Playing favorites and making quid pro quo deals have been longstanding practices in the financial services industry, and the 401(k) marketplace is not immune to its ill effects. As such, federal regulators have joined their state counterparts in examining the opaque nature of 401(k) fees and related revenue-sharing arrangements.

Most Americans have a good portion of their retirement savings in deferred contribution vehicles such as 401(k) plans offered by their employers, but there is growing concern about the lack of information plan participants are receiving about the performance and fees associated with their portfolios. Many employees have no idea what they're paying for in these plans and what they're getting in return outside of the bi-monthly deduction from their paycheck.

To boot, some employers are just as in the dark when it comes to asking the right questions and choosing investment options. That creates a problem because mutual fund shares offered in company retirement plans carry higher fees than other fund shares that employees can purchase directly. Despite what may be legitimate costs of running the plan, those fees can eat away at plan participants' returns.

As part of a larger effort to shake down the mutual fund industry and curtail abuse, the Securities and Exchange Commission recently sent a letter of inquiry to more than 20 of the biggest mutual fund complexes regarding payments made to 401(k) plan sponsors to feature their funds among its investment options.

The Commission's list of questions included: What is this money for? Do these payments lead plans to favor some funds over others that might have stronger track records and lower expenses? The purpose of the agency's broad sweep of all the large players is to determine whether these payments skew the fund selection process and create inappropriate choices for investors.

A spokeswoman for Fidelity Investments confirmed that the firm received the letter and said, "We intend to answer the questions in this request." One firm, Morgan Stanley, is being formally investigated for the fees it charges on some index funds, according to an SEC filing. The probe into index fund pricing is part of the SEC's inquiries into fee and revenue sharing, Morgan Stanley said in the filing.

"The fees and revenue-sharing arrangements are disclosed in a very minor way, if they're disclosed at all," said Jeff Robertson, an employee benefits attorney with law firm Bullivant Houser Bailey. Robertson is in favor of abolishing the practice, arguing that it would be "a monumental, comprehensive shift that could have some excellent ramifications for participants."

The SEC has jurisdiction over mutual funds and is looking at the fund companies' practices with respect to 401(k) plans that invest in them. But the U.S. Labor Department has jurisdiction over 401(k) plans; any 401(k) reforms would have to cross its desk. Its Employee Benefits Security Administration (EBSA) arm is investigating collective funds and 401(k) plans covering the employees of several mutual fund companies to make sure they are complying with the Employee Retirement Income Security Act (ERISA).

Ann Combs, assistant secretary of the EBSA, said her staff is "looking at a number of issues, including whether fiduciaries are accepting improper payments for directing investments; whether fiduciaries have used plan accounts to facilitate late trading/market timing of other clients; and whether plans have incurred losses as a result of fiduciaries knowingly directing investments to mutual funds or pooled accounts, which permitted late trading or market timing."

"These financial arrangements have not been adequately disclosed, are substantial and frequently result in the best low-cost managers not being selected for plans," said Edward Siedle, a former SEC attorney and president of Benchmark Financial Services, a firm specializing in investigations of money management abuses. "The problem in the 401(k) context is particularly exacerbated because you have uninformed plan sponsors selecting investment options for the participants, which are generally not the best investment alternatives available."

Siedle noted that if you scroll through a list of 401(k) offerings, very rarely will you see low-cost funds such as Vanguard, but rather the big broker-sold funds. "The vast majority of the marketplace belongs to the high-cost, poor-performing funds, [while] the market penetration of the low-cost, well-performing funds is dismal nationwide. They don't have enough grease in their fee structure. It's a national tragedy," he said.

Jeff Keil, vice president of Global Fiduciary Review at Lipper, argues that it's not all that different from mutual funds paying brokers for shelf space. "The only piece of the puzzle that makes it more concerning is that in a 401(k) plan, you have a captive investor with very limited choices, whereas in the shelf-space example, you've got perhaps a bunch of different choices. It elevates the bias bar, makes it tougher to make a choice," he said.

Still, Keil is not in favor of abolishing the practice. Rather, he believes that the point of sale disclosure rule proposed by the SEC would be a step in the right direction. "They can extrapolate that concept to 401(k) providers and sponsors to where they really know that there is some extra cash flowing at the table, which is incentivizing providers to choose certain funds over other funds."

David Wray, president of the Profit Sharing/401(k) Council of America and chairman of the Labor Department's ERISA advisory council, defended the fee structure of 401(k) plans, saying that if the fees were excessive, then people would be clamoring to get into the marketplace. He noted that 20% of 401(k) providers exited the business last year. "The issue is complicated, and it leads to people who don't understand it to be concerned," he said.

Wray compared a 401(k) to a car in that it has many different parts manufactured in different places and is put together in a plant. "You don't ask the car manufacturer, How much did you pay Firestone for the tires?'" Essentially, he was illustrating that plan sponsors should be looking at whether they're getting a quality product for a reasonable price and not pricing all the bits and pieces. Given that revenue sharing is such a integral part of fund distribution, it is not likely to go away overnight. "[However,] a few pieces of litigation would set the whole scenario straight very, very quickly," Keil said.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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