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What will the 401(k) Plan of the Future Look Like?

What will the 401(k) Plan of the Future Look Like?
Ron DeLegge, Editor
November 15, 2011

The 401(k) retirement plan has come a long way since its humble beginnings in the early 1980s. Today, roughly 72 million people have a combined $3 trillion invested in 401(k) plans.

What will the 401(k) plan of the future look like?

100% Fee Transparency
Most 401(k) plans are riddled with so many hidden fees, the typical 401(k) participant isn’t aware they’re even paying them. And while 401(k) sponsors (employers) have a fiduciary duty to protect their employees against fangled retirement plan fees, most employers themselves are pretty clueless. Even worse, some employers are acting in collusion with 401(k) providers to obscure the true cost of their company’s 401(k) plan.

A recent study by the U.S. Government Accountability Office (GAO) proves this. The GAO study revealed that revenue sharing, whereby a mutual fund company shares its fee income with the 401(k) plan’s administrator, is a common practice. The actual compensation can range from 0.05 percent to 1.25 percent. Why is it a problem? Because it creates a hidden incentive for the 401(k) service provider to recommend investment choices with higher fees, some of which may even include proprietary funds with substandard performance.

Closely related to this are 12b-1 fees, which are another perfect example of what’s wrong with today’s generation of 401(k) plans. How does it work? The 12b-1 fee takes money taken from 401(k) participants and funnels it back to brokers and financial intermediaries. Shame on the Securities and Exchange Commission (SEC) for even allowing 12b-1’s to be called “fees” because these reoccurring costs are really tantamount to sales commissions.

The original intention of 12b-1 fees was to help the mutual fund industry to grow its business and to pay for that growth through marketing fees. With around $11 trillion in assets, the mutual fund industry has matured beyond the point of needing any more help. 

The 401(k) of the future will not have 12b-1 commissions or other camouflaged costs, but rather, 100% upfront disclosure in plain English. Put another way, financial professionals will need to find other ways to get paid.  

No More Phony Diversification
Today’s generation of 401(k) plans are sold under the misleading premise that they offer adequate investment diversification. Not only is this a massive failure by the mutual fund and 401(k) industry to tell the truth, but it’s a regulatory breakdown.  

The main explanation for the 401(k) industry’s faulty and outdated definition of diversification is due to the Employee Retirement Income Security Act (ERISA), which the 401(k) industry has been adhering to. According to ERISA, an adequately diversified 401(k) plan is one that offers exposure to stocks, bonds, and cash.

True diversification in a 401(k) plan is an investment menu that goes beyond offering exposure to U.S. stocks (NYSEArca: SCHB), international stocks (NYSEArca: VEA), bonds (NYSEArca: AGG), and money market funds. True diversification includes the previously mentioned categories, plus other important areas like commodities (NYSEArca: GCC), global TIPS (NYSEArca: GTIP), international real estate (NYSEArca: RWO), and international government bonds (NYSEArca: BWZ). No 401(k) menu or provider can rightfully claim to be diversified without exposure to all the major asset classes.

Account Statements that Tell You Something
The chief purpose of a 401(k) plan is to provide you with an adequate source of retirement income so that when you’re grandma’s age, you don’t have to eat ALPO for dinner. Yet, when 401(k) account holders look at their quarterly statements, they have no clue about how much income their current stash will generate.

The future 401(k) plan will have participant statements that clearly show how much monthly or annual income that the person’s 401(k) sum is capable of generating. Ultimately, this is the bottom line reason for a 401(k) plan – to have the accumulated sum generate an adequate level of income that 1) covers a person’s expenses and 2) doesn’t prematurely run out.

A recent report from Reish & Reicher titled “401(k) Account Balances as Monthly Retirement Income” hinted at this future trend.

Innovation, not Bureaucracy
401(k) plans of the future will be shaped by innovation instead of back room deals between third party administrators (TPA) and mutual fund companies. People will decide what they want to invest in, not some bribed TPA.   

Although it seems like there’s more bureaucracy than innovation in the 401(k) market right now, hints of a major shift are already here.

Invest n Retire (INR), a Portland, OR-based company, is the sort of open source 401(k) provider that is radically altering retirement plans for the better. The company was just awarded a patent on its system for managing tax-deferred retirement accounts.

Rather being force fed a rigged menu of subpar mutual funds, INR’s technology allows it to use multiple investment products, including low cost exchange-traded funds (ETFs).

INR’s system is so advanced that it takes contributions to a person’s 401(k) plan and buys underweighted funds in their portfolio so that the employee’s investment mix maintains an optimal balance. INR calls this breakthrough “Self-Aligning Portfolios,” but I like to call it just plain brilliant.

Conclusion
Today’s generation of 401(k) plans are built upon outdated legacy platforms that are one-trick ponies because they only accommodate mutual funds. It’s a method of business that has worked well for the 401(k) industry in the past, but won’t work in the future.

In contrast, the next generation of 401(k) plans are smartly designed systems that use multiple investment products, offer 100% fee transparency, and genuine diversification.

401(k) providers will have to embrace these changes or be forced into extinction. Why? Because the retirement plans market demands it. 

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Bob Francis said on November 17, 2011
  You are both spot on, particulalrly the comments regarding 70's era mainframe based legacy systems. 40's Act funds seking alpha at premium prices will continue to experience slippage to collectives utilizing ETF's and index funds. Third party managers using this strategy will be enormous beneficiaries!
 
 
Neil Plein said on November 17, 2011
  Ron- you’re right on here. The mutual fund dominated, education laden, manual process driven juggernaut currently in place only finds slight variation between major service providers.

In this model, the status quo, fundamental change moves at a glacial pace; the systems and technological infrastructure used by the industry are nothing short of museum quality by today’s current programming standards. And even considering a change to this system fundamentally, is a task which becomes exponentially difficult when you realize that the systems are essentially 70’s technology, hidden under layers upon layers of programming updates using different languages at different times just to achieve some basic level of functionality in the current environment.

As a result, very few people can even explore fundamental change. The current paradigm has become so developed that the same questions keep circulating round and round in the retirement world, “Best Mutual Funds,” or “Steps to better educating participants.” Each time I see a topic like this I can’t help but be reminded of how closely such questions mirror those of Christian monks in the middle ages, questions like “how many angels can dance on a pin?”

It’s not that bad of course, but it is that way in terms of the importance of what’s being discussed and what catches headlines; as it pertains to building truly adequate retirement funds on a large systematic scale. For real change to come to 401k plans, it must be fundamental and Invest n Retire has answered the call. Thank you for the kind words.
 
 
Ron the Editor said on November 16, 2011
  With all due respect Leo, any 401(k) insider worth more than ten cents will explain to you the industry is still plagued by perverse revenue sharing programs. Right now it's the rule not the exception.

The DOL, ERISA, and Congress have been talking tough for the past number of years, and yet the 401(k) lobby always gets its way.

The fact is people shouldn't have to dig through to IRS form 5500 to see or understand what they're paying. Nor should a set of substandard menu of investment products be their only choice.
 
 
G. Leo DuMouchel said on November 16, 2011
  Fee disclosure is coming early next year for the plan participants. It' already here for the plan sponsors. Plus there is the enhanced disclosure on Schedule C of the 5500's, which started for the 2010 plan year.

Open architecture providers allow to put as much diversification as you want. Many are now offering ETF's.

The future has been here for quite awhile.
 
 
Neil Plein said on November 16, 2011
  EXCEPTIONAL article!
 
 
mike dever said on November 16, 2011
  Ron, I agree with you wholeheartedly that 401(k) plans force people to create concentrated portfolios that result in them taking unnecessary risks with their money. There needs to be a push by investors to require plans to open up and permit the types of investments that can truly diversify a portfolio. I discuss 'true' portfolio diversification in my book "Jackass Investing" Don't do it. Profit from it." It's time for 401(k) plans to open up their investment options so that people can diversify and stop gambling with their money in their retirement plan (my definition of "Jackass Investing!").

 
 
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