Correcting the 401(k) Problem

Perceptions play a critical role in the world of investing. Perceptions determine credibility, which affects interest rates, currency values, credit ratings, and institutional stability. It is the major reason why depositors make a run on a bank, and why junk bonds must pay higher rates than quality issues.

So it must have come to a surprise to the mutual fund industry to see the October 19, 2009 cover story in Time magazine, “Why It’s Time to Retire the 401(k)," with the provocative subhead “And what you can do instead.”

As a major general circulation publication, this article is based on the widely-held belief that “the data are telling us that even in the long run, consumers need better options.” Even worse, reporter Stephen Gandel writes that “the ugly truth, though, is that the 401(k) is a lousy idea, a financial flop, a rotten depository for our retirement reserves.” This is a powerful article for the retirement and mutual fund industry, but what changes are they making?

The article cites that the average 401(k) balance fell 31% from the end of 2007 to the end of March 2009. This loss posed the greatest danger to people closest to retirement. While the article notes the effect on retirees, some of whom had pensions, it also notes the need for new products, specifically a pooled-risk product that provides a buffer for retirement-type accounts in down markets.

Whatever Happened to Active Management?
The problem is that active mutual fund management is supposed to do exactly that. The failure of 401(k)s is actually a failure of active management, especially in load mutual funds which charge large fees for their supposed diligence and nimble investment skills.

One problem is that fund companies get paid on assets under management. Their profitability suffers in down markets when asset values decline. They also suffer when shareholders makes the critical decision to redeem their shares and move 401(k) assets to another firm, often to a no-load company.

Too many mutual fund portfolio managers defamed 401(k)s by remaining fully invested in 2008 during the same time they saw the market going into steep decline. Going to cash is not an option for too many managers who have to sell stocks and then incur additional trading costs selling, and eventually re-buying the stocks to rebuild the portfolio. ETFs offer more alternatives, but unfortunately, not enough fund managers construct their portfolios exclusively using ETFs.


Some Suggestions
The mutual fund industry can adopt some defensive practices from the hedge fund world. gere are a few suggestions:

--Stop trading at key loss points. Many hedge funds automatically stop trading when they suffer losses, say 20%, from a previous peak. When hedge fund managers know their strategy is not working or they are working against the market, they stop trading. Mutual fund managers should have this option. If they did, they would not hurt their shareholders.

--Adopt high hurdle rates for better compensation schemes. Mutual fund managers get paid large salaries to actively manage portfolios. They then become eligible for significant bonuses if they beat their benchmarks, peer group ratings, or earn industry recognition. Unfortunately, they do not suffer as much as their shareholders on the downside.

A better compensation scheme would be to create high hurdle rates in which the manager does not get paid unless a shareholder makes a return which is more then their last highest quarterly or semi-annual gain. The technology certainly exists to implement this idea at the fund level, but fund managers have a guaranteed salary regardless of performance. Under the current system, shareholders take all the risk.

That’s another reason why the public understandably questions the validity of the 401(k). However, it is not the tax-deferred structure of the 401(k) which is the problem, it is with the problems associated with active fund management, especially with load fund companies which charge higher fees for a better-quality product. Shareholders have every right to ask if they are getting what they are paying for?.

Not Enough Innovation
The last major problem why the public has lost faith in the ability of 401(k)s to deliver retirement security is that the mutual fund industry is not innovative. The need for new products, as the Time magazine story notes, is critical. Yet the fund industry has not introduced new products since the money market mutual fund, circa the Seventies.

The latest new twist, target-date funds, failed to deliver during the recent downturn because they are basically a marketing gimmick. They are comprised of mediocre mutual funds offered by a large fund company. Packing the mediocre funds together guarantees a new source of assets when they are sold to future retirees as being a simple solution to meeting their retirement needs. Wrong.

The target-date funds are a great way to provide portfolio diversification, but the better approach is to either pick the best fund in all classes (albeit too expensive to administer) or construct the diversified portfolios using index funds or ETFs.

The more important reason why the fund industry is not innovative is because it is artificial supported by 12b-1 fees. These fees were originally introduced to improve communications with shareholders, who in turn would invest more in a fund, so total fund expenses would be reduced. For the most part, that has not happened.

Instead, 12b-1 fees have been diverted to support marketing activities which largely have nothing to do with shareholders. They are used to buttress and fund sales staffs, sales events, meals and entertainment with financial reps. Like too many other activities in load-mutual fund companies, the needs of the individual shareholder are the least important consideration, even when 12b-1 fees are being collected in their names.

Too Many Mutual Funds
These fees also explain the rampant commoditization of the fund industry. There are too many similar funds in too few equity styles following very similar strategies. This only focuses more attention on why a load fund deserves to charge a high fee when it is so similar to many other funds. Worse, long-term performance results often do not merit the higher expenses.

Another conclusion we can reach is that the problem is not with 401(k)s themselves, but the investment engines which drive fund returns. The other big problem is that the 401(k) industry is largely run for the benefit of the mutual fund companies and 401(k) plan administrators, and not for the participants themselves. This perverts the interests of the investor versus their investment adviser.

So if the load-mutual fund industry is concerned about shareholder confidence and wants to restore purpose to 401(k)s, all they have to do is make some changes in the way they conduct their daily business. The solutions are all in their hands.