There are three platforms for the defined contribution plan:

 

An annuity is a tax-advantaged vehicle that is of value because it offers:

Without these three important guarantees, of what value would it be to purchase an annuity? None. These guarantees may be expensive. But, are usually worth it.  Unfortunately, the majority of retirement plans, and the largest dollar amounts are controlled by the wrap annuity programs; usually sponsored by Principal, Hancock, Prudential, etc.  But none of these offer any of the three guarantees in the 401(k).

 

Some may argue that it is redundant to have a tax-advantaged investment inside a tax-advantaged vehicle. That is not truly nor necessarily the case, and is a subject for a different discussion. One of the most disgusting things about these plans is the fee structure.

 

Fees for all or any 401(k) include:

These are borne by the participant, or the plan sponsor on rare occasions.

 

Many of the above are hidden or wrapped inside the plan, except for the open architecture platform where they are transparent and on the lower end of the scale.

 

In addition, there are the investment vehicle fees such as the Net Expense Ratios of the mutual funds; this averages 1.85 percent, according to Morningstar, for actively managed funds. And, especially in the case of an actively managed fund, there are the additional expenses associated with portfolio turnover. Average turnover is 115 percent. This incurs a bid-ask spread cost* (which is hidden in the net asset value, but nevertheless is a cost borne by the participant), irrespective of the participants’ additional actions, and a transaction cost.  The bid-ask spread varies by asset category (higher in the thinly traded securities, lower in the largest

 

capitalized and most liquid securities such as the S&P 500 shares); and the transaction costs of the broker who make the trade—combined the turnover average cost of each mutual fund can add up to an additional 2.15 percent.  

 

Of course many of the non-open architecture platforms own their brokerage or have a “business” relationship with a brokerage for the transactions, thus generating more income for themselves, at the participants’ expense.

 

But the wrap annuity plans function in an even more egregious fashion. The participant does not invest directly in the mutual fund. No. The investment is in a “separate account” of the wrap annuity (remember, without the guarantees that make an annuity attractive) that mimics the underlying mutual fund.  Sometimes, though, there is no mimic at all. 

 

In fact, many plan prospectus materials state clearly – in the footnotes (in 6 point type) – that the separate accounts may not have similar investments, similar managers, or even similar performance characteristics, despite similar names (such as “XYZ Such-a-fund II, NSG” which behaves not at all like the “XYZ Such-a-fund”, does not share the same manager, nor the same investments).  

 

To make matters worse, when you look at the carriers’ Web sites to determine the returns, and compare these with the underlying mutual fund it is said to mimic (but too often does not even do that), there is usually a 2.00+ percent deficiency of performance. This is a direct cost to the participant in everything but the name. True some of these costs reflect custodial, record keeping and advisory fees.  But, still….and usually, the sponsor pays an additional annual fee to the carrier on top of all those usually in the 0.5 percent range;  presumably to cover the record keeping and custodial costs.

 

So the participant in a wrap annuity defined contribution, 401(k) plan incurs at least 4 percent, and sometimes, in excess of 6 percent in hidden costs/fees –every year.  An open architecture or brokerage house platform fees are on the order 2-4 percent.  A structured fund or an index fund or an indexed ETF that follow the broad and liquid indices keep the total costs down to the under 1.5 – 2 percent level.

 

 

*Bid-ask spread can best be explained by analogy.  Imagine purchasing a new car for $10. The minute you drive it home, you realize you must sell it back to the dealer. The dealer offers you now only $8. That $2 difference is the bid-ask spread. Then the dealer sells the very same car to the next buyer for $9. That $1 difference is the bid-ask spread.  Again.  The dealer makes money whether you buy or trade in a car. The broker makes money whether you buy or sell a stock. Just like a casino makes money when you gamble; it matters not whether you win or lose. In the long run, the house always wins. The bid-ask spread for large cap stocks is minimal; the smaller and more thinly traded issues have an exponentially higher bid-ask spread (sometimes as high as 8-20 percent in Emerging Market Micro-caps). High turnover of a mutual fund stock portfolio incurs these costs at an alarming rate.