The combination of a surging stock market and our diligence in socking retirement money away led average 401(k) balances to hit record highs in 2013. But those balances would be even higher if the underperforming funds in your plan got the boot. Here's one big reason why subpar funds remain on your 401(k) menu.
How trustworthy is your trustee?
Employers that sponsor 401(k) plans must appoint a trustee to hold plan assets. That trustee has a fiduciary responsibility to manage the plan for the benefit of participants and must act within reasonable standards of prudence in selecting suitable, diversified investment options. But when a mutual fund company acts as trustee, conflicts of interest run rampant.
Trustees have a duty to act in the interest of investors. But they're also incentivized to funnel retirement dollars into their own funds. This sets up an inherent conflict of interest between a fund company's role as a 401(k) trustee and its self-interest in promoting its own funds.
A recent paper by the National Bureau of Economic Research concluded that the worst-performing funds are less likely to be removed from the 401(k) fund menu if they are affiliated with the trustee. Just how much return is sacrificed by trustees' reluctance to remove underperforming in-house funds? Roughly 2.4% to nearly 4% per year for participants, according to the study.
Trustee favoritism towards their own funds -- and forgiveness of poor performance -- is a reason subpar funds may still linger on your 401(k) menu.
The true 401(k) beneficiaries
Several class-action lawsuits were brought against companies regarding 401(k) mismanagement, improper disclosure of fee arrangements, and excessive plan fees in recent years. A 2012 Department of Labor ruling helped make fees more transparent. However, the issues of which mutual funds make the menu, which don't, and why are much murkier.
In addition to managing money, most large mutual fund companies also offer trustee services for retirement plans. But traditional fund companies aren't the only players faced with this conflict of interest. After an onslaught of mortgage losses, years of low interest rates, and new fee regulations, banks are sniffing out fresh ways to make money and circling the multitrillion-dollar 401(k) market.
Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), and Wells Fargo (NYSE:WFC) have ramped up staff and developed technology to vie for a slice of this lucrative business. JP Morgan doubled its retirement plan services sales force in 2010, and Bank of America brought aboard execs from Fidelity and other rivals. As of year-end 2013, Bank of America had $301 billion in client retirement plan balances. Meanwhile, Wells Fargo administered nearly $266 billion in plan assets as of Dec. 31, 2012. At the end of 2009, Bank of America, JP Morgan, and Wells Fargo had a combined 10% share of the 401(k) market, compared to the much larger 43% combined share for Fidelity, Vanguard, and Aon Hewitt. But big banks are making retirement plan business a priority, and their slice of the pie will likely grow.
All three of these megabanks house and manage their own proprietary mutual funds. As with traditional fund companies, the more dollars corralled into their funds, the greater their revenues. Bank of America, JPMorgan Chase, and Wells Fargo offer competitive fees on their 401(k) products to lure employers away from the traditional mutual fund companies. But this money won't come without a fight from fund shops boasting loyal clientele. For example, Fidelity claims a 97% client retention rate.
Think your best interests are aligned with those of your 401(k) trustee? Not necessarily. Find out who acts as trustee on your 401(k) plan. If it's the same investment firm that also manages all or most of the fund offerings in your plan, start asking questions. Politely prompt your HR department to explain the reasoning behind their choice of trustee. Consider advocating for a plan with an open platform -- i.e., one that includes mutual funds managed by multiple fund families. That will minimize the conflicts of interest in your 401(k) and set you up for a better chance at great fund offerings.