The 401(k) has been touted for decades as the safe place to put your money for retirement. Unfortunately, many of us have been unknowingly sold bunk products. We need to take control of our future and we need to do it now. Start by understanding exactly what you are putting your wages into, and what it is doing to your wages.
The Birth of 401(k) A Brief Overview
Before 401(k)s, many companies offered pensions. Workers were promised a secure income upon retirement.
But pensions were getting expensive from an employer’s perspective. People started living longer and maintaining them became difficult in light of new regulations and market volatility.
In 1978, the IRS added section 401(k) to the Internal Revenue Code. Section 401(k) of the The Revenue Act of 1978 enabled employees to defer paying taxes on deferred income. In other words, if you received income as cash, you’d continue to pay taxes. But if you deferred part of your income, the money could grow tax free. In 1978, the plans were called “cash or deferred arrangements.”
Ted Benna, a consultant and co-owner of The Johnson Companies, a small benefits consulting firm located in suburban Philadelphia, saw an opportunity in the code and created the first 401(k) for the employees of The Johnson Companies in 1981.
By 1983, nearly half of all companies offered a 401(k).
401(k)s turned out to be cheaper for companies than pensions. 401(k) plans essentially shifted the responsibility and payment for an employee’s retirement from the company to the employee. Instead of the company being on the hook to pay for pensions, that responsibility now fell on the employees themselves.
How were millions of Americans convinced that 401ks were better than pensions? Marketing. We were told that we’d have a lot more freedom by managing our own investment choices for retirement. Imagine that. Instead of the company guaranteeing a pension, we were now given the freedom to pay for our own retirement.
The Rise of 401(k)
This decision to shift from pensions to 401(k)s created millions of new employee investors for Wall Street and the financial industry.
However, the very idea of trillions of dollars in the hands of newbie investors opened the doors for all kinds of potential abuses within the financial industry.
The explosion of 401(k) investing coincided with their intermingling in mutual funds. The growth of 401(k) and mutual funds somewhat parallel each other. In 1990, 401k investments stood at $385 billion and were invested 9% in mutual funds. By 2000, nearly 50% of the 401(k) assets were invested in mutual funds.
During the bull runs of the 80’s and 90’s, when the markets were doing well, the returns on 401(k)’s seemed consistent, even invincible. So it was perhaps easy not to perceive any dangers.
Signs of Trouble for Individual Investors
The dotcom bubble of 2000 was the first warning sign that 401(k)s were putting people’s retirement plans at risk. Many took a big hit and lost their retirement savings.
Eight years later, the subprime mortgage crisis of 2008 hit retirement savers again, devastating many who not only lost their plans to retire, but also equity in their homes. The rash of bonuses handed out by bailed out banks was a slap in the face to those Americans left teetering on the financial edge.
The Problem with 401(k)
It is critical to remember that having a 401(k) is not saving for retirement. It is investing. And investing carries with it inherent risk.
“The problem with the 401K and the retirement industry, in general, is a definitional one. Saving money, or “pure asset” accumulation is different from investing. Saving money carries little to no risk outside of the counterparty risk of the saved currency. Investing always carries risk, regardless of whether the invested asset is gold, oil, or bushels of wheat.” – Future Money Trends
If the quality of the mutual funds in a 401(k) plan is poor or even mediocre, how would an everyday employee without investment experience know?
Undisclosed fees are another problem altogether. Most of the people who look at their 401(k)’s prospectus have no idea that these fees are being taken out. And when trying to discern what they are, they are hit with a myriad of terms that are increasingly confusing.
- Asset managing fees
- Marketing fees
- Administrative fees
- Trading fees
- Legal fees
- Trustees fees
- Transactional fees
- Bookkeeping fees
- Finders fees
- Expense ratios
To name a few.
It can take a ton of research to figure out what is actually eating away at the earnings of your 401(k). These fees are expressed in percentages, and they grow over time, just like your money.
Compound interest, the very thing that grows your money, also applies to fees, which reduces your money. And as your money compounds, the fees compound.
“According to our fee model, a two-earner household, where each partner earns the median income for their gender each year over their working lifetime, will pay an average of $154,794 in 401(k) fees and lost returns.” — Robert Hiltonsmith
Many of these fees can come from revenue sharing arrangements. The fund advisers pay off the middlemen who are selling to potential investors to push their funds. This can also be how funds get on a 401(k) list to begin with. The more hands in the pie, the more fees.
“The 401(k) is one of the only products that Americans buy that they don’t know the price of it. It’s also one of the products that Americans buy that they don’t even know its quality. It’s one of the products that Americans buy that they don’t know its danger. And it’s because the industry, the mutual fund industry, have been able to protect themselves against regulation that would expose the danger and price of their products.” – Teresa Ghilarducci, Professor of Economics, The New School
Still, another part of the problem is the term “financial advisor.”
Exactly what is a financial advisor? Financial advisers can don a number of names: financial planner, retirement planner, financial retirement advisor. But ultimately, a “financial advisor” is a salesperson. And you have to ask yourself if a salesperson has your best interest in mind. Because, historically, financial advisors did not have a fiduciary duty to put your interests before their own.
Many financial advisors sell you financial products because they make money doing it. They make a commission from selling you that specific product. It is important to recognize that.
The Department of Labor Fights Back
The Department of Labor is responsible for regulating employee retirement plans.
In 2010 it submitted a proposal binding the fiduciary duty of financial advisors, which would require that they put their client’s interests in front of their own when dealing with retirement products. The financial industry lobbied against it. Congress got involved, and the Department of Labor was forced to rescind the proposal.
But the Department of Labor did not give up. A controversial new rule which requires retirement investment advisors, including broker-dealers and insurance agents, to abide by a fiduciary standard took effect in April 2017. However, any financial advice given before April 2017 is not covered by the new rule.
In addition, while the new rule prohibits revenue sharing arrangements, pressure by financial lobbyists has added a loophole to the rule by allowing an exemption to the prohibited transactions. This exemption is known as BICE (Best Interest Contract Exemption).
BICE allows the now prohibited methods of conflicted compensation to continue if the broker enters into a contract with the participant or IRA account holder stating the broker will:
- Attempt to act in their best interest.
- Disclose all potential conflicts of interest.
- Provide a detailed breakdown of their collected commission
Finally, the growing list of class action 401(k) lawsuits against companies for their lack of fiduciary duty and excessive fees should give anyone pause that something foul has been going on in the 401(k) markets.
- J.P. Morgan Chase
- Suntrust Bank
- International Paper
- Fidelity Investments
- Kraft Foods
- Lockheed Martin
- Northrop Grumman
- American Airlines
- Edison International
- General Electric
Take Control of Your 401(k)
If you have a 401(k) plan, it’s time for you to get your hands dirty and do some research. If the responsibility for retirement using 401(k) has been pushed upon the backs of employees, employees simply must take it upon themselves to understand what their 401(k) is invested in, what fees they are being subject to, and how they can get a better deal.
Remember that your 401(k) is not a savings account. It is an investment and you must actively manage it to mitigate risk.
Take control by asking your company questions so that you can make informed decisions. John Katovich of Cutting Edge Capital mentions that most people don’t know that they have a lot more power than they think they do.
“Individuals can march into their HR office and say, ‘Let’s have a talk, tell me about my investments or put on a seminar for us. Explain to us how our money is impacting us. Am I investing in something’s that doing good, am I investing in something that’s actually harming me, I should know that, right? I want to know that.” – John Katovich, Cutting Edge Capital, Prosperity*
According to Katovich, the little-known secret about the 401k is that you can actually ask your company to set up a separate account that allows you to invest the way you want to invest.
“Imagine going into your company and saying, ‘I want to take 10% of my 401k retirement savings account and I want to invest it in some companies in my town.’ You can do that today, they’re not set up for it, the companies themselves don’t even know that they can do that, no one has been told that they can do that.”
If you have a 401(k), you need to find out exactly who is managing it, what they are charging, and what your money is doing. You can start by using free tools available online by the Financial Industry Regulatory Association (FINRA). FINRA’s job is to regulate brokerage firms doing business with the public in the United States. It’s a great place to start.
You can find out about your broker is by using FINRA’s free BrokerCheck Tool.
You can find out what funds you are invested in with FINRA’s free Fund Analyzer Tool.
You can also use Morningstar or Google Finance to help you research your funds.
Get a copy of your Fee Disclosure Statement. It is usually included in your 401(k) prospectus. Understanding your fees is going to take some effort, but there are free resources available that can help. The internet is your friend here.
Check out Demos.org’s The Retirement Savings Drain: The Hidden and Excessive Costs of 401(k)s which is a free booklet that you can download.
Once you have a clear picture of what your 401(k) is doing, you can make some informed decisions and take control.
Don’t like where your money is invested? Worried about People and Planet?
You have the power to incorporate Socially Responsible Investments into your portfolio. A new rule passed by the Department of Labor in 2015 makes it easier for you to invest in your 401(k) along with your values.
The Forum For Sustainable and Responsible Investing (USSIF) offers some tips and resources that may help you incorporate Socially Responsible funds into your 401(k) plan.
The bottom line?
The money in your 401(k) is your future. People can no longer afford to simply tick the box on their risk portfolio and hand the oversight of their future over to fund managers. The illusion that the financial industry, and even your HR department, actually have your future in mind while playing with your money has got to be discarded.
And only you can do it by exercising your rights and taking control.
Check out more great interviews and videos from leaders in conscious capitalism in the new feature film Prosperity
Photo by Jakub Gorajek
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