Could your 401(k) company go broke?

Layoffs are sweeping the 401(k) industry as its assets shrivel. Already, the cuts include the kind of people who keep your plan's records, and they threaten those who actually pick the stocks and funds you're invested in.

Should you worry about them going bust?

For the most part, your 401(k) is probably safe from this worst-case scenario. But as the industry rebuilds, funds within your plan will disappear, managers will change, and you'll have to pay extra attention to make sure your money is being promptly put to work. Life as a 401(k) investor is going to get harder.

How to plan your 401(k)

There are other, bigger threats you need to watch as well, because 401(k) plans are hurting.

Your 401(k) could be sitting mostly or entirely in your own employer's stock. Despite ample evidence of the danger -- remember Enron, anyone? -- this is still the biggest mistake people make in company-sponsored 401(k) plans.

The biggest 401(k) mistakes

And of course, your 401(k) has probably been wounded by the bear market more than you could have imagined one year ago, and it could fall more. But markets will eventually rebound, and so will your 401(k).

The downturn has brought with it a toxic stew of anxiety that borders on panic, which affects you as an investor and your employer as a business.

"Individuals have reduced their contributions, companies have reduced their matches, and people are borrowing from the 401(k) plans, all of which is not good," says Geoff Bobroff, a consultant to mutual fund directors. "They need to be focused on rebuilding that wealth and not siphoning it off prematurely."

Your 401(k) company's warning signs

But let's assume you and your boss are stalwarts, and money keeps moving into your 401(k).

You now need to be vigilant for red flags that signal diminishing services, both in administration and investment management. Even at small plans, most routine services are heavily automated, but hand-holding -- time on the telephone with service agents who handle questions and resolve complaints -- is not.

Similarly, the first step in the 401(k) process, which is transferring your contributions from your paycheck to the plan administrator, is probably done in your employer's back office, where cutbacks might also be under way. You should be watchful for any sign of a lag in getting your money put to work, and you shouldn't tolerate delays longer than seven days.

Finally, keep a close eye on the funds you own. As assets shrink, small or unprofitable mutual funds will liquidate, confronting you with decisions about what to do with your investment in them. Left to themselves, the fund companies will transfer those assets into another of their own funds, whether or not that fund is a good fit for you.

If, like a lot of investors, you review your 401(k) results only once or twice a year, the inattention could cost you.

Calculator: How much can you save?

The big 401(k) problems

Woes in 401(k) plans start with company stock. Many employees of companies felled by the financial crisis have seen their nest eggs savaged and in some cases erased. Some participants in the 401(k) of Countrywide Financial, a mortgage lender since absorbed by Bank of America (BAC, news, msgs), have sued over matching 401(k) contributions that Countrywide made in the form of its own stock. The worth of that stock, of course, withered in the subprime meltdown.

The stocks of companies such as Bear Stearns and Lehman Bros. (LEHMQ, news, msgs) were also blasted by their failures, so employees holding a lot of either stock are now facing big holes in their portfolios as well as lost jobs.

At the same time, the stock market is suffering one of the steepest declines since the Great Depression, and the mutual fund industry, mainstay of the 401(k) marketplace, is hemorrhaging assets. They plunged $2.707 trillion, or 22%, in the 12 months ending Oct. 31, according to the Investment Company Institute. That's mainly due to the market crunch; overall, money is still flowing into 401(k) plans.

Because they earn more fees for managing more money, investment firms have suffered financially as assets have fallen. In response, a host of them are planning or making layoffs, many of them huge. Legg Mason Capital Management has slated furloughs of as many as one-third of its 147 employees. American Century Investments is sending pink slips to nearly 270 workers, or 17% of its work force. Fidelity Investments, the largest administrator of corporate 401(k) plans, is cutting 3,000 jobs, or 7% of total employment.

Legg Mason aside, most of the announced layoffs involve back-office workers -- and the back office is what runs retirement plans. Smaller staffs necessarily mean diminished services, although technology is blunting that impact.

At Vanguard Group, for example, 69% of all 401(k) transactions were processed over the Internet in 2007, including more than 80% of all exchanges and contribution allocation changes, according to a spokeswoman. Vanguard has not laid off workers and says it doesn't plan to.

Who's managing the money?

More worrisome are changes that affect investment management. The Legg Mason employees losing their jobs worked for Bill Miller, the manager of Legg Mason Value Trust (LMVTX, news, msgs). Once a nearly godlike figure who beat the market for 15 consecutive years, Miller lost his golden touch in 2006, and his funds have collapsed since. This year, as of Dec. 3, his fund was down 59%.

Assets have fled as performance has faltered, to $4.31 billion now from $11.95 billion as recently as 2004.

Miller's experience is extreme, and his fund has been hurt far more than most, both in the fund universe and in 401(k) plans. For what it's worth, I never recommended this fund when it was hot -- its expense ratio of 1.68% is unconscionable. But I wouldn't sell it if I owned it. Miller isn't suddenly stupid; the whole world has gone a little mad. He'll come back.

Cutting costs is now key

That said, the entire industry is under enormous pressure to stanch the flow of red ink. With the average big-cap equity fund down 41.7% in the last year, according to Morningstar, cost cutters are going to begin using their long knives at some point.

First to fall will likely be managers of money market funds. With interest rates at 1% and possibly headed lower, such funds are yielding barely more than 1%. If they hit that mark, small funds, in particular, will be forced to close because they can't cover expenses.

Next would be managers at second- and third-tier firms, smaller than the 401(k) giants Fidelity, Vanguard and American Funds. The majority of mutual fund complexes are boutiques that operate only a few funds, often in niches such as technology, emerging markets and small-company stocks. Anyone whose name isn't on the door is vulnerable.

Just last week, the Utopia mutual fund boutique of Traverse City, Mich., announced that this month it will liquidate its four funds, which have total assets of less than $100 million.

In addition to miserable performance, Utopia was afflicted with a new special tax, unique to Michigan, that taxes interest and dividends at both the fund and investor levels.

Already threatened with the collapse of the bloated automobile industry and disgraced by a philandering former mayor of Detroit, "it seems like the goal of Michigan is to see how many businesses they can send out of state," groused Paul Sutherland, Utopia's chief investment officer.

Last to go as 401(k)s cut costs would be superstar managers and management teams, such as those at American Funds. But they represent a small fraction of the total industry, and even investors in top-tier funds usually supplement those funds with niche boutique offerings.

The likelihood that many of the funds you own or your 401(k) plan will go broke is still close to nil. Plan assets belong to participants, including money that employers have contributed via company matches, subject to vesting rules. A plan is a separate legal entity from the company that sponsors it; even if your company fails, you should suffer only market losses (which can, of course, be substantial).

And when a fund house such as Utopia does go out of business, investors still get money back. But since this would usually happen after huge market losses, they may get back much less than they put in.

The mutual fund bloodletting

The implications of widespread layoffs at actively managed mutual funds could be to condemn many of them to extinction. Active management is already under threat by exchange-traded funds, the lowest-cost index funds yet created, as investors decide the added cost of a savvy manager too often doesn't pay.

You still can't buy ETFs in a lot of 401(k)s, but mutual funds that simply track indexes are widely available. So far this year, as of Dec. 3, both Vanguard 500 Index (VFINX, news, msgs) and Fidelity Spartan 500 Index Investor (FSMKX, news, msgs) have outperformed more than 66% of similar large-company stock funds.

Ironically, among the mutual funds most likely to survive would be the very worst ones -- those managed by brokerage firms, banks and insurance companies. These funds are sold aggressively by huge networks of brokers and insurance agents whose livelihood depends on flushing them into, particularly, small and not-for-profit pension plans. In general, their performance is terrible.

The job is yours

All of these pressures put a greater burden on you to maintain control of your retirement kitty.

Should you abandon your 401(k)? Almost certainly not. You have excellent protection against misdeeds. Federal regulations provide harsh sanctions for abuses of plan participants, and the Department of Labor undertakes regular enforcement action. The Supreme Court recently allowed individual plan participants to sue over abuses they suffer; previously, only class-action suits were allowed. Also, 401(k) assets are protected from creditors, while individual retirement accounts and other individual accounts are not.

Rather, you should monitor your plan closely, looking for warning signals such as poor service and relative performance. Don't hesitate to complain. And complain especially about any delay beyond seven days in transferring contributions into plan investments, which courts have defined as the limit.

Whenever possible, sell your company's stock down to the minimum allowed by the plan. Even if the price is depressed, as it surely is, company stock is a bad investment because it ties your job and your retirement into the same package; lose the company, and you could lose both.

One of the smartest steps you can probably make right now is to dump stable-value funds, whose returns are puny, in favor of domestic stocks and high-quality bonds, particularly corporate and mortgage bonds, all of which have seldom been as cheap in modern financial history.

I'm betting the bear market reached absolute bottom in November. Even if it didn't, it has to be close. We're already in as bad a shape as markets got in 1973-74 and 2000-02. It will become easier for prices to climb out than to dig deeper into this trench we all occupy at the moment.

Meet Middleton at The World Money Show

MSN Money's Tim Middleton will be among more than 100 investment and finance experts sharing their advice on what to buy and sell in 2009 at The World Money Show in Orlando, Fla., Feb. 4-7. Invest four days dedicated to planning and refining your portfolio by attending some of the event's more than 300 workshops and panel presentations.

Admission is free for MSN Money readers. To sign up, call 1-800-970-4355 and mention priority code No. 012661, or register online.

At the time of publication, Tim Middleton didn't own or control shares of any stocks or funds mentioned in this article.

Published Dec. 9, 2008