FOOL ON THE HILL
Pulling a Boehner With Your 401(k)

It appears likely that a new "pension protection" bill will include Rep. Boehner's provision eliminating the law against 401(k) plan service providers giving investment advice to plan participants. Watch your wallet. The fox may soon be guarding the henhouse.

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By Tom Jacobs (TMF Tom9)
April 18, 2002

Everyone knows that Congress has been working to prevent your 401(k) plan from suffering the same fate as Enron employees' plans, but you probably don't know about an annoying little provision that looks to become law. Both the House and Senate have passed "pension protection" bills, so now they go to a House-Senate conference charged with reconciling the two bills. The House bill is expected to win. It contains Rep. John Boehner's (R-OH) provision that would allow employers to offer professional investment advice through the plan's service provider as long as that provider discloses fees and conflicts of interest. You will need to be careful.

Investment advice
Current law generally prevents parties in interest from providing advice to plan participants. "Parties in interest" means people with conflicts. If Fidelity or T. Rowe Price or Vanguard, for example, is your 401(k) plan's service provider, it would have a conflict because it earns money from the plan, not only in management/administration fees but also in fees earned from the mutual funds if it quite naturally offers its own products through the plan. The House bill allows your employer to provide investment advice through the plan's service provider as long as it discloses all fees and potential conflicts of interest. The Senate bill retains the current prohibition.

As a for-profit business, any plan service provider has a strong incentive to drive plan participants to the products that earns the provider the most money. Let's say a provider offers two mutual funds to plan participants. One is an actively managed stock mutual fund, with a management fee of 1.5%, and the other is an S&P 500 index fund, with a management fee of  0.25%. The provider wants to drive people to the one with the higher fee, for sure, and will tilt its advice in that direction. Investors will start out losing 1.25% a year. Over the years to retirement, it adds up substantially.

The need for help
According to the Profit Sharing/401(k) Council of America (PSCA), employers find that providing advice increases employee participation in 401(k) plans. And employees are faced with so many choices that they naturally want assistance. The PSCA's September 2001 survey found the average 401(k) plan to offer 10 or more fund options, yet only 35.3% of plans offered advice about how to navigate among those options. Interestingly, smaller companies were more likely to offer advice (50.3%) than large companies (18.1%), even though I would think that large companies would be more likely to offer it because they would be better able to handle potential liability concerns. 

Not surprisingly, the options most commonly available in plans were actively managed domestic equity funds (offered in 79% of plans), actively managed international equity funds (73.1%), and balanced stock/bond funds (70.3%). Anything "actively managed" means more fees to the offeror. Despite the obvious bias towards higher fee producing funds, the way people actually invest suggest that someone is getting the word out about index funds:

Actively managed
   domestic equity funds         18.1%
Stable value/guaranteed 
   investment contract funds     10.2%
Balanced funds/bond funds         6.7%
Indexed domestic equity funds    10.6%
Company stock                     9.2%

Given the prevalence of actively managed funds, the 10.6% in index funds is good, though of course we don't know if this or that index fund is low expense. Just because a fund is an S&P 500 index fund doesn't mean it's low expense: Vanguard may charge low fees, but others charge more.

What about that large percentage in company stock? While company loyalty may drive 401(k) investments in stocks, ultimatums may too. Many employers match employee contributions with company stock and then restrict its sale.

Data show that 75%-80% of actively managed stock funds fail to outperform the S&P 500 over periods of five years or more. And it's not a good idea to have more than 20%-25% in company stock. Those two things alone and the PSCA's results prove the need for investment advice for plan participants.

Independent third parties
But why should any plan sponsor encourage you to invest in the index fund when it's almost certainly the lowest fee producer? The first thing we tell people here about any financial advisor is to ask how that advisor is compensated. Do you pay a flat fee, or does the advisor earn a percentage from any products you buy through her referral? You should insist on independent third-party advice -- advice from someone whose advice is not tied to financial products. It's tough to find. You're probably here because you think this is one place to get it.   

Pa/maternalism
For the most part, I believe that people need to be responsible for their own decisions, and that argues in favor of allowing employers to make the most cost-effective decisions for them, provided that advice providers disclose conflicts. Employers almost certainly will find it cheaper to buy an integrated package from a plan service provider -- one-stop shopping for fund options, administration, and investment advice -- and it may be less expensive than separate packages. Employers will certainly argue, with some legitimacy, that lower expenses for them could mean a more-generous employer contribution to the plan. And employees are always free to find other sources of advice, on- and offline.

But the danger, and the major justification for government regulation of the plans, is that if people make bad decisions and end up with fewer retirement resources, political reality means that in one way or another, others will pay. It's natural and simpler for people to heed advice from a plan service provider: Remember those experiments you studied in Psychology 101 where even though there was a rational choice (here, the fund with the best long-term performance), subjects still made the choices that pleased perceived authority figures (here, the "expert" plan service provider)? And it's also natural for that advice to lead participants to choose investment options that mean higher fees for the provider and lower returns to the participant.      

The message for investors is this: If and when you receive advice regarding your 401(k) plan investments, find out who is profiting from what. Is this an add-on service from the plan sponsor? Does it cost you anything upfront, or in hidden fees because the plan sponsor makes more money from steering you to this or that fund option? It's to any sponsor's advantage to have you in the products with the highest fees, even if the index fund might be the best option.

Get information from as many sources as you can and rely on those you trust. Your decision will serve you well. A good place to start is our Retirement Investing discussion board or our Rule Your Retirement Online Seminar.

Looking for independent advice on your finances? Voila, TMF Money Advisor!

Tom Jacobs (TMF Tom9) will not stand for any move to displace Diet Coke with lemon from the Fool HQ soda machine. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.