Ripping Off Investors… Selling Proprietary Options

aged and worn fund options

Proprietary Options aka Dominated Funds

Imagine you own a used car sales lot, and every customer that buys a car from you lets you set the price… no argument.  Ask whatever you want for the car, and your customer/buyer agrees to pay that price.  That is exactly how your 401k plan works.  Principal Life Insurance Company offers mostly proprietary options in their 401k separate accounts.  They set the price, you pay the price… simple, isn’t it?   

Principal generates HUGE profits from the sale of their proprietary options to the public.  They make so much money that their own employees decided they were getting ripped off.  They filed a class action lawsuit for charging excessive fees and offering exclusively proprietary options in their defined contribution retirement plans.

Every deposit your employer sends Principal Life for your 401k plan invests in a proprietary fund.  Until now, there was no way to know the amount of excessive fees Principal was charging your plan.  Thanks to new software being offered by RiXtrema, we can now put together a close estimate of your financial loss due to excessive fees, and in part, to the sale of proprietary options lacking diversification.  When Principal bundles proprietary funds into separate accounts, those funds will often contain closely related investments.  Through the high volume private purchase of often risky shares of stock, Principal will pay bargain basement prices for that investment.  Shares have to be divided into multiple mutual fund investments, having the same risk factor and diminished value for the investor.

 

The 401k Fiduciary Optimizer

The 40kFidicaryOptimizer, offered by RiXtrema, is designed as a selling tools for financial advisors to encourage Corporate Chief Financial Officers to consider favorable investing options for their employee’s 401k plans.  The video developed by RiXtrema to demonstrate the effectiveness of this software actually illustrated a proprietary option offered by Principal.  In this video, Principal’s International Emerging Markets Institutional (PIEIX) is compared with several other similar products… using a 10 year “horizon” generating a 7% return, an annual inflow of $400,000 a year would have an aggregate plan savings of $697,260 over 10 years.   This is a savings of 17.5%.  

The Principal International Emerging Markets Institutional mutual fund has returned -12.68 percent over the past year, -2.09 percent over the past three years, -3.96 percent over the past five years, and 2.81 percent over the past decadeWith an average return like this, why would anyone want to invest in Principal related investments?

The 401k Optimizer not only addresses fees charged by service providers , but the advisor can also identify the amount of diversification in a 401k plan.  Using a Principal 401k plan as an example, very little diversification is offered.  The plan has a diversification rating of 23, a “very poor” rating.  But fees and diversification are only the tip of the iceberg when it comes to examining investments offered by insurance companies. 

 

The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans

Dominated funds, aka proprietary funds found in separate accounts, are both expensive and poorly performing.  A large percentage of Principal’s proprietary options are offered to investors, with as many as 3 million investors holding these funds.  The Yale Law Journal recently published an article entitled Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans.”    The article provides the following Abstract to describe their findings:

“Notwithstanding ERISA’s fiduciary requirements, a significant portion of 401(k) plans establish investment menus that predictably lead investors to hold high-cost portfolios. Using data from more than 3,500 401(k) plans with more than $120 billion in assets, we provide evidence that fees and menu restrictions in an average plan lead to a cost of seventy-eight basis points in excess of index funds. We also document a wide array of “dominated” menu options, which we define as funds that make no substantial contribution to menu diversity but charge fees significantly higher than those of comparable funds in the marketplace. We argue that courts should read existing fiduciary-duty law to challenge plans that imprudently include high-cost or dominated options, even if other options are available in the plan menu. But because heightened fiduciary duties are unlikely by themselves to solve the problem of excess fees and dominated funds, we also propose three additional structural reforms. We argue that low-cost default options be made universally available, that investors be permitted to roll assets out of designated high-cost plans, and that participants be required to demonstrate financial sophistication before investing in higher-cost funds.”

In case you are wondering what a “basis-point” is, Investopedia defines it as:

“… a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form. In most cases, it refers to changes in interest rates and bond yields.

For example, if the Federal Reserve Board raises interest rates by 25 basis points, it means that rates have risen by 0.25% percentage points. If rates were at 2.50%, and the Fed raised them by 0.25%, or 25 basis points, the new interest rate would be 2.75%.  In the bond market, a basis point is used to refer to the yield that a bond pays to the investor. For example, if a bond yield moves from 7.45% to 7.65%, it is said to have risen 20 basis points.

The usage of the basis point measure is primarily used in respect to yields and interest rates, but it may also be used to refer to the percentage change in the value of an asset such as a stock. It may be heard that a stock index moved up 134 basis points in the day’s trading. This represents a 1.34% increase in the value of the index.  The easiest way to convert basis points into a percent form is by simply taking the amount of basis points and multiply by 0.0001 which will give the percent in decimal form. So if you have to convert 384 basis points into a percent, simply multiply 384 by 0.0001. This will give you 0.0384 which is 3.84% (0.0384 x 100).

This can also be done in reverse to find out the number of basis points that a percent represents by dividing the percent (in decimal form) by 0.0001. For example, say the rate on a bond has risen 2.42%, simply take 0.0242 (2.42% / 100) and divide by 0.0001 to get 242 basis points.” (Read more: What is a basis point (BPS)? | Investopedia http://www.investopedia.com/ask/answers/05/basispoint.asp#ixzz4LI9CpJi3)

 

Structural Changes in the Anderson v. Principal Class Action Settlement & Release

In the Class Action Settlement and Release involving litigation between Principal Life Insurance Company and their employees, an adjustment in the “basis points” charged by Principal resulted in an overall cost savings of over $8 million in the related retirement plans.  Other conditions included a provision for a “Brokerage Window”  of non-proprietary option offerings.  The “structural changes” in the retirement plans included the following agreements:

4.2 Reduction in Record keeping/Administrative Fees     (a) Defendants agree to reduce the amount that the Plans pay for the administrative expenses of the Plans as of the Effective Date of this Agreement, including but not limited to record keeping services, from 14 basis points to 7 basis points on a weighted plan-wide basis for each the Plans. This change results in a net reduction of 7 basis points in the overall fees charged to plan participants. This charge will apply to the current level of services provided to the Plans. Defendants will implement this reduction by changing the rate level for each investment option offered by the Plans to the rate level that does not include any amount for revenue sharing (which would result in a 14 basis point reduction from current levels on a weighted average) and charging participants an annual fee equal to 7 basis points times the amount of assets in each Plan.

(b) In exchange for Defendants’ agreement to reduce administrative expenses to 7 basis points, the Structural Changes Class Members agree to the covenants not to sue set forth in Section 6.2(a).

4.3 Addition of a Brokerage Window     (a) As part of this Settlement, the Company agrees to add as an investment option within each Plan a brokerage window, through which it shall make available a wide selection of unaffiliated, non-proprietary mutual funds (the “Brokerage Window”). The investment options
available through the brokerage window shall consist of a selection of passively managed index mutual funds. The parties acknowledge that there are many such passively managed index mutual funds available in the marketplace that are not affiliated with the Company, meaning that Settlement Class Members shall have a wide selection of unaffiliated, non-proprietary mutual funds as a result of this Settlement.  

(b) Defendants will not impose any charge on the Plans or Structural Changes Class Members for the cost of establishing the Brokerage Window or any annual fees associated with use of the Brokerage Window.

(c) Defendants agree that the cost of transactions executed through the Brokerage Window shall be limited as follows. The Company will charge (i) a fee of twenty-five dollars ($25) to each Structural Class Member for each individual Brokerage Window transaction that the Structural Class Member makes online, and (ii) a fee of thirty-five dollars ($35) to each Structural Class Members for each individual Brokerage Window transaction that the Structural Class Member makes through a representative over the phone.

(d) The Company retains the right to revise or eliminate the Brokerage Window in the event of any change in, or modification of, applicable law, including but not limited to regulations or guidance from the Department of Labor or any other applicable regulatory body.

4.4 Managed Account Service      As part of this Settlement, the Company agrees to provide the Managed Account Service presently offered by Ibbotson at cost to the Structural Changes Class Members, meaning that the Structural Changes Class Members will only be responsible for paying the amount that the Company is required to pay to Ibbotson for participating in the Managed Account Service.

A New Protocol for your 401k Plan

If you read this blog post carefully, you should come away with an obvious conclusion.  Dominated funds, aka proprietary options, are a serious health risk to your 401k plan.  Yale University cannot be wrong, Principal employees cannot be wrong, and the fiduciary community cannot be wrong.  Principal Life Insurance Company agreed to a Final Settlement with their employees based on making “available a wide selection of unaffiliated, non-proprietary mutual funds.”

The time is long overdue for an overhaul of all Principal clientele 401k plan offerings.  Principal is recognized in the 401k service industry for a widespread failure to act in the best interest of their clientele.   I have a strong affinity for 401k investors that have fallen victim to Principal’s fraudulent behavior, because I was a victim as well.  Unfortunately, most employers are profiting handsomely from their relationship with Principal, and your Employer could be one of those profiteers. 

As a Fiduciary, your employer is required by law to act in your best interest.

The law requires your employer and/or financial advisor to act in your best interest.  If you have Principal Life Insurance Company for a 401k plan provider, they are NOT meeting that responsibility.  The evidence is widespread.  This website covers the most grievous efforts by Principal to defraud their clientele.  Billions of dollars have been stolen during the past decade by Principal Executive Directors and others in elevated positions of authority.  If your employer is reluctant to take action to represent your best interest, then, like thousands of Principal employees, you have a tough decision to make.  Millions of individuals like yourself have saved through a 401k retirement plan during their working careers,  only to have it destroyed within a few months by Principal’s greed.  You have a tough choice to make, but make the right choice.  Your future will thank you.

 

 

 

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Author: Dennis Myhre

Mr. Myhre can be contacted at..... dmyhre@fiduciaryfactor.com