Mutual Funds and 401 (k) Plans

Ann C. Logue | Jun 16, 2008 12:00am EDT | Comment

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Private-sector employee retirement plans are regulated by the Employee Retirement Income Security Act of 1974, also called ERISA. Because the Federal government will guarantee certain employee pension arrangements, it has an interest in ensuring that pensions are run properly. A key provision of ERISA is that the retirement plan sponsor, usually the employer, takes on fiduciary responsibility and must act in the best interests of the plan beneficiaries, even if that is at odds with the best interests of the employer. Companies, looking to get out from under some of the most onerous of regulations under ERISA and other laws, have pushed the onus for making investment choices onto employees through 401(k) plans. In most of these arrangements, employees contribute to their retirement plan using pretax dollars, choosing the investment options themselves. Employers often match all or part of the employee's contribution, but they are under no obligation to do so.

The employer is still responsible under ERISA for the plan's investment offerings, which are usually an array of mutual funds. The employer is also responsible for administering the program properly. Most do a fine job, some don't. The employee is responsible for choosing the best funds given their investment objectives, and most do a terrible job with that.

Some employees are responding by suing their employers. In February of this year, the U.S. Supreme Court ruled that employees had the right to sue employers under ERISA for alleged breaches of fiduciary responsibility. The case that the court heard involved an employee who had asked his employer to move the money in his account to different investment options. The employer never got around to making the switch, and the employee lost $150,000.

More recently, Wal-Mart (NYSE:WMT) has been sued by employees who argue that the company's 401(k) plan consists of funds that have high expense ratios and mediocre returns. In the old-fashioned, defined-benefit world, in which the company has an obligation to pay out a regular pension when the employee retires, companies have a huge interest in performance and fees because if they do not get an adequate investment return on the plan assets, then the company has to make up the payments from operating income. Companies are loath to do this, which is another reason why most have moved to 401(k) plans. However, it's unclear that the company gives up the need to concentrate on performance and fees.

Still, "just because you lose money in your 401(k) doesn't mean your employer is doing something wrong," says J. Michael Scarborough, president of Scarborough Capital Management and author of 401(k) Knowledge (The National Underwriter Company, 2008). In fact, he argues that a properly invested person will lose money some years, because most people should need exposure to stock funds in order to meet their retirement goals.

Scarborough works with individual investors who want help making the investment choices in their retirement plans. Most of the plans he sees are good ones, but the participants could be making better choices. What he doesn't like to see is company stock as an investment choice, because it limits the employee's diversification. "Employees will make the mistake of saying that they want to be loyal to the company" and place their contributions in company stock, Scarborough says, when the company doesn't care. He is somewhat more comfortable with company stock used as a match for employee contributions; if it is used, then employees should be able to sell or transfer it without limitation.

If an employee does see potential problems with a 401(k) plan, Scarborough says that the best option is to tell someone responsible for managing the plan. It may be a very simple matter for the company to add a low-cost index fund or other investment option, no lawsuit required.

The worst thing an employee can do, Scarborough says, is decline to participate in hopes that someone comes along to provide for retirement. Some people are counting on finding a spouse to do the savings for them, others are hoping that an inheritance will arrive right around their retirement age, and still others think that "someday," they will get such a big promotion that savings will become easy. "To make the assumption that someone, somewhere is going to provide is a crapshoot," he says. "Retirement does, in fact, happen for most of us." That's why the biggest reform that he would like to see in 401(k) plans is a provision for mandatory employee enrollment.