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Ted Benna invented the 401(k) plan in 1980. Today we think of it as a technological stone age, but back then we celebrated the wondrous improvements technology was bringing to financial markets. Charles Schwab had opened a “discount brokerage” in 1975 after deregulation. It now only cost a few hundred dollars to make a stock trade. The “no-load” mutual fund was gaining market share. A young upstart John Bogle at Vanguard was putting pressure on the mutual fund industry. Loads fell to “only” 4.5%. Mainframe computers (with front doors) were communicating with each other over phone lines, thus allowing for 24-hour stock quotes and automated trading.
The service known today as 401(k) recordkeeping needed to be invented – and quickly.
The largest businesses were the first to adopt 401(k) plans. All of the paperwork was manual. Information and money moved slowly. Everything was done on a custom basis. Savings from economies of scale were enormous.
Three key factors led to the birth of indirect compensation:
- Financial services in the early 1980s were commission driven. Vanguard and Schwab were upstarts. Everyone else used a different compensation model. Payments to advisor/brokers came from the fund company.
- The early 401(k) plans were seen as brass-hat deferred compensation schemes – not the backbone of the nation’s retirement system. After all, big companies had pension plans and made massive contributions. The large employers made the decision that employees would bear the costs of these new compensation schemes.
- Mutual funds were the ideal investment vehicle for plans making periodic contributions. Mutual funds traded after market close at a fixed price. In addition, mutual funds already had in place commission schedules and the back office technology to efficiently deduct fees from assets.
As money started to rush in to plans, fund companies took the lead in marketing 401k plan products that included investments (by necessity all were from a single fund family), brokerage fees, and proto-recordkeeping services. Fund companies collected all the fees, and paid out service providers. Fund companies already had the technology to most efficiently handle the trading transactions and to keep track of everyone’s fees.
Indirect compensation in the 1980s not only made sense, it was the most efficient means of handling plan services in an era when investing was an expensive proposition.
Cash flows into 401(k) plans took off, and the competition for assets became fierce. New fund companies emerged and opened multi-family investment lineups. Consulting firms specializing in benefits design sprang up and offered new savings arrangements. The cost of investing fell, but only for the largest plans.
Then market slump and recession of 1991 put an end to private pension plans. 401(k) plans became the key (only?) vehicle for retirement savings. 401(k) plans became synonymous with “retirement plans.” Plan participation was no longer a benefit for the few, it was darn near an entitlement. The bull market of the 90s served to hide some of the costs of 401(k) plans, and fund company profits went through the roof.
Then technology changed everything.
With a new robust internet, change came quickly. By 2000, loads on mutual funds disappeared. Trading costs fell to pennies. Daily valuation and trading became the norm. Many of the services became commodities. Plan administration as a percentage of assets fell. The high costs and economies of scale that favored larger employers were competed away. ETFs and index funds rose and fees fell. Target retirement date funds appeared. Investment advisors used new compensation arrangements to accommodate those funds that no longer paid commissions. New technology allowed service providers other than fund companies with access to efficient cash movement. In short, fees got democratized.
Today, access to information and transparency are better than ever before. Seriously. So much has changed, except for… indirect compensation. There is no longer a market efficiency argument for its existence. To the contrary, indirect compensation arrangements are now the primary means of 401(k) fee obfuscation.
Why do we still have mutual funds collecting fees for other providers?
While the industry squabbles over fee disclosure regulations, the root problem has been, and remains indirect compensation arrangements. Reforming fee disclosure regulations would be great, abolishing indirect compensation would be better.
