The 401(k) industry lags behind the growth of cheaper mutual funds and ETF options offered by other online retirement advisors. The tide is turning in the employees’ favor. Several lawsuits have already demonstrated that employees will pressure companies to offer better investment options instead of the previous scant alternatives with only a limited number of mutual funds with high fees.
“These lawsuits are about high 401(k) fees and conflicts of interest,” said Grant Easterbrook, co-founder of Dream Forward Financial, a new low-cost 401(k) plan based in New York. “Employees are demanding plan sponsors or businesses to abide by their fiduciary duty to do what is in the employee's best interest.”
Even the Supreme Court is weighing in and later this year is likely to vote in favor of the employees at Edison International, a Rosemead, Calif. public utility company. The outcome of the case, Tibble v. Edison International, would likely set a precedent for additional lawsuits in the future.
“The Supreme Court decision will cause awareness of the legal liability that is expensive 401(k)s to skyrocket and potentially increase the number of lawsuits over 401(k)s,” he said. “It will push the issue up the corporate ‘to-do list.’”
Other lawsuits have settled in the favor of the employees. Even financial services companies are not immune to this growing issue. Ameriprise Financial, the Minneapolis-based financial services company agreed to pay $27.5 million while Lockheed Martin, the Bethesda, Md.-based defense firm paid $62 million. The other lawsuits which have been settled, include Nationwide, the Columbus, Ohio insurance company; Fidelity, the largest 401(k) plan administrator in the nation and based in Boston; ING, the Amsterdam-based bank; and International Paper, the Memphis pulp and paper products company.
Fees Do Matter and Add Up Quickly
The fees assessed in 401(k) plans are complicated, so examine the plan carefully. The first set of fees are the ones assessed by the mutual funds, and 401(k) plans are “notorious for using very expensive mutual funds often, because the plan sponsor or the employer receives a credit against the fees they pay to manage the plan from including these funds," said David Twibell, president of Custom Portfolio Group in Englewood, Colo.
The fees “can eat up nearly 30% of your retirement savings over 10 years, even a seemingly small annual fee such as 1.27%, which is the average U.S. mutual fund fee,” said Mitch Tuchman, managing director of Rebalance IRA in Palo Alto, Calif.
“It benefits most investment firms and brokers to keep their customers blissfully ignorant,” he said.
A second category of fees are those that are passed through to the participants by the employer. They can vary quite a bit, because the company has wide latitude in deciding which fees to pass onto employee participants, said Twibell. In some cases, the employer picks up all the fees, but more often than not, the employee foots most of the bill.
The two fees can really add up, and some employees end up paying over 2% in additional management and administrative fees by keeping their money in an employer’s 401(k) plan. Plain and simple, that's $2,000 in unnecessary fees on a $100,000 retirement account each year.
“Imagine someone who keeps their funds in their former employer’s plan for a decade or two, which happens more often than you might think,” he said. “Now we’re talking as much as $40,000 in unnecessary fees. There aren’t many people that can afford to throw away that kind of money for no real purpose.”
The industry is now approaching a tipping point and employers are going to become increasingly aware of the legal liability their legacy 401(k) plan may pose, said Easterbrook. The legal pressures may force changes in the industry that will benefit employees. This remains a large and problematic issue because employees can not choose the plan provider for their 401(k) plans.
Too many 401(k) plans are “way behind where they should be and offer dated websites, high fees and conflicts of interest when it comes to investment choices,” Easterbrook said.
“When people talk about America's retirement crisis, they tend to focus on Americans' failure to save enough for retirement and the fact that people are living longer, but the shortcomings of the 401(k) system are a big part of the problem as well,” Easterbrook added.
The increasing legal pressure could continue to drive long, overdue changes which benefit the average investors.
“Nothing drives action in the corporate world like the threat of a lawsuit, and legal pressure may help lower fees and reduce the conflicts of interests and opportunity costs that reduce the size of employee's nest egg,” he said.
Mutual Fund Fees Are Declining
The “relentless” pressure since 2000 on fees for mutual funds has been a boon for employees, said Don Shelly, a finance professor at Southern Methodist University’s Cox School of Business in Dallas. This trend is partly due to the fact that employees are becoming more aware that high fees are eating into their returns and because of “natural market forces,” he said.
During the past 15 years, average mutual fund expense ratios have gone down “significantly,” a win for employees, Shelly said. The average expense ratio for 401(k) investments in equity mutual funds fell from 0.77% in 2000 to 0.58% in 2013 or a 25% reduction, according to the Investment Company Institute (ICI). For bond funds, the fees dropped from 0.61% in 2000 to and 0.48% in 2013.
As the asset size in the accounts grew, larger employers were able to negotiate lower expenses, and now the average expense ratios for 401(k) accounts are 15% to 20% lower than industry average figures.
Conflicts of interest have arisen, especially with asset managers offering some of their own funds in the employee retirement accounts, he said.
“Employees naturally feel a sense of loyalty to their employer, consider it a way to enhance their own job security and assume employer funds are competitive in the marketplace,” Shelly said. “This must be weighed against the fiduciary requirement that the plan trustee always act in the best interests of the plan participant’s retirement investments, not the company’s.”
--Written by Ellen Chang for MainStreet