Trapped In A Mediocre 401(k)…

bad-401k-choices-expensive

401(k)s, as we all know, are retirement accounts where one can shelter $17K pre-tax per year (2012 tax year) and the money grows tax-deferred (not tax-free as some mistakenly assume) until you reach 59 and 1/2 years of age. This, by far, is one of the best investment vehicles to save for retirement. But there is a caveat. Sometimes, the investment options available in a 401(k) are so awful that you might be better off investing outside the 401(k) and letting go of the tax-deferral.

I happen to come across  one such 401(k) when putting together a plan for one of my clients who worked for a large multinational company (if that helps). It didn’t take much time or effort to realize that there was not a single investment which stood out or which could be used as a piece to create a well-rounded portfolio. Either the investment options available were mediocre at best or the costs to invest in these options were prohibitive, both scenarios almost wiping out the benefits of tax deferment. A snapshot of the plan is shown below.

The first set of funds available in the plan were the target date retirement funds from the American Funds family. Analysis of the two extreme year options (2010 & 2055) is listed below.

American Funds 2055 Target Date Ret. R3

The first issue is with all the coding involved with this fund and other American funds. There are seven different categories of funds with exactly the same investments.

Holdings for a fund with R1 as the code shown below

 Holdings for a fund with R6 as the code shown below

 Holdings for a fund with R3 as the code shown below (part of the 401(k) plan)

Exactly same investments but a big difference, expenses.  R3 has an expense ratio of 1.87% which is unbearable in today’s environment. On top of that, the fund has a 0.5% of 12-b-1 fees. This is a marketing (junk) fee assessed to the shareholders of the fund so that the fund can attract more assets.  R1 is even worse. It has an expense ratio of 2.25% and 12-b-1 fees of 1%. R6, on the other hand, is much better with 1.04% expense and no 12-b-1 fee.

Another issue is with the turnover ratio of the fund. More turnover or churn will result in higher trading costs as well as taxes. Taxes are not the issue in a retirement plan but the cost of buying and selling is there and that will eat up the fund’s return. Turnover ratio more than 20% is considered excessive. This fund has a turnover ratio of 44% (average holding period of each security is approx. 2 years). A 20% turnover ratio amounts to an average holding period of 5 years which is not bad but could be better. Preference is for a fund with 10% turnover ratio (10 years holding period for each security). This is rarely seen with managed mutual funds.

A big disadvantage of target-date fund is the two layers of fees charged by the fund. Not only is there a fee for putting a fund package together but there is also a fee for the underlying investments. Another issue is the reliance on one fund manager with respect to the fund’s asset-allocation which may or may not be appropriate for each and every portfolio.

So all target date funds are out.

Next in the lineup was the American Funds AMCAP R3. Again the same story. Expense ratio of 1.05% with 12-b-1 fee of 0.5%. Not worth it.

This same story was repeated for all American Funds and were not considered henceforth.

Columbia Midcap Growth Fund A

This fund is atrocious.  Expense ratio of 1.24% and a 12-b-1 fee of 0.25% and on top of that, an annual holdings turnover of 138%. Looks like that the manager either does not know what he is doing or he likes to gamble with shareholder’s (your) money. One last thing, it has a front-end sales load of 5.75%. Every $100 invested with this fund, only $94.25 gets invested.

Just based on this, the second Columbia fund was also ruled out.

Davis Real Estate Fund – There are 4 classes of this fund. Which one was offered was not clear?  Based on a few that were reviewed, none of them stood out.

Franklin Templeton Founding Allc R – This one looked like another asset-allocation fund with very high expenses. Reject.

Invesco S&P 500 Index Fund Class A – This is unbelievable. Expense ratio of 0.61% with 12-b-1 fee of 0.25% for an index fund. Vanguard has exactly the same fund with 0.06% of total expense ratio. And then, there is a front-end sales load of 5.5%.

No point looking at the other Invesco fund.

Templeton Developing Markets R – Expense ratio of 2.06% with 12-b-1 fee of 0.5%. Performance trailing the index by 20% over the last 5 years. Unacceptable.

Thornburg International Value Fund – Expense ratio of 1.63% and 12-b-1 fee of 0.5%. Not going to work.

So there you have it.

What is one supposed to do?