Mutual Funds 101

Mutual Funds 101

Mutual funds are a big deal in America. According to the Investment Company Institute, more than half of all households own shares in a mutual fund, and assets in mutual funds totaled $13.0 trillion in 2012. We understand the idea behind them. They are designed to allow the average investor to diversify and invest en masse so as to have the advantages of larger investors. With millions of American workers pumping money into 401(k) plans every month, and with that river of cash dumping right into the mutual fund ocean, it’s no wonder they are so big. But do people really know what they are buying? Mutual funds had some advantages at one time, but any more, with the onset of rapid trading via computers and ETFs (Equity Traded Funds), are they really all they were cracked up to be?  (Source: 2013 Investment Company Fact Book, 53rd Edition, Investment Company Institute)

Here is a quote from Forbes Magazine: “Most mutual funds are plagued by more drawbacks than benefits — they’ve become inefficient and largely outdated investment vehicles.” The magazine goes on to list the following four areas in which mutual funds are inefficient: (a) Poor performance relative to indexing, (b) tax inefficient, (c) difficult to manage, and (d) excessive costs.

Don’t get me wrong. I am not disillusioned with mutual funds. They are useful when used at the right time for the right purpose. As an investment instrument, mutual funds are among the many financial tools that should be included in any comprehensive financial toolbox — along with stocks, bonds, annuities, trusts and scores of others.

To illustrate the point, Janine, a financial advisor with me at Northwest Financial & Tax Solutions, had made plans to meet her husband and their young son for dinner at a favorite café of theirs in Hazel Dell, a northern suburb of Vancouver, Washington. She was running late, and her husband and son decided to visit a pawn shop next door to the café just to kill some time. As they perused the endless assortment of odd items in the shop, the son was fascinated by some oversized wrenches and other strange tools. What could such giant tools possibly be used for? he wondered. The subject came up over dinner. All in the family admitted they had no clue as to what possible use such enormous tools could have. Then, on the drive home, they passed a giant dump truck, as big as a two-story house with tires over 10 feet high. It suddenly became clear. Every tool has a purpose.

Mutual funds are useful tools in building a retirement nest egg during the accumulation phase of life. Mutual funds are the bedrock of most employer-sponsored tax-deferred retirement plans, such as 401(k)s. They can make for excellent diversification during the accumulation phase of one’s financial life. The problem I see so often, however, is that individuals in their 60s and 70s invest as if they were still in their 30s and 40s. Different life phases call for different approaches in wealth building and wealth management.

Anne Kates Smith, senior editor for Kiplinger’s Personal Finance magazine, feels that mutual funds carry administrative fees that can deceptively cut into the returns mutual funds could otherwise provide. She had the following to say about this in an article titled “Mutual Funds’ Hidden Fees” in the magazine’s September 2011 issue:

“Depending on how trigger-happy a fund’s manager is, trading costs can prove a formidable hurdle for returns to overcome. Trading costs are among the most opaque because they’re not reported as part of a fund’s expense ratio the same way that other costs of running the fund are. Funds must disclose the brokerage commissions they pay, but most times you have to hunt the disclosure down in a fund’s statement of additional information.”

Defined contribution plans such as 401(k)s are the largest repository of mutual funds in America. How did that come about? Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at The New School for Social Research, is quite candid about 401(k)s and the myriad mutual funds they contain. In an article that appeared on April 13, 2013, in the online magazine FRONTLINE, she said the 401(k) system is a “failed experiment” for middle-class Americans because it was never designed with them in mind.

“It’s not the fault of people that they don’t have enough savings in their individual retirement account or their 401(k)s,” she said. “It’s the fault of the system, and the whole system needs to be reformed.” She called 401(k)s, and by association the mutual funds they contain, “only products that Americans buy without knowing its true cost.”

To understand where we are with mutual funds in America, we have to go back to the passage of ERISA, the Employee Retirement Income Security Act of 1974. It was a time when people started losing their pensions after many years of working for a company that had now gone bankrupt and had no money with which to keep their pension promises. The most notorious example was that of the Studebaker automobile manufacturing company. (You may be a baby boomer if you ever rode in a Studebaker). The company was really ahead of its time, but America wasn’t ready for some of its innovations. The sleek Studebaker was the first to have seatbelts in every car and came out with the first power steering. But the car was a flop with the fickle American car-buying public and Studebaker went bankrupt and couldn’t pay their pensions. The last Studebaker rolled off the line in 1966. Some folks had worked for 30 and 40 years making Studebakers and were left holding the bag. Studebaker and other workers with the same problem complained loudly to Congress, which led to the passage of ERISA in 1974. This new law, intended to force corporations to back up their pensions, led to another law passed in 1978 that would dramatically change how Americans prepared for retirement: The Revenue Act of 1978.

Enter the 401(k)

Not everyone noticed that this new legislation contained a section 401, paragraph (k) that permitted American workers to save money for retirement and lower their current taxes at the same time. But the wording did not escape the notice of Ted Benna, a Philadelphia benefits consultant who saw that it allowed for bonuses that could be tax-deferred if saved for retirement. Benna noticed nothing in the law that said that regular wages couldn’t receive the same tax treatment, and the 401(k) was born. He had to get it approved by the IRS, which finally came through in the spring of 1981. The 401(k) quickly began spreading across the country, eventually replacing pensions. Similar salary-deferral retirement plans are authorized in the tax code for public-sector employees (known as 457 plans) and nonprofit-sector employees (known as 403(b) plans).

There are advantages and disadvantages to the 401(k). The money you put into it is tax-deferred as it grows. Money you would have been paying in taxes growing at compound interest — what a sweet deal, right? Compounding means you earn interest and then you earn interest on that interest and then more interest on that interest.

But like chickens coming home to roost, the taxes would eventually be paid when you began using the money for its intended purpose — retirement. Put that down as a disadvantage. Tax deferred doesn’t mean tax free. Uncle Sam was making us all a deal. Let’s say that you are a farmer walking into a store to buy seed for the spring crop. Over by the checkout counter is Uncle Sam in his stars-and-stripes suit, wearing a hat that says IRS.

“I will make you a deal, young fellow,” Uncle Sam says, extending his hand. “I won’t charge you a penny on this seed, but you pay me full bore on the harvest.”

Most of us took the deal. Assuming your account grows, the IRS will be rewarded for waiting. Not only that, but when you leave what you don’t use in a 401(k) to your heirs, they will have to pay both income tax and possibly estate tax on the amount received.

Another thing: Pensions were guaranteed for life. The balance in a 401(k) account, while it can be invested in any number of vehicles, is usually invested in mutual funds or other securities products, often by a custodian, such as Vanguard or Fidelity. Are they subject to the volatility of the stock market? Yes, indeed.

Since 401(k)s are heavily invested in mutual funds and many American workers don’t realize how much they are paying in fees.

It would be nice, of course, if you could open your statements and see a large headline that read, “FEES and OTHER CHARGES,” at the top of a page and then had all the fees and charges printed there in 22-point type.

I know some people who don’t even open the envelopes containing their account statements. They just stack them up in chronological order and procrastinate until they finally have to file them away. One couple, after attending one of my educational seminars on retirement income planning conducted shortly after the 2008 market crash came into the office the next afternoon for a consultation. They brought with them a box with several unopened envelopes containing statements from their stock broker. When I asked them why they hadn’t opened the envelopes, the man spoke up and said, “We know there is bad news in there.” And there was! They were invested in risky market positions, which had cost them more than a fourth of their life’s savings.

Bank statements are usually pretty straightforward, but you should at least scan them for charges you may not have agreed to. One woman who started using an online bill pay program provided by her bank didn’t realize that it came with a $15 fee attached. Pay attention to minimum balance accounts. One slip below the line and fees can add up quickly. Please don’t be embarrassed to ask questions of any financial organization that charges fees. You should feel comfortable enough to ask, “Why was I charged this?” and “what can I do to avoid this fee in the future?”

Dollars add up to hundreds of dollars and hundreds add up to thousands.

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