I doubt that I’m unusual in being a finance type who has heard about 401 (k) abuses and bad practices for a very long time. So it’s gratifying to see the Financial Times that something is finally being done to try to curb this behavior. But that is hardly the full extent of what is rotten in retirement fund land.

Some of the failings reflect a combination of poor implementation of already not-so-hot finance orthodoxy (see a layperson rendering in Benoit Mandelbrot’s The (Mis)Behavior of Markets, or a recap of Mandelbrot and other critiques in chapter 3 of ECONNED). For instance, one mainstay of investing is to diversify across asset classes. It won’t increase your returns but it will lower your risk.

But what is an asset class? Wellie, the academic work on this topic defines “asset” classes in very large buckets that (as least historically) really were distinct markets and therefore moved only weakly in synch with each other (the financespeak term is “covary” or “covariance”): stocks, bonds, real estate, cash. Later research added foreign stocks and foreign bonds. But then pension fund consultants, whose role is to be a liability shield for corporations and government entities that still run defined benefit plans, have proclaimed all sort of types of investments to be asset classes, like private equity funds and hedge funds (and not just “hedge funds” in general, but specific hedge fund strategies, like global macro versus “event driven” (merger arbitrage) versus distressed debt. If pressed, hedgies admit that the value they create is largely “synthetic beta” or portfolio diversification, which can be achieved way more cheaply than the classic “2 and 20” fees (2% per annum, 20% of the gains, sometimes over a hurdle rate. As an aside, one has to wonder how much value is added by asset class diversification, given the proliferation of investors who move money quickly from one “asset class” to another in their search for return. Remember, for instance, the “risk on/risk off” pattern of much of 2012?).

But you can see the clear conflict of interest: the fund consultants have incentives to designate more investment strategies as “asset classes” so as to give them more to do and make their role look more significant.

So if this is going on with the big pension funds, you can imagine what happens in 401 (k) land. Admittedly, large corporations sponsor “defined contribution” plans too, but they generally have gotten less attention since defined benefit plans (trust me, the guys running defined benefit plans are very heavily solicited by Wall Street). But you’ve got a broader range of sophistication among plan sponsors (think of CFO at a Fortune 100 company versus the guy tasked to run finance at a medium-sized or small company). So you see a lot of “not in line with orthodox thinking” fund menus, such as too many flavors of US equity funds, worse, managed funds (when you might as well get a broad index and be done with it), and not enough options that allow for bona fide diversification (like foreign stock and bond funds).

But as bad as that is, the flat-out abuses are worse. Readers have complained about their inability to get information about fees. The lack of transparency is bad enough, and that raises the specter of possible overcharges. 401 (k)s typically allow moving monies from one fund to another only once a year, while by contrast, an IRA at a custodian like Vanguard faces virtually no such limits (what I’ve seen is in certain bond funds, and even then, the restrictions are pretty mild).

But one of the longest-standing types of fraud has involved float. I’ve heard tell of it typically taking weeks for transfers from one fund to another taking weeks to be credited; in one case, a full six weeks. This is the fund manager preying on captive customers, pure and simple.

It appears that finally these bad practices are being exposed by lawsuits. The Financial Times gives a recap tonight:

The cases allege the companies breached their fiduciary duties to participants in their 401(k) plans, which are roughly equivalent to defined contribution programmes in Europe, by charging excessive fees. Some suits also claim the plans engaged in improper revenue-sharing arrangements with service providers. “These lawsuits have pushed fees and revenue sharing to the very top of the list of issues that plan fiduciaries have to face,” says Greg Ash, partner at Spencer Fane, a US law firm. “These cases, and the [Department of Labor’s] focus on fees, have completely changed the dialogue among plan fiduciaries.”… The litigation has had a profound impact on the retirement industry, leading to fee reductions and changes in the way companies manage their 401(k) plans. Many cite the Department of Labor’s rules requiring greater disclosure about fees as also exerting enormous influence on the retirement industry. The rules went into effect in 2012, but were first floated in 2007… Eight of the lawsuits have resulted in settlements of $150m in total.

Readers may also be surprised to learn that the investment manager actually providing the funds in many cases can’t be sued directly:

In early 2009, the US Court of Appeals for the Seventh Circuit upheld a lower court’s decision to dismiss a lawsuit against John Deere, the farm equipment manufacturer, and the plan’s administrator, Fidelity. The plaintiffs claimed the company failed to monitor the plan’s investment options and that Fidelity charged excessive fees and did not notify participants of its revenue-sharing agreements. The court ruled that Fidelity was not a fiduciary of the plan, and therefore did not breach any such duties.

“[The case] was the first real victory” for defendants, says Ian Morrison, partner at Seyfarth Shaw. Patrick DiCarlo, counsel at Alston & Bird, notes the court gave particular weight to the fact that John Deere’s pension plan provided participants access to a brokerage option with more than 2,000 fund choices. While the case was a good win for defendants, “not every case has the same set of facts”, Mr DiCarlo says.

Lawyers please chime in. I’m at a loss to see how providing lots of choices has bupkis to do with overly high fees and lack of required disclosure. I’d hazard this ruling relies on the notion of secondary liability. As we wrote in ECONNED:

Legislators also need to restore secondary liability. Attentive readers may recall that a Supreme Court decision in 1994 disallowed suits against advisors like accountants and lawyers for aiding and abetting frauds. In other words, a plaintiff could only file a claim against the party that had fleeced him; he could not seek recourse against those who had made the fraud possible, say, accounting firms that prepared misleading financial statements. That 1994 decision flew in the face of sixty years of court decisions, practices in criminal law (the guy who drives the car for a bank robber is an accessory), and common sense. Reinstituting secondary liability would make it more difficult to engage in shoddy practices.

And we have kickbacks!

A Missouri federal court ruled in April 2012 that ABB, the US unit of a Switzerland-based manufacturer of power and automation equipment, was liable for removing a Vanguard fund from the plan menu in favour of Fidelity target-date funds. The court also ruled that the company paid Fidelity, the plan’s administrator, above-market rates in order to subsidise separate ABB corporate services.

The same case also targeted the failure to credit funds promptly:

The court ordered ABB to pay $35m. It ordered Fidelity to pay $1.7m for breaching its fiduciary duties in how it handled earnings on money moving to and from the plan’s investment options, known as float….the lower court’s decision has spawned at least four class-action suits against Fidelity over how it deals with float. The cases have all been filed this year.

It’s good to see some action on this front. The US provides for a great deal of regulation in the fund management and retirement fund arena precisely because you often have very unsophisticated customers, and the vendors can engage in all sorts of skimming that looks small on an individual account basis but adds up across a business. Now the interesting question is where the Obama Administration has been all this time. Will it join this party late and try to create the image that it really was taking early reports of these abuses seriously, or sit on the sidelines, on the assumption that this story won’t get much airplay? Stay tuned.