the advice of local resident John C. Bogle. Nonetheless, although few pension trusts seem likely to give up all managed investments, many are re-examining their investment mix to reduce exposure to hedge funds in particular, which have particularly high management fees.

So is the solution to try to increase the investing expertise of ordinary 401(k) investors to enable them to do as well as pension trust managers? It is difficult to imagine who would fund such an educational program, since most 401(k) costs are covered by the financial service firms who administer them - in anticipation of sharing in the investment fees charged by the mutual funds offered in the plan. Many experts say that we should instead get rid of 401(k)s entirely and advocate a return to "good old-fashioned" pension plans where employers collected money from paychecks and added enough of their own money and investment expertise to be able to promise employees a "defined benefit." In fact, 401(k)s were never intended to displace employer-provided pension plans; they were originally adopted as "supplemental" retirement plans for highly-paid executives whose pension benefits were capped by federal income tax regulations. Employers soon realized that they could control pension benefit costs by converting all employees to "defined contribution" plans such as 401(k)s.

Recognizing that participant knowledge is the key to a successful 401(k), The Online 401(k), a provider of 401(k) services for small business owners, stresses the participant's responsibility to acquire at least a basic understanding of investments and risk. Andrew Meadows, the company's Consumer and Brand Ambassador, notes that his clients have access to a full range of Morningstar research and services, including an online survey that allows the employer and employee to gauge their risk tolerance and develop an investment strategy that best reflects that tolerance. As a result, plans administered through The Online 401(k) can be tailored closely to the needs and goals of plan participants. Furthermore, participants also have access to a network of local and institutional financial advisors.

This level of individual focus and flexibility is seldom available to participants in the 401(k) plans of large corporations which often limit investor choices to a few options - many of which carry high management fees. However, some large plans offer participants the option to establish a "self-directed" account within the 401(k). An educated, market-savvy participant can do well by actively managing his own 401(k) investments through a self-directed account, but this is no place for an inexperienced investor. People without the time or resources to educate themselves about investing may be best served by engaging the services of a financial advisor. Many experts (and investors) would advise using a fiduciary financial advisor who is duty-bound to place the client's interests first, if there are funds available for advisory fees.

For those who can't afford a fiduciary financial advisor - or who simply prefer to manage their own retirement funds, many information sources are available.

After being blind-sided by the 2007-2008 stock market crash, many investors decided to take matters into their own hands. One example is Gary Holt who began his self-education process by following financial blogs. As a would-be broker with a family and responsibilities, Holt initially considered himself "risk-averse" and invested primarily for dividends. However, as his understanding evolved, he realized that the stocks paying the highest dividends are often those that bear the greatest risk.

Today, Holt's portfolio includes options and derivatives - investment vehicles that many would consider far too risky. Yet the options in Holt's portfolio are primarily covered calls. Generally, the population naturally associates words such as "options" and "derivatives" with risk. This is indicative of fundamental misunderstanding. When traded properly, option can provide quasi-insurance for positions in almost any asset class. Specific strategies such as a collar (buying options at strike prices on either side of current share price), straddle or basic covered call can guarantee investors sales and purchases of stock at prices of their choosing. The broad association between derivatives and risk comes largely from horror stories about amateur traders buying on margin without owning the underlying and ending up in more debt that their accounts were worth. Although few-and-far-between, these incidents do occur and budding investors should be aware of option risk. Although he sometimes trades options without owning the underlying assets, Holt generally does this only with a modest amount of money he keeps in a "hobby account" that he maintains as a learning tool.

The rise of the educated investor is changing the face of retirement fund investing. Individuals who must maintain their retirement funds in a 401(k) will seek out those investment options with the lowest management fees, and they will lobby their plan administrators to add low-fee index funds to the plan's investment array. Other individuals will elect to actively manage their own retirement funds, either through self-directed accounts within 401(k) plans, or by rolling over their 401(k) fund upon retirement into accounts at e-trade and other online platforms. The most favored platforms will be those that offer quality research as well as reasonable fees, since these investors are determined to increase their knowledge base.

"Yes" is the answer to the question asked at the beginning of this article - Is it out with the old IRAs and 401(k)s. These vehicles will continue to house the nation's retirement funds, but they will no longer be cash cows for the investment community as the individual beneficiaries of these plans educate themselves and gain the confidence to take management into their own hands. The wise 401(k) provider will be one that meets plan participants' needs for information, education - and investment options whose returns won't get eaten up with high management fees.

--Written by Liam Fox for MainStreet

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