How your 401(k) could rip you off

If you have a 401(k) plan, there's a pretty good chance that you're getting ripped off. At least, this is the opinion of Dan Solin, director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He argues that between high costs, poor investment choices and bad behavior on the part of plan managers, investors are better off taking the advice of Warren Buffett and simply investing in a low-cost index fund.

Solin's argument is built on an alchemical cocktail of experience and research, which has proven to be an exceptionally strong foundation. He has called attention to a paper called "Beyond Diversification: The Pervasive Problem of Excessive Fees and Dominated Funds in 401(k) Plans," written by Ian Ayres and Quinn Curtis, which "provided sobering advice for plan participants." The advice is basically this: If you're one of the 51 million Americans invested in a 401(k), you're probably getting the short end of the stick.

Here's why — many plan managers are either bad investors or bad actors (meaning they are not necessarily committing fraud but sometimes act in their own personal interest instead of in the interest of their clients). According to the study, 16% of 401(k) plans charged fees so high that they actually negated the entire tax advantage of the 401(k) plan for young investors. Moreover, the study found that 52% of plans were invested in "dominated funds," which Solin defines "either as funds that were more expensive than comparable funds in the plan, or funds that were unattractive options in which no prudent participant should invest."

Solin is not the only person who has argued that 401(k) plans can be a trap. The issue of excessive management fees has simmered since the dawn of money management, and it has recently come to a boil as alternatives to professional services – such as low-cost index funds – emerge. The conversation has come to revolve around this fairly fundamental choice. As a normal person looking to build a nest egg for retirement or a college education, what is the best way to put your money to work? Is it by employing savvy "active" money managers, or is it by utilizing a low-cost index fund?

Vanguard, which offers a popular low-cost S&P index fund, argues for the latter alongside Solin and others. Vanguard has conducted research on the performance of actively managed funds versus passively managed funds and versus the market as a whole, and found that active managers often don't earn their keep. In a January report, Vanguard found that a majority of active funds underperformed the average return of a low-cost fund for the 10-year period that ended December 2012. Vanguard's S&P index fund charges fees of 0.05% compared to an average expense ratio of 1.09% for similar funds.

So it's clear that management fees can be anathema to satisfactory investment returns. What's not as clear, though, is exactly where and why outsized management fees emerge. The paper by Ayres and Curtis suggests a medley of poor investment choices and dubious behavior on the behalf of some money managers, which are the subjects of a lawsuit that could help shed light on exactly this problem.

The lawsuit is Tibble v. Edison International, featuring a company that sponsors a 401(k) plan with approximately $3.8 billion in assets. The plaintiffs in the case were employees of Edison International and participants in the plan who argued that plan fiduciaries breached their duties under the Employee Retirement Income Security Act of 1974. Specifically, the argument with the most traction — the one recognized as legitimate by the court — is that plan fiduciaries breached their duty by investing in higher-cost retail shares of mutual funds instead of lower-cost institutional shares of those same funds. This decision effectively robbed plan participants of returns.

The case is particularly interesting because it may have piqued the interest of the U.S. Supreme Court.

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