In 1970, Congress took to task the responsibility of mutual funds to offer a fair price for their services. This "fiduciary duty with respect to ... compensation for services" suggests that investors should know how much a fund is charging. But these fees are not always as transparent as we would like.
Buried inside many 401(k) plans are fees charged by the plan sponsor that are often in addition to what many would consider the transparent information available. These fees are not often known to the 401(k) investor at a glance.
Is Any Fee Fair?
On Monday the Supreme Court heard arguments in the case of Jones v. Harris Associates. Harris Associates was accused of charging higher fees for 401(k) investors than they charged for similar investments made by pensions. The trial was heard in the 7th District Court and the ruling suggested that the fees, while almost twice that charged for institutional investors was not out of line with what is considered the industry standard.
The question remains, what is fiduciary responsibility? The late Justice Benjamin Cardozo, writing in the widely cited case Meinhard v. Salmon, believed that "partners in a business have a fiduciary duty to inform one another of business opportunities that arise." He wrote: ""a fiduciary represents the punctilio of honor, and that is contrasted with the morals of the marketplace operating at arm's length."
This would suggest that the business partner relationship extends to the investor, who is essentially locked into the plan offered by their employer. They do not, as in other business dealings, have the ability to walk away from the investment and choose something else. This lack of portability, the old "money walks" notion of how free markets conduct themselves does not apply in this situation.
When Higher Fees are Noticed
These fees are particularly troublesome in light of the recent downturn. What would be considered reasonable fees when the stock market is outperforming become a glaring slap in the face when fund returns are down. The belief that fees whittle away the potential of greater returns is well founded.
As an example, consider the 45 year old, gender neutral investor who has a household income of $50,000. With an 8% contribution rate and an 8% return (after fees) over the remaining 20 years this person plans on working (a beginning balance of $100,000 and a potential of inflation, which is currently running in negative territory but historically runs around 3%). This person would have enough cash on hand, provided that the 8% return remained in place on the investments accumulated throughout their retirement, to not run out of money until they were 87 years old.
In the case heard before the Supreme Court, the additional half percentage point levied against the investor in the 401(k) would remove almost two years of income from the plan. The Court was asked to determine whether these fees were excessive in light of what other investors paid for similar products.
In an overview of the argument: "Open-end investment companies – more commonly known as mutual funds – are often created and managed by investment advisers. Although the funds and advisers are separate entities, the overlapping nature of their relationship can create conflicts of interest. The petitioners believed that Harris Associates did not "provide full and accurate disclosure of all material facts related to the transaction; and (2) ensure that the transaction is fair to the shareholders."
Does Your Plan take Responsibility?
The Investment Company Act of 1940 was designed to keep the role of advisor and client separated by a board, which would determine fees the advisor would like to charge. Prior to this, the relationship without the board made the practice of who paid what. But the advisor hires the board making the threat of firing the advisor much less of a possibility than if the board was independently elected. "Justice Scalia, for example, speculated that even if a board could not directly fire an advisor, it could set the advisor’s fee so low that the advisor would quit."
But the argument came down to an apples and oranges comparison of which fees were reasonable. The Court has numerous options including doing nothing. Yet, as long as investors focus on the fees charged, the argument should continue if only as an act of dissent voiced by the participants in the plan. Forcing the plan sponsor to shift to a more fee friendly environment, possibly with a new advisor would be a step in the right direction. But that could lead to a less focused fund manager who may not try as hard.
Fiduciary responsibility remains a difficult ideal to litigate. "Captive" investors may simply have to deal with higher fees in the short-term until there is some ruling supporting comparisons. Or, as many in the investment community hope, the markets will return and these concerned investors will simply forget how much they could have made with lower fees as higher return offset the losses.
Paul Petillo is the Managing Editor of BlueCollarDollar.com and a fellow Boomer