Mutual Funds
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| | Mutual Funds
Banks profit from employees' 401(k)s
Employees of banks often find their 401(k) investments are in mutual funds operated by the bank itself. Those funds are often mediocre or worse.
By Timothy Middleton
Even if you've got a terrible 401(k) plan, the chances are your boss isn't profiting off the money you invest in the plan. Unless you work for a bank.
Big banks -- including two of the nation's largest -- routinely pack their employees' retirement plans with funds run by the banks themselves. The banks collect fund management fees from employees, who have little choice about where to invest their retirement dollars. And those bank funds are often average performers at best.
It's all legal. But it shifts millions of dollars a year from bank-employee retirement accounts into the banks' coffers. Over the long run, the banks will reap billions in additional revenue by keeping employees in the plans.
Among the offenders, as detailed in regulatory filings: Bank of America (BAC, news, msgs), which has profited directly on more than 80% of its employees' retirement investments; and Citigroup (C, news, msgs), where nearly 90% of employees' 401(k) mutual-fund investments have been in portfolios managed by the bank and its affiliates.
"The 401(k) system is a thoroughly dysfunctional system, and this is just another example of it," says Wayne Miller, chief executive of Denali Fiduciary Management Corp., an investment advisory firm in Seattle. "Financial institutions in this country have a lot of pull in Congress, and that's why this is not specifically outlawed."
President Bushs push to privatize part of Social Security shines a spotlight on the growing responsibility workers have for their own financial security in retirement. While the 401(k) has become the principal retirement-savings tool for America's work force, employers make it nearly impossible for workers to understand what their investment options are, what their plans cost, and how they compare with other companies' plans. This is the third in a continuing series of columns I'm devoting to dissecting specific plans, in hopes of showing just how problematic some plans can be.
A gift from lawmakers to money managers
Virtually all sponsors of 401(k) plans are prohibited from running their own companies' plans for profit -- except money managers. Lobbyists won that exemption from the Employee Retirement Income Security Act, or ERISA, when it was written 30 years ago.
"Yes, it's self-dealing. Yes, it's blatant, if you want to use that word. But that doesn't mean it's illegal," says Arthur Bachman, a partner in the New York law firm of Blank Rome. As a young lawyer for the Internal Revenue Service, Bachman drafted portions of ERISA, as well as the IRS regulations that implement it.
More about mutual funds
Employees aren't the only ones who may feel disadvantaged when stuck in Bank of America's funds. In April 2004, a class-action lawsuit was filed in federal court for the Eastern District of Missouri over claims involving the use of the bank's proprietary mutual funds in 401(k) plans, trust and other so-called fiduciary accounts, which the bank manages on behalf of customers. "Ninety percent of these funds are held in fiduciary accounts. Nobody else will buy them -- they're too expensive," asserts Steven M. Hamburg, a partner in the St. Louis law firm of Summers, Compton, Wells & Hamburg, who is litigating the issue.
Bank of America says it will not discuss pending litigation. It declined to comment for this article, except to issue a brief statement saying it "offers an array of benefits designed to help (employees) reach their future financial goals. Our 401(k) plan contains a variety of investment options."
Paying full price for mediocrity
The Bank of America 401(k) plan had $7.06 billion in assets and 176,670 participants at the end of 2003, the most recent year for which regulatory filings are available. About 81% of those assets were captive assets: - $3.58 billion was invested in Bank of America stock.
- Another $2.14 billion was invested in mutual funds managed by Nations Fund, which the bank manages.
The Nations Funds are most remarkable for their mediocrity. Comparing them with their rivals in every investment category, fund researcher Morningstar pegs them in the absolute middle on average and well below par for fixed-income funds. Those bond funds show the scars of expenses the most because their returns are low relative to stock funds.
| Nations Funds' performance | | Rank for 1 year | Rank for 3 years | Rank for 5 years | | Equity funds | 44 | 42 | 42 | | Fixed-income funds | 61 | 57 | 57 | | All funds | 53 | 50 | 51 |
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Notes: Data as of April 5, 2005. Ranking: 1= best. 100 = worst. Performance is asset-weighted. Source: Morningstar Inc.
In 2003, Bank of America participants had 19 investment options available, 12 of them from Bank of America and seven from outside providers, including Vanguard, Dodge & Cox and Fidelity. The outside providers were added only in 2003 and accounted for just a trifle of plan assets by the end of the reporting period.
As a result, the non-Nations funds, because they had so few assets, generated only $780,000, or 2.7%, of the plan's mutual-fund investment income. The bank's own portfolios produced 97.3% of fund returns.
The largest single portfolio owned by plan participants was Nations LargeCap Index Fund A (NINDX), with $762 million. The bank's own revenue from those accounts, given the fund's 0.26% expense ratio, was nearly $2 million.
Bank of America's filings indicate its plan paid roughly $8 million in 2003 for administration. The lion's share would have gone directly into the bank's own coffers -- including $500,000 in overhead charged by the bank's retirement office and personnel center.
Hoping to save money
At least that index fund was among the cheapest alternatives available. Given the opportunity to save money, participants in bank plans seize it. At Citigroup's plan, the most popular investment option, aside from company stock, was Delaware Bankers Trust Index 500 Fund, with plan assets of $784.7 million.
That portfolio, not technically a mutual fund, is run by a Citigroup affiliate, according to filings. It is known as a bank collective fund, akin to a separate account. Its expense ratio is 0.06% -- one-fourth that of the similar fund in the Bank of America plan.
The $10.84 billion Citigroup plan offers 27 portfolios -- most of them mutual funds -- that are managed by Citigroup itself and another five portfolios that are not. A total of $4.25 billion was invested in those options in 2003, with 88.9% of the money held in Citigroup-affiliated funds.
Like many publicly held 401(k) plan sponsors, Citigroup matches a percentage of employee contributions. The match is made in company stock, which cannot be sold for five years or until the employee is 55.
Citigroup likewise declined to comment on its plan, except to offer a brief statement saying, in part, "Our 401(k) plan offers employees a diverse array of investment options, consistent with ERISA requirements, that are reviewed on a regular basis by an independent third-party advisor."
When mutual funds aren't the answer
The problems at Bank of America and Citigroup -- and at many companies sponsoring 401(k) plans -- are not just that employees are steered to invest in their own employers' funds: It is also that they are forced into mutual funds at all.
Funds charge expenses for such things as servicing numerous small individual accounts that institutional portfolios do not. Big pension funds eschew expensive mutual funds for what are called separate accounts -- portfolios managed in the same style as funds but without the extra costs of fund administration.
Denali's Miller says, "One could say it's thoroughly improper to use a mutual fund in a plan that size. Any investment discipline you want is available at that size of plan at a fraction of that cost."
The contrast between the expense ratios of the index mutual fund in the Bank of America plan and the much lower expenses of an otherwise-identical fund in the Citigroup plan illustrates the potential for savings. And other money-saving alternatives abound.
For example, a popular choice in the Citigroup plan is Smith Barney Aggressive Growth Fund (SAGYX), run by Smith Barney, a Citigroup subsidiary. Some $633.9 million of plan assets are invested in the fund, but employees can invest in the fund's institutional shares, which charge annual fees of 0.78% of assets. It has been managed by Richard Freeman for more than 20 years and is described by Morningstar as "superb."
But plenty of other investment managers will do the job and charge half Smith Barney's rates or less. Denali estimates Wellington Management, a fabled large-cap money manager, would charge 0.3% on the first $300 million of assets in a separate account, and 0.1% on amounts over that.
"Why do (the banks) charge so much?" Miller asks. "Because they can. It's nothing more sophisticated than that. Until the plaintiff's bar comes after a plan like that, they'll continue to do it."
The average expense ratio on an equity mutual fund is around 1.5%. A separate account might cost 0.35%. The difference is $1,150 per year on a balance of $100,000. Over a lifetime of investing, including compounding, that could drain perhaps as much as $100,000 from a retirement account.
Even if the cost were half that, when you multiply it by 175,000 participants, the windfall to a bank-plan sponsor would be $8.75 billion over 30 years.
Like most 401(k) plan participants, bank employees are forfeiting too much of their retirement savings in the form of fees. The difference is that bank employees are giving the money to their own bosses.
At the time of publication, Timothy Middleton owned none of the securities mentioned in this article.
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