Mark Brandon is the Managing Partner of First Sustainable (http://www.firstsustainable.com), a registered investment advisory catering to socially responsible investors. In addition to Socially Responsible Investing (SRI), he may opine on social venturing, microfinance, community investing, clean technology commercialization, sustainability public policy, green products, and, on occasion, University of Texas Longhorn sports.

Thursday, October 05, 2006

Blue Chip Companies Face Class Action Over 401(k) Fees

St. Louis law firm Schlichter Bogard & Denton has filed a class action suit against US Blue Chip companies Lockheed Martin (NYSE: LMT), General Dynamics (NYSE: GD), United Technologies (NYSE: UTX), Bechtel Group (private), Caterpillar (NYSE: CAT), Exelon Corp. (NYSE: EXC), and International Paper Co. (NYSE: IP) over excessive fees in their 401(k) plans. Each defendant has either denied wrongdoing or refused to comment thus far, so let's examine some evidence against them.

At issue is the companies' fiduciary obligation to ensure adequate supervision over fees under the Employee Retirement Income Security Act (ERISA) of 1974, which sets forth standards for qualified plans. Put simply, companies that sponsor these plans have an obligation to make sure that their plans are being managed -- this is crucial -- in the best interests of employees.

Why choose these companies as the first defendants? I'm speculating, but I would think it is because these are old line companies that happen to have both old-line pension plans and 401(k) plans at the same time. With pension plans (defined benefit), a company has to make up any shortfall from promised benefits. With 401(k) plans (defined contribution), the employee bears all risk. Therefore, by comparing the company's pension management with it's 401(k) management, malfeasance (or at least negligence) can be shown.

Financial people have known about this negligence for years, and I am glad someone is shining a light on this cesspool of corruption. Management and the fund complexes have been conspiring at the expense of employees for years. First, some background.

A mutual fund is supposed to enable small investors to have sufficient scale to afford professional management and lower expenses. As assets increase, scale increases, so a fund's expense ratio should go down. Over 25 years, assets in mutual funds have increased from a few billion to over 8 trillion in assets, thanks in large part to the increasing popularity of 401(k) plans. Roughly half of all mutual fund assets are held in defined contribution plans. With that kind of spectacular growth, one would expect expense ratios to fall. Instead, they have actually inched up. The average actively managed mutual fund in a 401(k) plan has an unconscionable 1.57 percent in fees. Companies such as Vanguard, whose funds are still truly mutual, are owned by their shareholders. Their funds have expense ratios which are roughly half of their brethren that are managed by mutual fund complexes. Think about that. Eighty basis points on $4 trillion dollars amounts to a $24 billion dollar skimming operation perpetuated annually by fund management complexes.

However, they could not accomplish this travesty without willing accomplices in senior management at large companies. How? The first way is by performing myriad services, such as compliance testing and administration, for free. By doing so, the company gets an earnings boost by not paying out of pocket for these services, in exchange for a larger management fee, which is almost invisible to employees and certainly does not count against earnings. The value of the extra percentage, however, far surpasses the value of these free services. The second, more sinister, collusion involves the implicit suggestion that fund managers, who collectively own a mammoth portion of corporate America, will not rock the boat on corporate governance and executive compensation issues. Company management gets free reign to loot the corporate till, while the fund complexes are free to fleece the employee retirement plans.

The cost to employees can not be overstated. That eighty basis points does not sound like much, but over a 30 year horizon, it could literally mean that the retiring employee's nest egg is 1/3 to 1/2 of what it would have been with reasonable fees. As pension plans are fast going the way of the dinosaurs, this affects just about everybody.

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