How Open Architecture Can Benefit You
By many measures, the 401(k) industry looks like a picture of success.
- According to a Financial Engines study, more than 50 millon Americans have 401(k) accounts.
- The balances of those accounts have reached over $4 trillion.
- 7 in 10 savers indicated a 401(k) was their main or only source of retirement savings.
But all is not well.
- The Financial Engines study revealed that 3 out of 4 participants weren't on track to reach their savings goals.
- AARP reports that most people are completely unaware of the mutual fund expenses and other hidden fees that are charged within their retirement plan.
- Charges in small to medium sized plans average 1.25%, but as reported by John Bogle and Stanford Professor Richard Sharpe, the all-in arithmetic of investment costs is much higher when transaction costs and market spreads, which detract from investor returns, are considered. These costs are significantly higher among actively managed mutual funds found on many 401(k) plan menus.
- According to Standard & Poors, in the three years ending 2013, between 75% and 87% of U.S. equity funds failed to beat their respective indexes and index funds -- the main type of fund in your plan.
Investors need help, but they've gotten a raw deal from the 401(k) industry.
The growth of retirement plan assets and the complications involved in record keeping and administering those plans led to a monopoly for name brand insurance, mutual fund and brokerage companies. These so called "bundled" plans combine plan administration, investment management (managing mutual funds) and investment advice (selection of funds on the plan menu), education and enrollment services. But significant problems with this model have emerged:
- Few employers and employees realize that such plans engage in "revenue sharing," -- the mutual funds pay the 401(k) provider and the advisors who select funds for the plan menu.
- Bundled plans often select in-house funds or select funds which pay generous revenue sharing to the broker ("advisor"); most participants think that funds are selected based on a combination of cost and quality.
- The types of funds favored by bundled plans are largely actively managed funds, the majority of which have higher expense ratios, higher turnover and transaction related fees, and tend to underperform indexes and index funds.
- "Advisors"(spelled with an "O") who work with bundled plans have titles like "financial consultant" but, as sales people who receive commissions and revenue sharing, they operate under a different legal standard called "suitability." Funds recommended must be suitable, but they don't need to be in plans' best interests, which opens the door to offering high cost funds.
Advice is important, but lacking
Investment Advisers (spelled with an "E"), like TWM, are registered with the SEC under the Investment Advisers Act and therefore have a fiduciary obligation to act in plans' best interests and recommend the best and lowest cost investments to the plan. When TWM signs on as adviser to your plan, we accept responsibility for acting in the plans' best interest, not our own.
The DOL regulates 401(k) plans and requires that anyone giving individualized financial advice (as opposed to general education) to the plan and participants operate as a fiduciary. Banks, brokers, insurance companies, and the sales people working as financial consultants at such firms, can't be fiduciaries and, therefore, they can't give true advice. And that might be the biggest problem of all, as evidenced by this huge investment Performance Gap:
- as reported by Dalbar, over the last twenty years, the average stock mutual fund investor earned just 5.19% vs. 9.85% for the S&P 500 Index,
- the average bond fund investor earned just .8% vs. 5.17% for the Barclay's Bond Index.
That performance gap has epic consequences for investors' retirement security. The reasons for it? High fund expenses, hidden trading-related costs, poorly performing actively managed funds and, last but maybe most important, lack of advice and behavioral coaching. Most small to medium sized plans are bundled plans. They're sold by industry players who have a vested interest in active management and trading. In subtle but critical ways, investment companies' plan communications train participants to do what they do -- think short-term, react to the latest news, and to select funds based on recent past performance. In other words, many 401(k) plans are structured to help participants fail.
There's a better way -- Open Architecture.
An open architecture plan separates each of the services provided to the plan: the custodian (Ascensus), the record keeper, the pension administrator, the investment managers for the funds, and the investment advisory firm, which selects the funds and provides advice, education and behavioral coaching. Each of these players -- the funds on the menu, the adviser -- can be changed without making wholesale changes to the plan. The competitive bidding process results in lower costs for the plan and participants.
This arrangement does away with revenue sharing and all fees are transparent. As an independent RIA firm, we charge an asset-based fee directly to the plan rather than take commissions offered by the mutual fund companies. This removes conflicts of interest and allows us to appropriately focus on the financial objectives of your plan when screening and monitoring investments. TWM is free to select from the universe of mutual funds based purely on quality and cost. TWM does the due-diligence work behind the scenes:
- Many of the funds on your menu are managed by Vanguard, which is a not-for-profit mutual fund manager and charges among the lowest fees in the industry.
- With an index-centric fund menu, the funds also minimize internal trading relating costs which would reduce your returns.
- Some funds on the menu are managed by DFA -- Dimensional Fund Advisers -- a firm that has made a science out of minimizing all-in fund costs. Note that DFA funds have been selected for less liquid asset classes where trading-related costs can be very high.
- The index funds provide dependable performance and consistent exposure to intended asset classes.
- Index funds are critical to use with asset allocation, a way of selecting an appropriate balance between risk and return. Investment planning for retirement goals is about trying to reduce the range of potential outcomes in a plan. Actively managed funds add additional variables which increase the range of potential risk and return.
Perhaps most importantly, we can provide professional investment and retirement planning advice to participants. How important is that?
- According to the 2012 Hewitt study, the annual performance gap between participants receiving and not receiving help was 3.32%, net of fees. For a 45-year old it could translate to 79% more wealth at age 65.
- Participants not receiving help had much higher variation in risk. 60% of participants not receiving help had inappropriate risk levels in their investments, with about two-thirds taking on too much risk and one-third taking too little risk, jeopardizing their ability to accumulate sufficient retirement wealth.
- Only 11% of participants receiving advice had inappropriate risk levels.
- You can read the Hewitt study here.