The Conflicts of Interest Around 401(k)s

401k

A new study in the Journal of Finance has found that conflicts of interest in 401(k) plans can lead to serious losses for individual investors. More specifically, the 2,500 funds surveyed were less likely to eliminate underperforming funds that were their own rather than another provider’s fund. This can be very costly to retirement savers. Clemens Sialm, a professor of finance at the University of Texas at Austin and one of the study’s authors, explained that the bottom 10% of funds continued to underperform by about 4% if kept on the menu of funds available to investors.

With all of the attention lately focused on reducing these conflicts of interest where financial managers invest your money in their own funds (among individual financial advisors rather than institutional), it is surprising to see the bias getting coverage on an institutional level. As of June 2015, $4.7 trillion were invested in 401(k) accounts, plus another $2.1 trillion in non-401(k) defined-contribution plans. As John Oliver recently detailed, these conflicts of interest can cost millions over the course of a single retirement plan’s life. (For related reading, see: Financial Failings of NBA Legend Antoine Walker.)

Why the Conflicts Exist

The reason for the existence of these conflicts of interest is simple. Managers are prioritizing the profits of their institution over the success of the retirement plans they oversee. And there is no question that it is a raw deal for the investor. We’ve previously covered how many actively managed funds don’t even beat the market in the first place, and this study confirms that failing funds aren’t even taken off the menu of options. Imagine if your local restaurant kept undercooking their chicken and everyone was getting sick, but they refused to change the recipe.
Many employees at big asset management firms are now suing their own companies to liberate their own retirement plans from management. These people know it’s a scam, and God forbid that their own money gets caught up in it, but by and large they are OK with selling you inefficient funds. (For related reading, see: 6 Questions to Ask a Financial Advisor and Do You Need to Change Your Financial Advisor?)

These current events—and the study—indicate that conflicts of interest are pervasive in all aspects of the retirement planning industry, whether it’s a 401(k) through your employer or via traditional financial advisors. Dealing with this reality requires vigilance on your part. To return to the analogy of the undercooked chicken, it would be an easy case to deal with since everyone could tell that the chicken was making them sick. But what allows traditional asset companies to get away with conflicts of interest is that many people are simply too busy to monitor their accounts—that is, to find out if they are sick or not. If the undercooked chicken gave you an illness that was hard to detect, it would be much easier for the restaurant to get away with it.

Luckily, the tide is beginning to turn, and you can impact change, even with your 401(k). You should become an advocate for your own money. Contact your HR department and ask to see the performance of the menu of funds. See who’s managing it, how the menu has changed and evaluate the extent of conflicts of interest.

Ultimately, independent, conflict-free advice and management is the best cure for the industry’s problem. (For related reading, see: Why Investors Can Be Their Own Worst Enemy.)

This article was originally published on Investopedia.com

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The views expressed in this blog post are as of the date of the posting, and are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Sherman Wealth unless a client service agreement is in place.
If you have any questions regarding this Blog Post, please Contact Us.

Do You Need to Change Your Financial Advisor?

Financial Advisor

In his song “Real Friends” musician Kanye West raps, “Real friends. It’s not many of us. We smile at each other. But how many honest? Trust issues.” West wonders whether those around him are there because they really have his best interests at heart, or if they only care about him for his money.

Given recent developments in the financial advisory industry, many Millennials might be wondering the same thing about their financial advisor. The Department of Labor (DOL) will soon be enacting a new rule that requires all financial advisors handling a retirement account to abide by a fiduciary standard, which means always acting in the best interests of the client and not the advisor’s or corporation’s profits. It might be surprising, but that is currently not always the case. If your advisor is not a fiduciary, he or she may not be obligated to act only in your best interest. You can read more about the new rule and our take on the fiduciary obligation here.

Opponents of the rule, unsurprisingly the financial services industry’s lobbyists, who largely oppose the rule, point to a study saying that it will decrease access to financial advice for small investors since advisors “cannot figure out how to make money when working with them.” Without the fiduciary obligation, how do advisors currently profit from younger investors? Forbes recently published an article by the Morgan Stanley team where advisor T. Gregory Naples says that with Millennial clients he,

“starts them out in managed mutual funds until they reach $50,000. After that, he often switches them to more transparent and lower-cost stock and bond funds managed by institutional money managers.”

Breaking it Down

This is a huge admission. Let’s break down exactly what Naples is saying. Crucially, Naples admits that, until you hit $50,000 assets under management (AUM), he invests your money in more expensive, less efficient funds. Many of these “actively managed” funds, which try to beat the market’s returns, have higher costs because of labor and number of trades they execute. After this period, once your AUM gets to a point where Naples can more easily make money off of you through fees, he puts your money into more efficient places it should have been all along.

Later on, he mentions examples illustrating the power of compound interest, but neglects to mention that the unnecessary fees you are incurring from the inefficient funds he has invested your money into will eat away at the returns you get from the compound interest. This illustrates the folly of the argument that the fiduciary rule will drive young investors away. Young investors who are just starting out are, in fact, much better off being driven away from advisors with non-fiduciary practices like Naples. Entrusting your money to a non-fiduciary, traditional financial advisor as a young, new investor is like intentionally hitchhiking on a road known for having murderous truck drivers when there’s a much safer road nearby. (Read more about 6 Questions to Ask A Financial Advisor)

People naturally gravitate towards big firms with name recognition. But as the Naples quote demonstrates, these large, non-fiduciary firms may not always be the best option, particularly for young investors. What the back-and-forth over the DOL rule reveals is that non-fiduciary advisors often don’t even really want your money. Most seek accounts with higher balances. So why go where your money is not wanted?

 

This article was originally published on Investopedia.com

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The views expressed in this blog post are as of the date of the posting, and are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Sherman Wealth unless a client service agreement is in place.
If you have any questions regarding this Blog Post, please Contact Us.