Three consecutive quarters of losses have many people frowning when they review their 401(k) statements. But they’d be fighting mad if they saw the fees they’re paying to brokers and administrators who manage their 401(k) money. Daniel Solin latest book, “The Smartest 401(k) Book You’ll Ever Read” states that ”…excessive 401(k) fees will cost you as much as 20 percent of your retirement assets [p.56]”. Solin go on to say, “…you can’t get outraged about price if you don’t know what you’re paying [p.56], and “[T]he retirement dreams of millions of Americans are being jeopardized because few people are gong to complain about something they can’t see and don’t understand [p.57]”. The sad truth is that employers have paid little attention to the fees built into 401(k) plans because they don’t pay them: you do.

Likewise, the watchdogs of the securities industries (most pension plan assets are invested in mutual funds), the U.S. Securities and Exchange Commission and FINRA (Financial Industry Regulatory Authority), are more concerned with the health of the mutual fund companies and their brokers than they are with your financial well-being. Luckily, the Department of Labor and the courts has taken an interest in the abuses running amok in the pension plan business.

On February 20, 2008, the U.S. Supreme Court rules unanmously that individual 401(k) plan participants have a right to recover losses if their employer fails to uphold their fiduciary obligations. This landmark decision means that 50 million Americans now putting their retirement money into 401k plans sponsored by their employers have a right to recover their losses if those responsible for administering the plans don’t fulfill what’s considered their obligation to manage their plans wisely. No doubt the legal community will take this Supreme Court decision as a lifting of the lid on Pandora’s Box to go after employers, mutual fund companies, third party administrators, brokers and others that are enriching themselves at the expense of working Americans. In fact, this trend has already started as you can see by doing a search titled “401(k) Class Action Lawsuits”.

The Labor Department is proposing a rule that would require employers to disclose to workers the fees and expenses charged by mutual funds and other investments in a chart or similar format. Obviously the DOL thinks that the transparency of fees and charges are obscure or they would not be usurping the power of the securities industry regulators by taking the initiative to police 401(k) investment disclosures. How do you find out what type of fees you’re paying in your employer’s plan? For starters, you’ll not find them on your quarterly statement. Generally you can find them on the web site for the mutual fund in which you’ve invested. Look under Fund Facts. Also, if you would have read the prospectus of the mutual fund you purchased, you could have found the fees if you were willing to devote substantial time and effort looking.

The prospectus is a very long, legally-written and hopelessly complicated document supplied by the mutual fund company, and blessed by the SEC, which is totally incomprehensible by the average person. This gobbledegook’s real purpose is to provide a legal shield for the players who recommend, select and manage the mutual funds that are options in your 401(k) plan. The asset management fees and the administration fees are totally intertwined and the average worker will never be able to uncover the true cost. But, rest assured that in most cases the fees for the broker, administrator, investment company and everyone else who collect fees from your 401(k) comes out of your earnings. And, if you don’t have earnings — which as been the case lately — they come out of the hard-earned money you contribute monthly for your golden years.

Is there any way to lower your fees? Not really, you see your employer, or a committee set up by your employer, selects the investment options available in your plan. Suffice it to say, there is little thought that goes into such selection because your employer is indifferent since you pay the fees and your co-workers who participate in this democratic process are generally unqualified. Of course, the broker is there to make sure the correct options are chosen. You should know that the broker has a vested interest in having high fees because they determine his/her commissions.

So, what can you do? You can demand that low-load or index-linked or exchange-traded mutual funds are included in your plan. Ironically, not only are the fees lower on these fund selections but the performance is generally superior to those chosen by the high-fee, hyperactive managed dogs recommended by your broker. You can insist that your employer put an in-service, non-hardship withdrawal provision in your plan which allows you to take out of the plan the vested money your employer has contributed at an age below 59-1/2. Also, this non-hardship provision will allow you to take the money you’ve contributed at age 59-1/2 without penalty and without triggering taxes if done correctly. Sadly, your employer is generally not aware of such provisions and you can bet your last dollar that the broker or administrator are not going to break their silence. Here’s some reading material for you:

1. “The Smartest 401(k) Book You’ll Ever Read” by Daniel Solin.
2. “The Hidden Escape Hatch in 401(k) Plans” by Shelby Smith & Whet Smith.
3. “Plan Would Make Tending to Your 401(k) Easier” by Christopher S. Rugaber, Associated Press, July 28, 2008. Check out the following web sites:

• http://www.401khelpcenter.com/401k/meigs_classaction_summary_062005.html
• http://www.allbusiness.com/legal/legal-services-litigation/5359471-1.html
• http://www.401khelpcenter.com/cw/cw_planfees.html

Do you think income taxes are going up or down in the next couple of years?  Judging from current presidential campaign rhetoric and the 2010 expiration of the tax reductions enacted between 2001 and 2005, taxes are undoubtedly headed higher.  In this retirement blog I mentioned that unless Congress acts the Roth IRA roll-over income rule will be relaxed in 2010 so that high income individuals can qualify.  Expected tax hikes, and the more liberal Roth IRA rule, means you should pay attention to your 401k [other qualified pension plans may also offer the same opportunities].  Let’s see how.

Let me introduce you to Leon, age 58.  Leon is his family’s primary bread winner and very concerned about where his retirement money is invested.  He learned a valuable lesson from the dot.com meltdown in 2000-2002 because a sizable portion of his family’s savings and 401k assets were lost.  It has taken the past six years to recovery from these losses and he’s especially concerned about what might happen in the current uncertain economic times.  He views the credit-energy-dollar problems as alarming and wants to move his 401k money out of harms way because he doesn’t have time to wait for a market recovery.  Also, he expects income taxes to rise and would like to use this to his advantage.  What can he do?

Leon’s employer has modified the company’s 401k plan to allow for in-service, non-hardship withdrawals.  This is a simply procedure implemented by the administrator that will allow Leon, and other employees, to take their employer’s contributions, and associated earnings, out of the company’s 401k plan and put them in an IRA.  Additionally, Leon and several of other employees in rolled over other qualified money into the employer’s 401k plan when they joined the company and these can also be moved to an IRA.  There will be no tax due or withheld from the rollover to an IRA if they do a direct trustee-to-trustee transfer.  Also, the 401k Plan, as modified, allows the employees to continue participating in the company’s 401k.  What are the advantages to Leon?

Several of Leon’s co-workers are moving to an IRA but a few have selected the Roth IRA.  Leon would like to put his 401k money in a Roth IRA but he makes more than $100,000 annually and this disqualifies him; however, in 2010 when this restriction is temporarily removed he will be able to roll his IRA into a Roth IRA without penalty.  If taxes go up as he expects at the end of 2010, he’ll pay the Roth IRA conversion taxes at the lower rate.  He’ll get an additional break because only one-half the associated income taxes are due in 2011 with the remainder paid in 2012.  Since he’ll have to leave the money in the Roth for five years following the conversion to avoid withdrawal penalties, he has decided to put the money in a seven-year bonus index-linked annuity.  There are two reasons for his selection.

First, he has moved his retirement money out of the way of another market meltdown and gotten a bonus to boot. Granted, the market may do fine but Leon can’t afford to take the risk that the market involves.  In seven years he plans to review his, and the economy’s, financial position and re-invest the money.  Unless things change, he’ll consider a bonus index-annuity at that time because the bonus will be tax free and he’ll be immune to market gyrations.  Second, he has “locked in” the gain from his 401k because he has no downside exposure if he holds the annuity until maturity.  The added advantage is that the Roth IRA grows tax-free and has zero tax liability, plus Roth income will not increase the taxes on his Social Security.  His Roth money can be used at any time after the fifth year following roll over.  If not used during his or his spouse’s lifetime, it can be passed forward tax-free to this children and grandchildren at his death.  The payments of principal and earnings taken during their lifetime will also be tax free.

At age 59½ Leon intends to take his employee contributions and earnings out of the 401k since the in-service, non-hardship provisions, and the IRS, allows him to do so without penalty and also continue participating in the company’s 401k.  He’ll decide at that time where he wants to put it and also whether or not another Roth IRA is suitable.  He can then be totally insulated from market losses that could easily ruin his retirement plans.

Leon, like a lot of 401k participants, is in the “red zone” (search the phrase red zone on top section of this retirement blog for a few related articles) right before retirement and as a practical matter cannot afford to suffer market losses.  Many small business people and professionals (doctors, lawyers, executives, etc.) are in the same position.  The investment selections inside their employer’s plan do not provide them the flexibility, selection or protection they need during this phase of their working years; thus, they opted to take control of their investments outside of an employer’s plan.  Additionally, they’re prepared to take advantage of the upcoming temporary changes in the Roth IRA qualifications and can pay all associated taxes before they increase.  Index-linked annuities are the perfect vehicle for the journey to this tax haven.  If you’re in a similar position, ask your employer about an in-service, non-hardship withdrawal from your 401k and then contact your financial advisor.

Shelby J. Smith, Ph.D.