Discussions are heating up around whether mutual funds still make sense for 401(k) plans.  These discussions have been precipitated by the looming SEC requirement that record keepers and their outside fund partners charge redemption fees which will result in massive technology upgrades and yet another layer of cost to Sponsors which will be even higher for platforms that include non-proprietary funds.

When 401(k) plans began, money mangers were hired to offer plan participants separately managed accounts with institutional prices negotiated by the larger Sponsors.  Record keeping and administrative costs were paid separately.  Things changed as participants wanted more choice and household fund names that could be tracked in the newspapers.  Fund companies offered to cut their record keeping fees if Sponsors used their higher priced, proprietary retail mutual funds.  Everyone was happy in an era of double digit returns.

Then came the need to offer non-proprietary funds, the market crash, steep declines in record keeping fees and finally the mutual fund scandals.  Participants no longer want choice, they want direction and they can go on their Provider’s website to determine the exact value of their funds in their plan.  The DoL and SEC are starting to question whether the cozy relationship between the Fund Companies, Record Keepers and Sponsors is in the best interest of the participants.  The price of a retail equity advisor sold fund averages 125-175 BP’s not including the wrap fees for insurance products or the hidden fund costs.  All tolled, smaller plans can pay as high as 300-500 basis points in an era where most of us would gladly accept single digit returns.  When you add in another 50-100 BP’s that asset allocation firms want to charge, it begins to become absurd.

Perhaps the simple solution is that record keepers could create white label “funds” that participants choose based on a simple combination of their income and retirement date.  Record keepers with billions under management, not the small plan sponsors, negotiate institutional prices with separately managed account firms.  Fund prices should be way south of 100 BP’s and they would not be subject to SEC scrutiny avoiding redemption fees.  Properly disclosed record keeping subsidies, without which hundreds of thousands of Sponsors could not afford to offer a 401(k) plan, could be baked into the fund prices.  Advisors could charge a wrap fee paid out of plan assets for their services and participants that want customized asset allocation could use low cost ETF’s.

This scenario is not likely to happen anytime soon given the incentive incumbent providers have in preserving the current system.  But even these top tier Providers have to admit that the current system is broken and needs more than a band aid in the form of redemption fee friendly record keeping software.  If not, expect a wave of new competitors that will feast on incumbents the same way that current dominant providers overran the banks and trust companies like Bankers Trust in the early 1990’s.