It’s as different from IRAs as debit cards are from credit cards

Individual retirement accounts and 401(k)s are America’s most popular retirement plans. Like all investments, each carries risks. Virtually no attention has been paid, however, to the substantially greater risks that 401(k)s involve.

401(k)s are as different from IRAs as debit cards are from credit cards. Debit cards offer almost none of the protections that credit cards carry. When you pay for something by debit card, your money is immediately withdrawn from your account. If something goes wrong with your purchase, God help you in your attempt to get a refund. When you purchase by credit card, all sorts of protections kick in. Most importantly, the card issuer gets involved in resolving the matter between you and the merchant.

By the same token, 401(k) investors have unwittingly exposed themselves to problems, many of which IRA investors will never encounter. Those additional risks can be broken into four categories: investment risk, record-keeping risk, employer-business risk and regulatory risk.

Risky business

Investment risk may seem to be the most obvious, but it actually is twofold. First, there is the risk in making the wrong investment selection. Your clients may choose to put their money in a value fund and suffer when value is out of favor. They might be too conservative and put all their money in a money market fund, thereby missing out on great stock market performance. They may choose poorly. While an IRA investor may also choose the wrong fund in which to invest, they are free to choose from any fund that’s out there. A 401(k) investor generally does not have that freedom of choice.

The second aspect of investment risk, peculiar to 401(k)s, is the possibility that the client’s employer might make a bad choice in determining what investment alternatives to offer employee participants.

One outrageous scenario, which has conflict of interest written all over it, is the mutual fund or financial services company that offers its employees only its own mutual funds. Often those funds are not the lowest-cost, best-performing funds available. One or two of the funds may be terrific, but it is highly unlikely that the employer’s funds are the best in every asset class. The fiduciaries involved with the 401(k) plan are supposed to consider all the alternative funds and do what’s best for the participants of the plan, but competitors’ funds just don’t seem to make it into the plan. Even financial services companies with poorly performing funds and high sales loads find ways to justify offering only their funds in the employee 401(k) plan.

The risk that record-keeping errors will arise over the course of an individual’s lifetime is huge. My wife and I participate in three 401(k)s, and in every single one, we have uncovered significant errors. Experts in the field have estimated that errors in 401(k) statements are widespread. Our experience confirms that. Record keeping for 401(k)s is exceedingly complex.

When you have thousands of employees, a dozen investment alternatives, participants’ contributions, sponsors’ matching contributions, changing pension laws, anti-discrimination rules, early retirements, layoffs, mergers, bankruptcies, dissolutions, and understaffed and sometimes untrained benefits departments, the potential for error is tremendous.

Errors are probably more prevalent in small plans, which lack access to software and consulting services necessary to ensure accurate records, than in larger plans.

Soon after she enrolled in her 401(k), my wife discovered that several of her salary contributions never made it into her account. I, on the other hand, found that when I moved from one state to another in the middle of a year, my employer’s record-keeping system treated me as a new employee and withheld the maximum allowable contribution – for a second time.

Over the course of a lifetime, your client may receive hundreds of 401(k) statements. An error may occur in one statement and, if unnoticed, be repeated. With each passing year, the monetary value of that error may grow. So it is important to ask for statements regularly and examine them closely. In our opinion, however, it is unlikely that the average participant would be able to ferret out many possible miscalculations.

Employers are trying to shift responsibility for ensuring statement accuracy onto their employees to by adding such disclaimers as, “It is the employee’s responsibility to verify the accuracy of this statement and notify us within 30 days of any inaccuracy.” Most debit card issuers have the same policy; credit card issuers do not.

The very fact that such disclaimers are appearing on 401(k) statements should tell you something. One would hope that the courts would not uphold such disclaimers, because it is virtually impossible for an employee to verify a statement’s accuracy.

What if you or your clients find an error? Be careful before you assert their rights. Given how often most Americans change jobs, chances are they will no longer be employees of the company that made the error by the time you or they discover it. It is unclear whether the Employee Retirement Income Security Act protects former employees from harassment and threats by the employer. Since all retirees and many plan participants will no longer be employees, this is a major Erisa oversight.

shifting responsibility

401(k) investors are also plagued with risks related to their employer’s business. When an employer goes bankrupt, voluntarily closes or merges with another company, guess what happens? The 401(k) plan often gets forgotten. In most cases, the 401(k) plan is unrelated to the company’s core business, and its trustees are not experienced in pension matters.

When the physicians group that employed my wife folded, for example, the physician/ trustees hired a retirement services firm to administer the distributions. The trustees thought that that was the end of their fiduciary responsibilities. The result was that it took my wife two years, and countless phone calls and letters, to have her assets rolled over.

Finally, 401(k) investors are subject to far greater regulatory risk. There is a big difference between investing in Fidelity mutual funds and investing in a 401(k) that invests in the very same funds when it comes to delivering a prospectus, or “summary plan description”; sending benefits statements; monitoring compliance; and redemption or distribution rights.

When you invest in a mutual fund, you get a prospectus. If you lose your prospectus, you can easily call Fidelity and get a replacement. When you invest in a 401(k), you should receive a summary plan description. Many employees never get them. If your clients lose their summary plan description, they may have a difficult time getting another copy. The entire human resources department of a small company may comprise just one person, who may not have copies to send out.

Mutual funds are required to send shareholders a quarterly statement and annual and semiannual reports. Believe it or not, 401(k)s are not required to provide benefits statements on a regular basis. Employees have the right to request an annual statement, but beyond that, it’s up to the employer.

How about when your clients want their money back?

Mutual fund investors call the fund company, and their shares are redeemed immediately, as is required under federal securities law. Mutual funds also must provide daily pricing of portfolios. When departed employees request a distribution of their 401(k) assets, it may take years.

I am told that employees who leave their jobs on unpleasant terms frequently experience longer delays in getting their distributions. Some plans do not price their portfolios daily, weekly or even monthly. Participants in those plans may have to wait until the next valuation date for a distribution amount to be determined – and longer still to have it processed. Obviously, mergers, bankruptcies and other factors regarding the employer’s operations may have an impact on distribution timeliness. While employees await a distribution, of course, the value of their account will fluctuate – for better or worse.

Useless to complain

The Securities and Exchange Commission inspects every mutual fund company every few years for compliance with federal securities laws. Any problems that investors experience may be directed to the SEC or the National Association of Securities Dealers Inc. There are established rules and arbitration procedures for dealing with investor complaints related to brokerages or mutual funds. No government agency regularly inspects 401(k) plans to ensure that assets are protected and participants are being treated fairly.

The Pension and Welfare Benefit Administration shares jurisdiction over 401(k) plans with the Internal Revenue Service. PWBA officials tell me that because there are so many 401(k) plans out there, they act on “predication” only. That is, if they have reason to believe that there is wrongdoing, they’ll look into it. That’s not very reassuring for participants. If there is a problem with your clients’ plan, it’s up to you or them to find it and report it to the agencies. Practitioners in the field agree that even when a participant reports a 401(k) error to the agencies, it is generally “useless.”

Unless you are able to convince the PWBA to get involved in your case, you’ll probably have to hire an Erisa-trained attorney to pursue your claim – and they aren’t cheap.

Don’t get me wrong. There are compelling reasons to participate in 401(k)s. The amount an employee can set aside is far greater than in an IRA. The employer’s matching contribution is a tremendous benefit. But, as is often the case in investment matters, the risks related to new investment vehicles unfold slowly over time.

Edward Siedle is president of Benchmarkalert .com and Benchmark Financial Services, both in Lighthouse Point, Fla. He also has served as an attorney with the Securities and Exchange Commission’s division of investment management.