Although the media has belatedly provided thorough coverage of the mortgage crisis and related scams, they’re always closing the barn doors after the cows have gone.

Instead of waiting until you’ve been victimized, it’s important to anticipate and mitigate potential threats to your assets.

One issue bubbling just under the surface affects droves of individual investors and demands the spotlight. The media has danced around the problem, likely because of the advertising dollars flowing from the industry in question. It involves 401(k) plan providers and the funds in those accounts.

More than half a trillion dollars evaporated from 401(k) funds in 2008, and those losses appear to exceed reasonable expectations, even in these down markets. So what happened?

All Mobbed Up

The origins of the 401(k) date back to a quirk in the tax code exploited by corporate executives. In 1980 the IRS ruled that section 401(k) also applied to deferred compensation for rank-and-file employees, while the Dept of Labor provided additional parameters to the program and the SEC took charge of overseeing investments in these accounts.

Congress tried to tighten things up with the Pension Protection Act (PPA) in 2006, which also encouraged employee participation and dealt with potential conflicts of interest among those managing the plans.

The PPA represented a sea change. It gave clear guidelines to plan sponsors and enabled employers to enroll employees automatically, increase investments automatically and choose from several 401(k) structures.

But certain oversights opened the door to some of the fowl that are now coming home to roost. In instances where laws didn’t explicitly ban a particular action, firms have continued to push the line–to their advantage, not yours. These loopholes will ultimately cost investors a great deal of money.

Fees, Conflicts and Targets

The mutual fund industry has been a huge player in the 401(k) arena, introducing a number of dubious structures designed to maximize fee income. Funds of funds, for example, hold shares in a wide range of other mutual funds rather than individual stocks.

This trend has two distinct disadvantages for individual investors. First, plan sponsors are required to disclose fully any costs and fees associated with the plans–a reasonable expectation. But the mutual fund companies are often unwilling, and possibly unable, to account for all the underlying costs associated with their plans.

The fees within funds of funds are stacked; each fund has its own set of fees. Few noticed this in the bull market, but now the lawsuits are starting to line up like airliners coming into Chicago’s O’Hare Airport.

Target date funds–a clever vehicle for the industry’s sales force–open another can of worms.

Here’s the concept: Pick a date when you’re going to retire, say 2039. The fund would manage your retirement account so that the portfolio would start with plenty of equity risk when you were a long way from 2039; as you approach retirement your nest egg would be in safer, fixed-income instruments.

But two unfortunate, and possibly related, things occurred.

First, the big mutual fund companies managed these target date funds as death funds, assuming they would manage the money for another 20 years after retirement, justifying keeping retirees in higher risk investments longer. This proved disastrous for aggressive funds whose target dates coincided with the downturn.

Second, there’s an inherent conflict of interest for mutual fund companies: Fees associated with riskier fare such as funds specializing in small caps, emerging markets or commodities are often much greater than money market funds or those focused on US Treasuries.

In short, tens of millions of dollars in fees are at stake; asset managers are incentivized to keep money in riskier funds as long as possible.

The market crash has called attention to failed 401(k) plans. Congress has launched its own inquiries, and the Dept of Labor is scrutinizing the conflicts of interest that inhere in the system.
Lawsuits are also coming down the pike, including potential class-action suits, and the threat of legal action captures the attention of CEOs even faster than threats to executive compensation.

The issues boil down to whether mutual funds are advertising a 2010 “retirement” fund that in reality is a 2035 “death” fund, and whether laws covering retirement plans are intended to prevent any self-dealing by fiduciaries. Mutual funds have decided that they’re exempt from these conflict-of-interest rules, arguing that they don’t manage retirement-plan money. They contend that responsibility lies with the employer that hired the fund firm–an interesting defense that some experts in retirement law describe as a “legal fiction.”

The Course of Action

Here’s what you can do to protect yourself while the big guns fight it out. Ask your investment manager and employer about the fees that you are paying in your 401(k). If the administrator doesn’t know, claims that it’s too complicated to explain or otherwise avoids the question, you should note this warning flag and dig further. Also ask about any hidden fees, not just for money management but special deals, one party to another, between the fund manager and related entities. Such transparency will help you ensure that you’re getting the best bang for your retirement dollars.

Finally, unless you are a complete do-it-yourselfer, start asking about exchange-traded funds (ETFs). Composed of stocks and bonds from a particular sector or country, ETFs diversify risk like mutual funds through a large number of holdings. Given that most ETFs track an index, management fees are considerably lower than those charged by most mutual funds.

Managers with conservative, low-fee approaches are the kind we are going to have to look for, or emulate, in the post-go-go years.