By John Wasik
Published on Jan 25, 2016 on Forbes
Some mutual funds within 401(k)s are just toxic. They eat up your nest egg through poor performance and high fees. You need to identify them and dump them.
So-called “proprietary” funds are among the worst of the worst. Typically they are offered by the fund companies running your 401(k) or are offered by financial services firms. They are also known as “in-house’ funds sold by your employer.
The least-obvious reason why these funds are stinkers are because they are layering on fees that are cloaked in “expense ratios.” In addition to management fees, they may charge commissions or marketing expenses such as 12(b)1s.
According to a recent survey by Brightscope and the Investment Company Institute (ICI), nearly 70% of 401(k)s surveyed have proprietary funds. Not all of them are bad, but they may be overpriced and pose a conflict of interest.
Your employer is legally charged with finding the most diverse, least-costly funds available. If they hire a financial services firm that loads up your plan with their funds, that may not be in your best interest.
Even if you tell your employer that you want proprietary funds removed, in only 14% of the plans surveyed was it indicated that the funds in question were culled.
Why? Because big financial services companies want to make money from charging exorbitant management and administrative expenses, so they keep their funds in your plan. The more assets under management, the more money they make since their take is based on a percentage, not a flat fee. This is perhaps the biggest reason why 401(k)s are bad deals for most people. The system is rigged to siphon off your money.
Yet with a recent wave of lawsuits by employees against their employers, one would hope that the practice of adding proprietary funds would be abating. JP Morgan Chase, for example, paid $307 million to the SEC for not disclosing conflicts with their proprietary funds. The bank said the non-disclosure was “not intentional.”
Still, the problem remains because most employees have no idea how proprietary funds come up short.
What do you replace toxic 401(k) funds with? The answer is simple: Have your employer replace them with exchange-traded or mutual index funds. Their costs are 10 times less and offer you diversification in a passive basket. That means you don’t have some manager guessing badly — and costing you money — as they mis-time the market.
You can also ask for funds with “institutional” expense ratios or managed accounts. Whatever you do, don’t accept funds that have “retail” expense ratios. You should be getting a much lower price.
Remember that any additional fee that’s passed onto you is money out of your retirement kitty. Most of these fees are unnecessary, so demand that they be dropped.
Also ask for an independent fiduciary audit. This is run by a consultant with no financial stake in the funds added to the plan. They can recommend funds with low expenses and sound management — funds run in your best interest and not that of a financial services goliath.