401(k) Plan Abuses Finally Coming to Light

I doubt that I’m unusual in being a finance type who has heard about 401 (k) abuses and bad practices for a very long time. So it’s gratifying to see the Financial Times that something is finally being done to try to curb this behavior. But that is hardly the full extent of what is rotten in retirement fund land.

Some of the failings reflect a combination of poor implementation of already not-so-hot finance orthodoxy (see a layperson rendering in Benoit Mandelbrot’s The (Mis)Behavior of Markets, or a recap of Mandelbrot and other critiques in chapter 3 of ECONNED). For instance, one mainstay of investing is to diversify across asset classes. It won’t increase your returns but it will lower your risk.

But what is an asset class? Wellie, the academic work on this topic defines “asset” classes in very large buckets that (as least historically) really were distinct markets and therefore moved only weakly in synch with each other (the financespeak term is “covary” or “covariance”): stocks, bonds, real estate, cash. Later research added foreign stocks and foreign bonds. But then pension fund consultants, whose role is to be a liability shield for corporations and government entities that still run defined benefit plans, have proclaimed all sort of types of investments to be asset classes, like private equity funds and hedge funds (and not just “hedge funds” in general, but specific hedge fund strategies, like global macro versus “event driven” (merger arbitrage) versus distressed debt. If pressed, hedgies admit that the value they create is largely “synthetic beta” or portfolio diversification, which can be achieved way more cheaply than the classic “2 and 20” fees (2% per annum, 20% of the gains, sometimes over a hurdle rate. As an aside, one has to wonder how much value is added by asset class diversification, given the proliferation of investors who move money quickly from one “asset class” to another in their search for return. Remember, for instance, the “risk on/risk off” pattern of much of 2012?).

But you can see the clear conflict of interest: the fund consultants have incentives to designate more investment strategies as “asset classes” so as to give them more to do and make their role look more significant.

So if this is going on with the big pension funds, you can imagine what happens in 401 (k) land. Admittedly, large corporations sponsor “defined contribution” plans too, but they generally have gotten less attention since defined benefit plans (trust me, the guys running defined benefit plans are very heavily solicited by Wall Street). But you’ve got a broader range of sophistication among plan sponsors (think of CFO at a Fortune 100 company versus the guy tasked to run finance at a medium-sized or small company). So you see a lot of “not in line with orthodox thinking” fund menus, such as too many flavors of US equity funds, worse, managed funds (when you might as well get a broad index and be done with it), and not enough options that allow for bona fide diversification (like foreign stock and bond funds).

But as bad as that is, the flat-out abuses are worse. Readers have complained about their inability to get information about fees. The lack of transparency is bad enough, and that raises the specter of possible overcharges. 401 (k)s typically allow moving monies from one fund to another only once a year, while by contrast, an IRA at a custodian like Vanguard faces virtually no such limits (what I’ve seen is in certain bond funds, and even then, the restrictions are pretty mild).

But one of the longest-standing types of fraud has involved float. I’ve heard tell of it typically taking weeks for transfers from one fund to another taking weeks to be credited; in one case, a full six weeks. This is the fund manager preying on captive customers, pure and simple.

It appears that finally these bad practices are being exposed by lawsuits. The Financial Times gives a recap tonight:

The cases allege the companies breached their fiduciary duties to participants in their 401(k) plans, which are roughly equivalent to defined contribution programmes in Europe, by charging excessive fees. Some suits also claim the plans engaged in improper revenue-sharing arrangements with service providers.

“These lawsuits have pushed fees and revenue sharing to the very top of the list of issues that plan fiduciaries have to face,” says Greg Ash, partner at Spencer Fane, a US law firm. “These cases, and the [Department of Labor’s] focus on fees, have completely changed the dialogue among plan fiduciaries.”…

The litigation has had a profound impact on the retirement industry, leading to fee reductions and changes in the way companies manage their 401(k) plans. Many cite the Department of Labor’s rules requiring greater disclosure about fees as also exerting enormous influence on the retirement industry. The rules went into effect in 2012, but were first floated in 2007…

Eight of the lawsuits have resulted in settlements of $150m in total.

Readers may also be surprised to learn that the investment manager actually providing the funds in many cases can’t be sued directly:

In early 2009, the US Court of Appeals for the Seventh Circuit upheld a lower court’s decision to dismiss a lawsuit against John Deere, the farm equipment manufacturer, and the plan’s administrator, Fidelity.

The plaintiffs claimed the company failed to monitor the plan’s investment options and that Fidelity charged excessive fees and did not notify participants of its revenue-sharing agreements.

The court ruled that Fidelity was not a fiduciary of the plan, and therefore did not breach any such duties.
“[The case] was the first real victory” for defendants, says Ian Morrison, partner at Seyfarth Shaw.

Patrick DiCarlo, counsel at Alston & Bird, notes the court gave particular weight to the fact that John Deere’s pension plan provided participants access to a brokerage option with more than 2,000 fund choices. While the case was a good win for defendants, “not every case has the same set of facts”, Mr DiCarlo says.

Lawyers please chime in. I’m at a loss to see how providing lots of choices has bupkis to do with overly high fees and lack of required disclosure. I’d hazard this ruling relies on the notion of secondary liability. As we wrote in ECONNED:

Legislators also need to restore secondary liability. Attentive readers may recall that a Supreme Court decision in 1994 disallowed suits against advisors like accountants and lawyers for aiding and abetting frauds. In other words, a plaintiff could only file a claim against the party that had fleeced him; he could not seek recourse against those who had made the fraud possible, say, accounting firms that prepared misleading financial statements. That 1994 decision flew in the face of sixty years of court decisions, practices in criminal law (the guy who drives the car for a bank robber is an accessory), and common sense. Reinstituting secondary liability would make it more difficult to engage in shoddy practices.

And we have kickbacks!

A Missouri federal court ruled in April 2012 that ABB, the US unit of a Switzerland-based manufacturer of power and automation equipment, was liable for removing a Vanguard fund from the plan menu in favour of Fidelity target-date funds.

The court also ruled that the company paid Fidelity, the plan’s administrator, above-market rates in order to subsidise separate ABB corporate services.

The same case also targeted the failure to credit funds promptly:

The court ordered ABB to pay $35m. It ordered Fidelity to pay $1.7m for breaching its fiduciary duties in how it handled earnings on money moving to and from the plan’s investment options, known as float….the lower court’s decision has spawned at least four class-action suits against Fidelity over how it deals with float. The cases have all been filed this year.

It’s good to see some action on this front. The US provides for a great deal of regulation in the fund management and retirement fund arena precisely because you often have very unsophisticated customers, and the vendors can engage in all sorts of skimming that looks small on an individual account basis but adds up across a business. Now the interesting question is where the Obama Administration has been all this time. Will it join this party late and try to create the image that it really was taking early reports of these abuses seriously, or sit on the sidelines, on the assumption that this story won’t get much airplay? Stay tuned.

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  1. DakotabornKansan

    Where has the Obama Administration been all this time?

    “A recent economic crisis was the result of both the irresponsible action on Wall Street and everyday choices on Main St…Ensuring this crisis never happens again will require new rules to protect consumers and better information to empower them…While our government has a critical role to play in protecting consumers and promoting financial literacy, we each are responsible for understanding basic concepts: how to balance a checkbook, save for a child’s education, steer clear of deceptive financial products, plan for retirement, and avoid accumulating excessive debt.” – President Obama announcing April as Financial Literacy Month [2010]


    Notice how Obama gives equal weight to the role of the financial institutions and households in the financial crises. This is total bullsh*t.

    Robert Kuttner’s Debtor’s Prison: The Politics of Austerity Versus Possibility documents the financialization of Americans lives. Middleclass family households have become major sources of financial products and debt.

    As corporations horded vast amounts of cash and federal, state, and local governments reduced spending and balanced budgets, American households became the locus of macroeconomic stimulus. Everything was turned upside down. Corporations used to be the debtors and households the savers. Risks were managed by government and employers. Corporations were rewarded with legal protections and tax favoritism for bearing this burden. Now it is households that take on the risks of financial loss. Corporations and financial institutions have successfully sheltered themselves from risk while enjoying the returns of high risk assets. Both Democratic and Republican presidents and the Congress have allowed this to happen.

    Thus, once defined retirement benefit plans were replaced by defined contribution plans, enabling the increase in predatory practices by mutual funds, investment advisors, and retail brokers.

    The public policy response? Arm households with basic financial literacy.

    [see above Obama proclamation]

    Teresa Ghilarducci, Schwartz Center for Economic Policy Analysis, says “financial literacy is like having a BB gun in a firefight with bazookas and stealth bombers.” “Research shows those households that think they are financially literate dive into financial markets and training with high fee brokers and end up buying high and selling low.”

    “The financialization of America” blames individuals for the housing crash. It blames impoverishment in retirement funds on individual’s decisions to save and not work. It blames financial insecurity on the lack of financial literacy by individuals.

    “The search for a scapegoat is the easiest of all hunting expeditions.” – Dwight D. Eisenhower

    1. Expat

      Excellent analysis on a most important topic. NC readers may be aware of the case of the Eastern Connecticut State University faculty who realized they had run a side-by-side experiment in which faculty members had selected at the time of their hiring to be in either a 401(k) or the state’s regular pension program (SERS).

      In 2008, after 25 years, professors who had selected the state pension option had a pension that was TWICE as big as the 401(k) pensions. Not only that, the state pensioners had paid less into the plan themselves AND the state’s contribution was smaller. In other words, the 401(k) was stunningly worthless, except to the rentier middlemen living off the earnings of others. The resolution of this issue for these middle class state workers was a one-time opportunity to opt into the state’s retirement plan.

      See, for example, “The Retirement Crisis in the United States.” Interview with James W. Russell on KPFA-FM (Berkeley), November 2, 2010. http://www.againstthegrain.org/program/500/id/472351/wed-11-23-11-retirement-savings-ideology There are also extensive links at the bottom of this site: http://www.easternct.edu/~russellj/ConnecticutAlternateRetirementProgramCrisis.htm

      At the time, I expected to see a flurry of these lawsuits because millions and millions of salaried workers had been forced into these dubious financial vehicles as part of the Reagan devolution, but as this article points out , getting traction with our corrupt judiciary is virtually impossible.

      As Dakotaborn says so well, ” ‘[t]he financialization of America’ blames individuals for the housing crash. It blames impoverishment in retirement funds on individual’s decisions to save and not work. It blames financial insecurity on the lack of financial literacy by individuals.” Verily.

      1. jrs

        Yea don’t expect anything to get better though. My company justifies not contributing to the 401k (matching) because people might lose money in the 401k and later sue. Wages are not greater because of this and there is no pension or any type of definied benefit plan. Well gee, it’s sure worth giving up matching for: ABSOLUTELY NOTHING!

        What’s really important is preserving things like Social Security, not suing corporations over poor 401k performance (outright theft is another matter).

    2. John Mc

      Helaine Olen’s book “Pound Foolish” discusses how the financial literacy movement has a real dark side to it. Confirms DakotabornKansan’s point and worthy read.

    3. NotTimothyGeithner

      Do you remember how W. used to play dress up? He could Lance Armstrong, a firefighter, a policeman, a pilot, and a cowboy. In much the same way, Obama is merely dressing up as President to fulfill his own delusions of grandeur.

      Like television or movie Presidents, Obama’s speeches and various diatribes are largely non-committal and sound like they were written by a committee with a few rah rah lines for the crowds.

      Understand the problems of finalization, the broken retirement promises, and how to fix it would require hard work. Obama would have to twist arms, threaten Congressmen, make sure the Blue Ribbon Committees are actually working, and then actually be “clear” with the population about the past, yes, he would have to acknowledge the complicity of both parties and Bill Clinton especially.

      This would be hard but ultimately successful work. Obama would face pleas from interns with parents who might be under scrutiny from new laws and regulation which would mean Obama had one less person who was impressed by his basketball acumen. These actions would not be fun. In a sense, these actions would be the mark of a great man which Obama is not because he doesn’t desire to be President, he desires the greatness which is ascribed to the office. Both, he and W. refer to the office of the Presidency at an alarming rate, not only to deflect responsibility but to demand tribute and glory regardless of their actual effort.

      Who remembers who the hell is Carter Glass? Who the hell is Steagall? They weren’t President like Ben Franklin (snark), and so they aren’t great for a number of people. Of course, there efforts will always be remembered and replicated unlike say Obama who will become a footnote of a broken age.

    4. readerOfTeaLeaves

      Great post.
      Terrific comment, especially:

      “The financialization of America” blames individuals for the housing crash. It blames impoverishment in retirement funds on individual’s decisions to save and not work. It blames financial insecurity on the lack of financial literacy by individuals.

      We’ve had an utter abdication of political and economic leadership that opted for the easy out of ‘blame the victim’. This makes it convenient for government to fail to take action, or crack down on shoddy practices like the forms of skimming described in this post.

    5. NotTimothyGeithner

      “– President Obama announcing April as Financial Literacy Month [2010]”

      If there isn’t a clearer sign of the religious devotion to markets, I don’t know what it is.

      1. McMike

        I am an experienced management professional and I find these choices and forms maddening. I cannot imagine how the bulk of the country goes through this.

        In fact, the more you know, the worse it is, because I actually try and sit down and figure it out and spreadsheet it out. And what you figure out is this: there is no good answer, not even a marginally better answer. They all equally stink in their own special way.

        What you figure out is the entire thing is set up to screw YOU, perfectly, almost like it had you specifically in mind. You will find yourself stuck right on the lower end of the next rate tier up. You will find out you have a The Price is Right choice between unknowable future events and unpalatable trade-offs. You find yourself wondering why the two features that are most important to you are segregated from each other and not available together.

        You begin to suspect that it doesn’t matter anyway, because they are going to screw you no matter what you choose.

        So, in fact, I do know how the bulk of the country goes through it. It involved darts.

        1. NotTimothyGeithner

          One issue is many policies were devised for issues in 1993. Senator Warren will gladly discuss credit card reform proposals from the 1980’s, and they are important for moving forward but don’t fix the problems of two decades of chaos. ACA would have been great in 1993 or much better anyway.

  2. Nathanael

    “But one of the longest-standing types of fraud has involved float”
    We’ve seen this even in TIAA-CREF, which is quite quick on transfers within TIAA-CREF. If you try to get money out as a withdrawal, though, suddenly it takes weeks…

    1. McMike

      The float is the time between date when it is divested from the investment fund in your account and when they cut the check.

      Or rather, the other way around, on the incoming side: the float is the time it takes from when it is withheld from your paycheck to the date it is credited to the investment fund for your account.

  3. susan the other

    Just wondering about Liz Warren’s consumer protection bureau and its effect or lack thereof against this fraud. Does Liz agree with Obama on everything? Like ‘the banks were immoral but didn’t do anything illegal’ and etc? Obama is about as missing in action as a “president” can be. He will not take any action whatsoever.

  4. jrs

    “While our government has a critical role to play in protecting consumers and promoting financial literacy, we each are responsible for understanding basic concepts: how to balance a checkbook, save for a child’s education, steer clear of deceptive financial products, plan for retirement, and avoid accumulating excessive debt.”

    This is a deceptive propaganda sentence if ever I’ve seen one. It equates things that are intellectually simple (like balancing a checkbook, that’s intellectually simple, if there is more month than money that is not a knowledge problem!) with things that are not simple at all like planning for retirement. Understanding investments and the economic system is not a basic concept.

    And who is giving this advice anyway, Warren Buffet? Well maybe he does too, but right here it’s being given by Obama, a man whose corruption made him rich. I mean really everyone knows how those politicos get rich. It’s corruption.

    1. NotTimothyGeithner

      “steer clear of deceptive financial products,”

      I thought this was the government’s job. I love how people pretend to feel betrayed by Obama. He’s pretty upfront about what a crummy guy he is.

      1. jrs

        Sept 1929: the masses really need to understand basic concepts to steer clear of all the deceptive financial products out there. — Barack Obama in a past life

  5. The Derivative Project

    This link to the FT article says it all:

    “Patrick DiCarlo, counsel at Alston & Bird, notes the court gave particular weight to the fact that John Deere’s pension plan provided participants access to a brokerage option with more than 2,000 fund choices. While the case was a good win for defendants, “not every case has the same set of facts”, Mr DiCarlo says.”

    We agree with Yves, very strange legal interpretation, but that is the reality of the courts and the financial services industry today. It will take years in the courts to unwind this wicked web, which also extends to IRAs, which are far more complex–with “no private right of action” and non-discretionary and discretionary accounts provided by dual registrants.

    The only solution currently is taking action through 401k brokerage windows to avoid the myriad of conflicts of interest presented by the financial services industry. It is a simple, straight-forward strategy that counters the years of misinformation and eliminates the redundant layer presented by the financial intermediary industry (“advisors” that are but sales personnel) that commenced with defined contribution plans in the early eighties.

    To address the conflicts and ongoing breaches of fiduciary duty, to eliminate the redundant, costly intermediaries, Not On My Nickel is now available.

    We provide the tools, training and transparency for both IRA and 401k investors and are truly independent of the financial services industry.

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