Fixing the 401(k)

This is a guest post from Patrick Collins, CFP^®, EA. Patrick is a Principal of Greenspring Wealth Management, Inc. and heads the firm's Private Client Group.

 The fraud perpetrated on the investors in Bernie Madoff’s investment fund is mind boggling. How a scheme of this magnitude could go unnoticed after multiple SEC examinations and numerous whistleblowers is beyond me. Bernie Madoff operated as a Registered Investment Advisor (RIA) and therefore by law, was considered a fiduciary. I am concerned that this one instance of fraud could result in massive regulation on a segment of the industry that has historically contained some of the most responsible, ethical and knowledgeable firms in the country. The overwhelming majority of RIA firms embrace their fiduciary duty and this fraud could undermine where the real dilemma is occurring. FINRA, the governing body for brokers, is already posturing to gain power in light of this fraud.

National brokerage firms, sometimes called “Wirehouses”, have been "legally" skimming unnecessary fees from clients for decades. A quick review of four of the largest firms (Merrill Lynch, Smith Barney, Goldman Sachs and Morgan Stanley) shows they manage approximately $4.5 trillion in client assets. Add that to the approximate $3 trillion in 401(k) plans and you have $7.5 trillion managed by firms that have repeatedly shown they do not put their client’s interest first. They may not have stolen money like Madoff, but the amount of excess fees charged to clients is colossal.

On average, we have found that clients that come to us from these institutions are paying approximately 1 percent in unnecessary additional fees. These could be in the form of sales commissions, 12b-1 fees, trading commissions, bid-ask spreads, expense ratios and/or advisory fees. For most brokers that work at these institutions there is very little incentive (maybe even a disincentive) to lower client fees through prudent investment selection and management. Now, I have no hard data to prove the 1 percent in excess fees; just what I have observed having been on both sides of the table (a broker at a major wall street firm and an RIA). According to a study in the Journal of Pension Benefits in the Spring of 2008, the average expense ratio of an equity mutual fund is 1.62% and turnover costs run at 1.47% of fund assets. This means many investors are paying over 3 percent in investment related fees, the majority of which they don’t even see. Let’s have a little fun with the economics of it all:

$7.5 trillion X 1% excess fees = $75 billion in excess fees

Present Value of $75 billion in excess fees paid annually = $1 trillion

(assumes 30 year period with 6% discount rate)

So the $50 billion that Madoff bilked from investors, while staggering, is peanuts compared to the present value of what major financial services firms are legally ciphering from their clients in the form of excessive fees. Unfortunately, when a group of firms is receiving $75 billion a year in extra revenue, you can be pretty sure they aren’t going to be pushing for greater disclosure and regulation on their client transactions and business practices.

If regulators want to make a real dent in consumer protection they should make every financial professional adhere to a fiduciary standard, requiring client interests to be placed ahead of their own. While this won’t stop another Madoff situation, I would argue that criminals are always going to find a way to scam the system, so more (or different) regulation may not be effective. Effective regulation requiring fiduciary standards would stop the legal pillaging of client accounts which are costing investors billions of dollars every year.

While this is just one man's opinion, I'd be interested in hearing what you think. Please feel free to add your comments below.