Of course this was also 1999, when the stock market was soaring beyond any values justified by profits, as investors would learn the following April when the Internet bubble collapsed and $7 trillion of paper wealth was lost to those who had not yet cashed out. More important, however, the law makes no distinction between charging excess fees to rich plans or poor ones. Norman Stein, a law professor who specializes in pension issues, explained, “the statute says you can’t violate your duty and charge excessive fees, not that you can charge excessive fees if a pension plan is overfunded.”
Alan Lebowitz, a senior Labor Department pension official, observed that cases like that at New York Life “were inevitable because the statute creates this situation where you can be” an official of both an investment company and its pension plan. “The individual who is both a plan fiduciary and a company official is in a very difficult situation because you clearly owe an obligation to both the plan participants and to the shareholders.”
More than eight years later, New York Life paid $14.7 million to settle the overcharging case. The company did not admit to wrongdoing (firms almost never do). But the Mehling case illustrates one reason that many millions of Americans are heading toward old age without enough resources to live out their last years well or even decently.
Mehling’s essential revelation was simple: there is no way for any of the 61 million Americans with money in 401(k) plans to know whether those permitted to shave slices of money from their accounts are taking more than the market rate. Indeed, there is no way to know the name of every company taking some of your money or just what they are doing for their fees.
Senators and representatives have known about this for years. Congress has been told repeatedly about numerous weaknesses in the 401(k) system by its own investigative agency, the Government Accountability Office. Academic researchers, journalists, whistle-blowers and even some industry leaders like Mehling have exposed clear and present financial dangers. The poachers include bosses who steal from their workers by never passing on 401(k) money from paychecks to be invested. Some workers are forced to invest in their own employers but given no voice in how their shares are voted. Most of all, far too little money flows into 401(k) accounts, especially for workers not in the top tiers of pay.
Yet little or nothing has been done to correct abuses and protect workers, whose voices are heard far less often than those of big campaign donors and the lobbyists they employ. The result is practices that enrich some corporations not from market capitalism but market manipulation, ensuring the haves have more at the expense of those with less.
AN ACCIDENTAL SYSTEM
The problem began at the very birth of the 401(k). Starting as a favor to one industry, it grew into a system, one that carries a burden, as a cornerstone of American retirement, it was never designed to carry.
The 401(k) is really one huge tax loophole. Tax loopholes are not intended policy, but often are the unintended result of laws that do not match up, leaving some income untaxed. Loopholes can be pure accidents; sometimes clever tax lawyers spot an opening and leap through it. Other loopholes are the product of lobbyists shaping legislation and of gullible politicians, too eager to please donors and prospective employers.
The 401(k) was created at the behest of bank holding companies so that their better-paid workers could stash away some extra pay without paying taxes until they retired. Back then the top tax rate was 70 percent, so in retirement all but the most senior executives could anticipate paying much lower rates. But when a Pennsylvania compensation consultant named Ted Benna read the law more than three decades ago, he recognized something much larger. In classic entrepreneurial fashion, Benna set out with no capital to build a business for himself; by his reading of the law—and it is a correct one—not just banks but most any business could create 401(k) plans. Benna promoted the widespread use of such plans, which quickly caught the attention of people with capital, like the Ned Johnson family of Boston, who own Fidelity; the Stowers family of Kansas City, who own Century Investments; and other mutual funds. They got in on the deal and made billions, although Benna never made it beyond being a tiny player, barely compensated for his rich insight.
The annual taxes avoided because of 401(k) plans come to about $110 billion, according to Teresa Ghilarducci, a pension economist who teaches at The New School in New York. To put that number in perspective, had the IRS collected another $110 billion in 2009, total income tax revenue would have gone up by close to 13 percent.
For those who can afford to save, the plans are a happy accident. Named after a section of federal tax code numbered (you guessed it) 401(k), workers can set aside money from their pretax pay. Employers with such plans have the option to add money, matching some or all of what the workers save.
As enhancements on top of Social Security and traditional pensions, 401(k) plans are a good idea because they encourage additional savings. Viewed as a kind of financial dessert, like meringue, the 401(k) makes sense.
But instead of being dessert, this financial meringue has come to be served most often as the main course, one that is no more healthy financially than pie topping is dietetically.
Mutual funds and other promoters of 401(k) plans sold them in the eighties and nineties as a way to riches, with charts showing young people how they could retire as millionaires. But it hasn’t worked out that way. Jack VanDerhei, research director for the Employee Benefits Research Institute, a straight-shooting nonprofit that gathers data, observed that “far too many people had false confidence in the past” that modest savings would make them flush in old age. “People’s expectations need to come closer to reality so they will save more and delay retirement until it is financially feasible,” VanDerhei said.
The rise of 401(k) plans illustrates how America is not prospering because its economic policies violate well-established principles. The typical 401(k) involves excess costs, added risks and inefficiencies that have become embedded in the law. Because of the concentrated interest of a narrow segment of the economy, people are certainly getting rich off the plans, but most of them aren’t the supposed beneficiaries. What we’ve seen is the financial equivalent of mechanics throwing sand in the gears of machinery they do not own. It gets them work, but not work that adds value.
Corporate executives know full well that these plans are seriously flawed. CFO, a magazine for chief financial officers, told its readers in 2009, “True, 401(k)s have not proved to be the perfect substitute for pension plans. Workers tend not to use them to full advantage, and employers don’t always follow best practices in designing them.”
That’s an understatement.
SLICING AND DICING
In all, 401(k) plans held about $2.2 trillion in 2010. After adding in the holdings of similar plans called 457s for government workers and 403(b) plans for nonprofit workers, the total comes to an estimated $4.5 trillion, according to the Investment Company Institute, a trade association.
Money in the trillions—that is, millions of millions—is almost incomprehensible. But divide the 401(k) pool by the 61 million people involved and you get an average of $33,375 in each account. Looking at just the 52 million workers who can add money to their plans (the others have moved on or retired), we find they did not put all that much into their accounts. Counting both worker savings and any match money from their employers, the average participant saved $4,061 in 2009, the latest year for which Labor Department data is available.
Some dollars have disappeared, as Jim Mehling warned us, due to excessive charges for record keeping, trusteeship, compliance, promotion and investment management. According to its own data, industry fees are at least a half of a percentage point per year higher than a competitive market would charge.
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 f
ind 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 Fine Print: How Big Companies Use Plain English to Rob You Blind Page 24