The Fine Print: How Big Companies Use "Plain English" to Rob You Blind (32 page)

A half of a percentage point may not sound like much but small amounts siphoned from large pools produce big numbers. The half a percentage point in excess fees for all 401(k)-style plans works out to $22.5 billion a year. Consult your calculator, and you’ll find that that amounts to an annual cost of $535 for the average 401(k) participant. After thirty years at 6 percent interest, the cumulative cost of such fees comes to an average of $42,300. That is more than the average balance of a bit more than $33,000. Looked at another way, it’s the equivalent of two years of after-tax pay for a single worker making the median wage of about $500 a week in 2010, though workers at that pay level probably don’t have much in their 401(k), if they have one at all. But even for a worker making
$50,000, a threshold for the top quarter of workers, that $42,300 siphoned off by Wall Street is more than a year’s take-home pay.

Look deeper and you will find average balances are highly misleading. There are a few people with huge accounts—some in the millions of dollars, like Mitt Romney—but many others with less than $10,000. Mostly the 401(k) plans amount to a shallow pool where most people only get wet up to their ankles.

The lost decade of the twenty-first century, when investment returns for many were less than zero, did little to slow the steady draining of funds through fees, some hidden and some explicit. The weak stock market hurt, too. A dollar invested in Vanguard’s low-cost mutual fund, Total Stock Market Index, at the market peak in 2000 lost one-third of its inflation-adjusted value by the end of 2011.

In 2007, a year when the stock market was on the rise, almost as much money came out of 401(k) plans in disbursements to retirees and people between jobs as went in from new contributions. The plans had a net gain of $223 billion or $3,700 per participant; only the next year the plans lost $723 billion as the crashing stock market more than wiped out $267 billion of new deposits.

Just in case you’re thinking that people out of work due to the Great Recession tapped their 401(k)s and caused the huge loss in 2008, not so. Payouts from the plans in 2008 were 11 percent smaller than in 2007.

What the Great Recession did reveal was how much 401(k) plans are like watering holes in a drought. People migrating from a job they lost to the next will find their retirement savings pool diminished because of the market crash. If the market does not recover for years, as happened between 1966 and 1981, your 401(k), already closer to a 201(k), may quickly turn into a financial mud hole, unable to sustain you.

INEFFICIENCY COSTS YOU

Making self-directed retirement savings plans like the 401(k) the foundation of old-age income is as economically inefficient as making pins one at a time (remember Adam Smith’s lesson?).

Specialization makes for economic efficiency. We do not all know how to wire our homes for electricity or plumb them to carry fresh water in and wastewater out without spilling a drop. Using self-directed investment through 401(k)-type plans is the economic equivalent of expecting every worker to be her own roofer and surgeon. Most people lack the
necessary time, knowledge and highly specialized skills to manage investments and time in order to accumulate enough wealth to sustain them from the day they stop working until they die. The result of creating a population of financial do-it-yourselfers is proving to be shocking and painful, leaving people worse off than need be.

Look at it this way: if investing was something just anybody can do, the average job on Wall Street would pay average wages. But stockbrokers, investment advisers and others who become expert at subtle concepts like the time value of money, asset allocation and risk and opportunity costs make more than most people because those skills add value by reducing inefficiency and increasing returns.

The Labor Department publishes data going back to 1989 comparing investment returns of traditional pensions and 401(k) plans through 2008. The professional managers of traditional pensions performed better than individuals in their 401(k) plans in fifteen of twenty years. In every year when the stock market was down, the pension plans lost less than the 401(k) plans, numbers that reflect the steady hand of professional money managers as opposed to the less informed and sometimes panicked hands of individual amateur investors.

In 2008, when the stock market fell sharply, pension plans lost almost 20 percent of their value, but 401(k) plans lost 24.9 percent. That means that for every dollar pension plans lost, the 401(k) plans lost $1.25. Recovering from those losses will be a lot harder for 401(k) savers than those in defined benefit pension plans.

Steve Butler, a San Francisco Bay Area financial adviser who calls himself “Mr. 401k,” praises 401(k) plans—
if
the costs are held down through smart shopping by the employer. His studies show that many workers pay one percentage point a year more in costs than necessary because their employers chose high-cost plans.

Again, a single percentage point may not seem like much but, over time, it adds up to a lot. Consider what happens if you put $1,000 in a 401(k) annually for forty years and earn 5 percent a year instead of 4 percent. After forty years, earning 5 percent annually would yield more than $181,000, but the other account would hold less than $137,000. That one percentage point a year of extra fees robs you of a third of your 401(k) savings at retirement.

Employers also shortchange workers by paying them with debased currency. It’s an old trick, dating at least to the sixteenth century, according to David Hackett Fischer, the Brandeis University historian, in his book
The Great Wave
. In that era, Fischer tells us, the merchants of Venice
and Florence got laws passed “that allowed them to insist on being paid in gold florins or ducats, which held their value, but permitted them to pay wages and taxes in silver coins, which were much debased.” The result? “As a consequence rich merchants grew richer and the poor sank deeper into misery and degradation.”

Modern companies debase their workers’ currency when they compensate them partly in shares of company stock. Companies not only can require workers to accept company stock in their 401(k) plans, they can force them to keep the stock until they reach age fifty-five. Contrast this with the stock options issued to executives. The options only have value if the price of company stock rises. But once an executive exercises the option, he is usually free to sell his shares and diversify into other investments or take cash and spend it.

Investing in the company you work for is one of the most basic rules that financial advisers warn workers against because it concentrates their risks. If the company gets into trouble, as all companies may, both your job and your investment in company stock are at risk.

Some companies funded their entire retirement plans with company stock. The results were disastrous for workers employed by scores of big companies, among them Enron, Global Crossing and the Carter Hawley Hale department-store chain, where retirement accounts suddenly evaporated. At Enron, 62 percent of the stocks and bonds in the 401(k) plan were Enron shares, which fell in value from $80 to seventy cents before losing all value. At Lehman Brothers, the failed Wall Street investment house, a tenth of the 401(k) plan was in company shares that lost all value overnight in 2008.

Despite this, many companies still match worker savings only with company shares. At better than one in four big companies in 2009, company stock accounted for a quarter or more of the value of the 401(k) plan. At one company in twenty, 80 percent or more of the 401(k) plan assets were company stock.

A 2004 study for the Federal Reserve by three academic economists noted that “participants in plans that match with company stock end up with a highly undiversified portfolio.” But most workers, who are not investment specialists, don’t recognize the importance of diversification, nor do they know when and how to rebalance their holdings to maintain diversification as some of their investments grow in value and others fall behind or otherwise lose value. Executives are more likely to have such specialized knowledge, which is why they are often selling stock in their own firms to buy shares of other companies’ stock.

There are those who take a reverse view of this practice. Professors Jeffrey R. Brown and Scott Weisbenner of the University of Illinois and Nellie Liang of the Federal Reserve wrote favorably about 401(k) matches in company stock, noting that “risk-tolerant individuals actually prefer” company stock to cash with which they could buy a diversified set of stocks. They reported that companies that use their own stock for their 401(k) match appear to be less likely to go bankrupt than companies generally. But even if that’s true, a reduced risk of bankruptcy is cold comfort to anyone who is forced to hold their employer’s stock when the firm does go under, as has happened to those who worked at Enron, Carter Hawley Hale and many other firms.

So why do companies use their own shares to make 401(k) matches? They take the position that employee ownership motivates workers, which can be true. But company shares are also cheaper than cash. The companies issue stock certificates. That means more shares are outstanding, which dilutes the value of existing shares. But they get to deduct the value of those shares as a business expense without having to spend cash. Neat trick.

Giving workers company stock and requiring them to keep it until age fifty-five seems to violate the legal basis for a retirement plan, since the courts have held retirement plans must be operated “solely and exclusively” in the interests of the workers. Yet nowhere has any court issued a definitive decision on this crucial point. Nor has Congress acted to protect workers from plans that force them to hold on to their employers’ shares for long periods.

Growing inequality has marked every great shift in prices in the past millennium, David Hackett Fischer wrote in
The Great Wave
, his book about price revolutions. Using historical records of prices for everything from bread to insurance contracts, Fischer showed that a growing gap between returns to capital and returns to labor is typical of price revolutions, be they shifts from stability to inflation or, as we are experiencing, from inflation to deflation.

Whatever the historical context, companies are clearly cheating workers when they pay them in the debased currency of the employer’s stock or even when they put their cash contributions into managed mutual funds. There are also winners in these plans, such as employees of Apple, with its astonishing rise in share value. But the principle of diversification should reign. Keeping company stock should be optional, not forced. And employees should be able to vote any company shares held for them in a 401(k) plan.

The numbers in the latest edition of economist Burton Malkiel’s
famous investing book,
A Random Walk Down Wall Street
, make the case against managed mutual funds. If you put $10,000 into an S&P 500 Index fund in 1969 and reinvested dividends, your portfolio in 2010 would have been worth $463,000. The same sum in an actively managed mutual fund would amount to $258,000. So over more than four decades, the low-cost index funds produced $1.76 for each dollar earned by the actively managed funds.

The lessons: company stock concentrates risk. Index funds are cheap. Managed funds cost more, but return less. Guess which type of fund the mutual-fund industry pushes employers to use in their 401(k)-type plan?

Official government reports, research studies and companies often refer to 401(k) plans as being “popular.” But it is companies, not workers, who decide whether workers get secure, insured, efficient traditional pensions or the less reliable, uninsured and very inefficient 401(k) plans.

This is not an isolated phenomenon, as there has been a watershed shift in how retirement assets are held. In 1984 just 13 percent of companies with fifty thousand or more workers offered only a 401(k) or similar retirement savings plan. Just nine years later a majority of companies offered only this kind of plan.

Since 1980 the number of people in traditional pension plans has hardly changed. There were just under 38 million Americans in large pension plans in 1980 compared to about 42 million in 2009, annual Labor Department reports show. That’s about a 10 percent increase during years when the number of Americans grew by a third. Over the same period, the number of people in all types of defined contribution plans, mostly those high-cost 401(k) plans where workers must decide how to invest, quadrupled from under 20 million to 82.5 million.

Perhaps the most telling numbers concern deposits. Consider that in 2008 employers put $107 billion into pension plans. That is $4 billion less than the $111 billion put into these plans in 1980 when adjusted for inflation. It is no wonder that the vast majority of American workers are worse off today and will be worse off in retirement than those in the generation before.

HOW MUCH DO THEY COST?

There is no way to know just how much of your 401(k) potential earnings are being siphoned off. The Securities and Exchange Commission issued a report in 2005 on conflicts of interest that put people into higher cost
plans or use undisclosed services that may cost more than they are worth. Four years later, the Government Accountability Office issued its own report warning that “conflicts of interest may be especially hidden,” and, in cautious bureaucratic terms, explained why you should care: “Because the risk of 401(k) investments is largely borne by the individual participant, such hidden conflicts can affect participants directly by lowering investment returns.”

Despite government awareness, the law continues to insulate companies from all but the most blatant and egregious abuses in 401(k) plans. The GAO did propose a solution that would be a good first step. It would require full disclosure of all fees charged to retirement savings accounts. Every vendor getting paid by the companies that act as trustees or record keepers would have to disclose who got paid what and why. That idea has kicked around Congress for years but has never become law.