When it comes to 401(k), mutual fund class matters!
Normal practice for 401(k) plan providers is to offer an investment lineup of mutual funds in multiple share classes. All of these share classes hold the same underlying securities and management but are offered to investors with different fee structures. Although this may be a convenient method to compensate selling agents, brokers, and record keepers, employers are required to make the lowest cost shares available to their plan so that participant returns are not negatively impacted by avoidable expenses.
Understanding the information available in a mutual fund prospectus and various fee disclosures is essential for employers to properly evaluate share classes offered to employees in a 401(k) plan. This information should be reviewed annually because mutual funds make frequent changes to share class fees. However, some basic education regarding mutual fund fees is necessary to properly complete this process.
Mutual Fund Fees: A Crash Course
Registered investment companies are compensated by charging both shareholder fees and operating expenses for their services. Shareholder fees apply to individual transactions and account maintenance while operating expenses are based on regular and recurring fund expenses. Mutual funds legally must be offered by a prospectus clearly disclosing these fees for all share classes, greatly simplifying the process of fee comparison for potential investors.
Shareholder expenses can include the following:
Sales loads: A fund offered with a sales load is basically a commission offered to a broker or agent. A “front-end” sales load reduces the amount available to purchase shares. A “back-end” or deferred sales load reduces the proceeds available from a redemption of fund shares.
Purchase Fees: These are similar to a front end sales load, the difference being that proceeds are paid to the investment company as opposed to a salesperson. The intent of purchase fees are to offset any costs involved in the purchase of shares.
Redemption Fees: In a like manner, these fees are similar to deferred sales loads, with the proceeds paid to the investment company to offset expenses involved with the sale of shares.
Account Fees: These are charged by some funds for falling below a minimum balance.
Exchange Fees: Some mutual fund companies may charge a fee for exchanging shares of a fund for those of a different fund managed by the same company.
Operating expenses can include the following:
Management Fees: These are fees paid out of assets to compensate the fund for portfolio management services.
Distribution and/or 12b-1 Fees: These fees are paid out of fund assets for the market or sale of shares, usually as compensation for brokers or agents who sell the fund’s shares. 12b-1 shares are named after an SEC rule that authorizes their use.
Other expenses: This category includes expenses other than those listed above. They can include transfer agent, legal, administrative and custodial expenses.
Revenue Sharing and 401(k) Investment Lineups
Mutual fund companies typically use share classes which include non-investment related fees to compensate agents of broker dealers and certain non-fee based advisors for including their funds within a 401(k) lineup. They are also utilized as a way to compensate other plan providers such as record-keeping firms and third party administrators. These compensating arrangements allocate a percentage of the total operating expenses charged by the mutual fund to plan participants in two general forms:
12b-1 Fees. These payments are usually made to a broker in exchange for providing plan services and for simply recommending that the plan utilize a certain fund and share class. They are disclosed in the fund’s prospectus as “distribution and/or service 12b-1 fees.”
Sub-Transfer Agency Fees (also referred to as “Sub-TA” fees): These payments are usually made to a 401(k) plan recordkeeper to subsidize or pay for those services. They increase “Other Expenses” and are included in the fund prospectus as estimates. In order to determine the actual amount being charged against plan assets, employers must reference the annual 408b-2 fee disclosure prepared by the plan administrator.
These additional fee sharing arrangements are known in the 401(k) industry as revenue sharing. Funds that offer revenue sharing typically are offered in a greater number of share classes, with each share class paying a different rate. And because 12b-1 and sub-TA fees are not related to actual investment expenses, they are often buried in the fine print of fee disclosures and fund prospectuses.
Share Classes and Investment Returns
To see the impact of various share classes on investment returns, I have included the following information from the November 1, 2019 prospectus for the Growth Fund of America, managed by Capital Research and American Funds Group.
Although this fund is offered in many additional share classes for individual investors, 401(k) plans usually include one of the 6 “R” share classes. I have shown only three of these 6 share classes below for purposes of illustration:
As you can see from the above table, R1 shares pay the highest 12b-1 fees, while R6 shares pay none at all. That means that R1 shares of the fund have significantly higher operating expenses than those of the R6 shares due to the additional fees which are deducted from participants holding these shares. These fees are paid to brokers who provide certain services to the plan and its participants.
Revenue sharing arrangements among retirement share classes present a very real fiduciary issue for plan sponsors. The reason? Fiduciaries are required to make the least expensive fund shares available to their participants. And as illustrated below, revenue sharing arrangements within share classes often have a devastating impact on investment results.
R1 vs R6 Shares: Do the Math!
Let’s take a look at a comparison of a participant who begins saving $10,000 a year at age 30 and who continues to invest this sum annually in the American Funds Growth Fund of America R1 shares. At age 65, he/she would have accumulated a balance of $1,728,850 assuming that the shares compound at the current lifetime rate. On the other hand, had the participant been offered the same fund’s R6 shares with lower expenses, he/she would have accumulated a far greater balance of $6,909,670. This represents a jaw-dropping difference of $5,180,820!
Employers Should Pay Attention to Share Class
When shopping for a 401(k) plan, employers should pay careful attention to share classes, since they have a meaningful and direct impact on retirement outcomes for participants.
They should also avoid advisors or brokers who are compensated by revenue sharing arrangements such as 12b-1 fees, since clear and obvious conflicts of interest exist between those advisors and plan participants.
If you are an existing plan sponsor not sure how your plan providers are compensated, you need to take a closer look at what share classes are offered in your plan. You may be paying more than you should.
Today, there are multiple low cost, open architecture platforms that allow institutional and retirement share classes free from 12b-1 and sub-TA fees. If your platform does not, it may be time to switch to a new provider.
At Strategic Retirement Partners, we avoid revenue sharing fee structures and are paid a flat fee based on total plan assets. If you would like a free evaluation of your plan fees, give us a call. We can help!
Brian C. Rall
President – Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
[1]Source: November 1, 2019 Prospectus, Growth Fund of America
One of the strongest features of a well-designed 401(k) plan is the ability of participants with higher levels of compensation to make significant contributions to a qualified retirement plan (up to $56,000 annually plus an additional “catch-up” deferral of $6,000 for those over the age of 50). This provides both meaningful tax benefits and allows the investment returns on these contributions to cumulate tax-free while they remain in the plan. The result is annual tax savings and significantly larger balances for employees at retirement.
One of the strategic ways where highly compensated employees can reach these maximum thresholds is through a discretionary profit sharing feature. The IRS rules allow employers to decide both whether a contribution will be made for a given year up and the amount, allowing them flexibility year to year based on their business results.
Profit Sharing Contributions: The Basics
Flexible Vesting
401(k) profit sharing contributions, in addition to being discretionary, are considered a type of “non-elective” employer contributions. This means that employees who may not be deferring into the plan are still eligible to receive contributions made to profit sharing. Profit sharing contributions also have added flexibility for the employer as they can be made subject to a vesting schedule – up to a 3-year cliff or 6-year graded. For organizations which may have short-tenured employees, this can involve forfeiture of these benefits upon termination, further lowering the overall cost to owners for utilizing a profit sharing feature.
When to Choose Profit Sharing
Because of the discretionary nature of profit sharing contributions, they can be a great choice for startups, companies with erratic profitability or those who frequently make corporate acquisitions.For professional organizations such as medical practices and certain law firms with stable or increasing cash flows, profit sharing contributions can be pivotal in achieving certain plan goals, including the following:
Allowing certain HCE’s to increase total annual contributions up to the legal limits (described above).
Giving your lower paid staff and administrative employees (whose loyalty greatly benefits the organization) a base retirement benefit.
Attracting and recruiting top employee talent through a generous retirement benefit.
To be clear, profit sharing contributions are not always good choice for every 401(k) plan. Matching contributions may be a more effective way to go for those plans whose primary goal is to incentivize a high percentage of employees to participate in salary deferrals.
Further, not all employers will qualify for the most flexible allocation methods due to IRS nondiscrimination testing limits and the demographic makeup of its workforce. But for many professional service firms, profit sharing contributions can be an extremely valuable tool to achieve plan goals.
Profit Sharing Allocation Methods
For professional firms such as legal and medical practices, achieving these upper limits of participant contributions for the highly compensated employees (HCE’s) of the practice without unfairly discriminating against those designated by ERISA as non-highly compensated (NHCE’s) involves choosing among a variety of methods by which to allocate the total annual profit sharing contribution. By comparing the resulting impact of each method and then combining it with other 401(k) features such as matching contributions, an overall plan design can be customized to best achieve plan goals.
When employers choose to “turn-on” the profit sharing feature of their plan, they can allocate these contributions using one of the following methods:
Option #1: Pro-Rata or Salary Proportional
This formula is the most basic and serves as the default allocation for many 401(k) plans. With pro-rata allocation, each participant receives an allocation equal to a uniform percentage of his or her compensation. This salary proportional method is a good choice given that the employer wishes to provide an easy to understand retirement floor for employees. It’s obvious drawback is that it may be significantly more expensive formula for those companies which want their highly compensated partners to max-out their retirement contributions.
Option #2: Permitted Disparity / Social Security Integrated
Unlike easier to understand methods such as pro-rata, permitted disparity allocation formulas are a bit more complex. This option is also referred to as Social Security Integration in that it recognizes that Social Security retirement benefits are provided only up to compensation at or below the Social Security Wage Base ($132,900 for 2019; $137,700 for 2020). This formula specifically allows additional plan contributions for employees whose annual compensation may exceed that level (termed “Excess Compensation”).
There are two steps to determining the contribution using Permitted Disparity or Social Security Integration:
Step 1 – A uniform percentage of total base pay, referred to as the “base percentage”, is allocated to all eligible participants. This would include those eligible but not actively deferring a portion of their own wages into the plan.
Step 2 – A uniform percentage of Excess Compensation is allocated to those eligible participants whose compensation exceeds the Social Security Taxable Wage Base (SSTWB) in effect for that year. This excess percentage cannot exceed the lesser of the base percentage or 5.7%.
For example, Curtis is a partner of ABC Law and earns $200,000 in 2019. Curtis would have excess compensation of $67,100 in that year ($200,000 – $132,900). If the base percentage set for the plan were 10%, Curtis would receive a profit sharing contribution of $23,825based on the formula as follows:
Total Compensation X 10% ($200,000 X .10) = $20,000
+Excess Comp X 5.7% ($67,100 X .057)= $3,825
Total Contribution$23,825
It should be noted that it is also possible to integrate the allocation at a level below the SSTWB. Doing so, however, would result in a reduction of the maximum excess contribution percentage.
This permitted disparity allocation formula should be considered for plans wishing to increase contributions for high income employees while insuring that the plan will also pass IRS nondiscrimination testing.
Option #3: New Comparability
The new comparability method uses the time value of money as a basis to allocate larger contributions to older participants who are closer to retirement. It is also the most flexible type of profit sharing allocation formula in that it allows employers to allocate contributions at multiple rates to different employee groups. This added flexibility allows employers to allocate larger contributions to business owners or other highly compensated employees (HCE’s).
The first step for determining the allocation for a given year involves dividing eligible participants into employee groups referred to as “allocation groups”. Participants are placed into various groups to maximize flexibility and employers are permitted to determine the amount of the total profit sharing contribution to allocate to each group.
NHCE’s are required to receive a minimum “gateway” contribution that is the lesser of the following:
5% of compensation
One third of the highest percentage allocated to any HCE
The next step is to project these contributions as a benefit at the plan’s normal retirement age (usually age 65) and cross-tested to confirm that the future benefits to be received by HCE’s is not disproportionately higher than the future benefits to be received by the NHCE’s on a percentage basis. This cross-testing can make a 15% contribution to a 55 year old employee with 10 years to retirement as relatively valuable as a 5% contribution to a 30 year old with 35 years to retirement. If the HCE benefits fall outside of the acceptable range, the company can correct by increasing the contributions for NHCE’s, reduce the contributions for HCE’s, or a combination of both.
Importantly, the effectiveness of new comparability is highly sensitive to the demographic composition of a company’s workforce. However, if one of your primary plan goals is maximizing business owner contributions at the lowest total cost, a new comparability formula may be a great option.
Due to the “cross-testing” required for determining new comparability allocations, companies with older business owners are often the best candidates for new comparability. A spread of 10 years between owners and NHCE’s often allows these employers to maximize owner contributions while limiting NHCE contributions to the “gateway minimum”. Often the annual tax saving to owners utilizing this method exceeds the additional non-elective contributions made on behalf of lower paid staff.
Changing Methods: What You Need to Know
Allocation formulas may be changed from year to year based on changing company demographics or profitability. However, it is important that the plan document specify the allocation method to be used for any particular plan year. The general guideline for making an allocation change is by the end of the year for which the contribution will be made. If you are considering making a profit sharing contribution this year, you should have SRP run an illustration of how the various methods would work for you and amend your plan document accordingly prior to December 31, 2019 (or the last day of your current plan year). Amending your plan’s profit sharing method will in not commit you to electing profit sharing contribution for the current year.
Call Us for a Customized Illustration
Profit sharing contributions are flexible and allow plan sponsors meet a variety of plan goals. You should understand your options in order to decide whether to implement them for your plan. Give us a call and we can provide you with an illustration tailored to your company.
Brian C. Rall
President-Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
I regularly get calls from legal firms, medical and dental practices and CPA’s looking to set up a company sponsored retirement plan. Not surprisingly, they usually want a plan that is simple to administrate and is low cost. Congress has established several types of retirement plans in addition to 401(k) that are intended to be easy for small businesses to implement and maintain. This article will attempt to highlight the similarities and differences between 401(k), Simplified Employee Pension (“SEP”) and Savings Incentive Match Plan for Employees (SIMPLE).
Although both SEP and SIMPLE plans require minimal documentation, no annual testing and limited government filings, each imposes some additional limitations that often lead to a regular 401(k) plan being a more cost effective solution.
The Size and Goals for Your Plan
Employers of any size are allowed to implement 401(k) and SEPs. SIMPLE plans are limited to companies of 100 or fewer employees with a minimum of $5000 compensation during the immediately preceding year. It is also important to determine whether the plan goals are to benefit more highly compensated partners and owners, or primarily to help rank and file employees save for retirement.
Exclusive Plans
A SIMPLE plan must be the only plan maintained by an employer in a given calendar year. This is important when transitioning a SIMPLE to a 401(k) plan in that the earliest a 401(k) can be established is January 1 of the subsequent year given that adequate notice of termination is provided to employees (not less than 60 days prior to year-end).
401(k) and SEP plans are not subject to this exclusivity restriction, allowing employers more flexibility to maintain multiple plans or to transition from one plan to another.
Eligibility
Flexibility in regard to eligibility requirements is a key feature of 401(k) plans, with employers allowed to restrict up to age 21 and completion of one year of service. A year of service is further defined as a twelve consecutive month period in which the employee works a minimum of 1000 hours.
In a SIMPLE or a SEP, this flexibility is lost. SIMPLE plans are able to limit eligibility to employees who have earned at least $5000 in compensation in the prior two years and are reasonably expected to do the same in the current year. There are no service eligibility exclusions. SEPs can limit plan coverage only to those employees who have earned at least $550 in compensation in at least three of the past five years. Importantly, there is no ability to exclude short-term or part-time employees if they meet this requirement. This often makes these plans more, not less, expensive for employers than a traditional or safe harbor 401(k).
Employee Contributions
Salary deferrals are not allowed in SEP plans unless they were established prior to 1997. While both 401(k) and SIMPLE plans allow employee deferrals, there are some critical differences.
The first is in regard to the limits to total annual deferral limits. A 401(k) participant is allowed to defer up to $25,000 per year ($19,000 plus an additional “catch-up” deferral for those age 50 or older). SIMPLE participants are capped at $16,000 ($13,000 plus $3000), a whopping $10,000 less than 401(k). Do the math! For business owners or partners in higher tax brackets, the tax savings alone often offset the additional cost of a 401(k) plan not to mention hundreds of thousands of additional retirement benefits at retirement age.
Employer Matching
Employer contributions are mandatory for SIMPLE plans, with the option of a match or profit sharing contribution. The match option is limited to 100% of the first 3% deferred by the employee. There are no additional matching contributions available.
401(k) plan sponsors, however, may elect a discretionary match, giving them flexibility from year to year whether to make a match and if so, how much. Employers who elect safe harbor provisions avoid certain non-discrimination testing restrictions by agreeing to a matching formula of 100% up to the first 3% deferred by participants, plus 50% of the next 2% deferred. This match is typically made each payroll, although some plans make a one-time match in the quarter immediately following year end.
Since SEP plans do not allow employee deferrals, matching options are eliminated by design.
Employer Profit Sharing
Employers with SIMPLE plans can elect a mandatory profit sharing contribution of 2% of compensation for each eligible employee rather than making the required matching employee contributions. This makes it easier for many employers to estimate the total employer contributions required.
Both SEPs and 401(k) plans allow discretionary profit sharing contributions of up to 25% of compensation, limited to the lesser of 100% or $56,000 in 2019. As an alternative to the tiered safe harbor match for 401(k) plans, a non-elective safe harbor profit sharing of 3% may be made on behalf of all eligible employees.
SEP contributions must be uniform, or pro-rata, for all eligible employees. An employer or owner contributing 10% of pay for himself or other key employees must also contribute 10% to each eligible employee. 401(k) plans on the other hand allow owners much greater flexibility to discriminate higher profit sharing allocations to those who earn more than the taxable wage base or target contributions based on job classification. These allocation options include age weighted, Social Security integration and new comparability. These profit sharing options make 401(k) a much more popular option for attorneys, physicians and dentists who benefit from the ability to maximize deferrals and tax savings.
Additional Tax Savings for Partners & Owners
In addition, a separate “cash balance” added to a traditional or safe harbor 401(k) plan may be established in organizations with strong and predictable cash flow and where owners, partners and other highly compensated employees wish to increase their annual pre-tax contributions. These plans enable certain targeted participants the ability to contribute up to a total of $280,000 annually, depending on age and annual compensation. I plan to discuss these plans in greater detail in future articles so stay tuned to the blog or give me a call for further details.
Vesting Considerations for Employer Contributions
A 401(k) plan can impose a vesting schedule of up to 6 years on employer contributions other than those which are designated as safe harbor. (All safe harbor employer contributions are immediately vested.) This can be an advantage to a plan sponsor who has higher turnover among its lower paid employees.
There is no such vesting flexibility with SIMPLE or SEP plans, making them less effective than 401(k) in regard to retaining key employees.
Loans and In-Service Withdrawals
401(k) plans are the only employer sponsored retirement plans that offer participant loans.
A participant taking an in-service withdrawal from 401(k) prior to age 59 ½ are subject to regular income tax plus a 10% early withdrawal penalty. SEP distributions in most cases are treated similarly. Withdrawals or rollovers from a SIMPLE, if made within the first two years of participation, are subject to a 25% penalty. This potential negative impact should be factored in both to decision and timing of terminating a SIMPLE.
Plan Documents
All of these plan types require some form of documentation. For plans that that can be standardized (i.e. no creative plan design, controlled or complex ownership) the IRS has forms available that you can adopt:
Form 5305 – SEP
Form 5304 – SIMPLE: This allows each employee the option of selecting his own custodian and financial institution. This means that a company of 10 employees may have to send contributions to 10 different custodians each pay period. This is clearly not simple!
Form 5305 – SIMPLE: Employer selects a single financial institution for all plan contributions.
Plans such as 401(k) or more customized SEP/SIMPLE plans typically adopt a pre-approved prototype format or an individually customized plan document. Many providers offer prototype plan documents that can appear to be straight-forward, but given the importance of the plan document, we recommend working with an advisor with expertise in plan design.
Annual Discrimination Tests
Both SEP and SIMPLE plans are exempt from most annual compliance testing, with the exception of minimum coverage requirements for SIMPLE plans. This is one of the reasons that administrative costs are lower for these plans.
A traditional 401(k) plan which has not adopted safe harbor matching or profit sharing provisions must comply with a series of compliance tests that ensure that employer contributions and the percentage overall invested assets associated with lower paid, rank and file employees are adequate. Although testing adds to administrative expense and complexity, the trade-offs for a well designed 401(k) plan may more than pay for this additional cost. Such trade offs include higher annual contribution limits and tax saving, employer profit sharing and lower investment fees.
Government Reporting
401(k) plans of all sizes must file an annual Form 5500 report with the DOL each year. In addition, most plans with more than 100 employees are required to perform an annual audit of the plan, adding to administrative costs. Those plan sponsors with terminated employees which continue to maintain a balance in the plan must also file form 8955-SSA.
Neither SEP or SIMPLE plan sponsors are subject to these filing requirements. However, plan sponsors must monitor and comply with participant reporting requirements related to required minimum distributions at age 70 ½ and other in-service withdrawals. Because monitoring participant accounts with multiple custodians is next to impossible, compliance is a real headache for plan sponsors of SIMPLE plans.
Plan Investments
Although there a few exceptions, financial providers of SIMPLE plans often offer mutual funds with front end or deferred sales loads that may range as high as 5%. In many cases, they offer proprietary funds that are subject to revenue sharing arrangements that offer them additional hidden compensation. In short, participants are treated as retail accounts and therefore the quality of financial advice to participants is subject to the lesser standard of suitability. In contrast, the fiduciary standard for an experienced, fee-based 401(k) advisor is a much higher level of prudence. Finally, fee disclosure requirements for SIMPLE plans are not uniform and transparency can vary significantly depending on the provider.
SEP plans are often invested in individual financial instruments subject to the restrictions of the plan document itself or the investment policies of the account. In most cases, participants do not self-direct their individual investment accounts or are offered standardized investment allocations with limited options to change during the plan year. As is the case with SIMPLE plans, fee disclosure transparency is often a huge downside.
Depending on the provider that you choose, 401K typically offers greater flexibility with regard to investment options. Although some bundled providers such as mutual fund companies or insurance companies offer more expensive mutual fund share classes or high-cost variable annuity products as turn-key solutions, there are many terrific, low-cost providers today who offer flexible “open-architecture” investment platforms. These designs permit lower cost, institutional share class funds and include both actively managed as well as passive index fund options that are superior to most of those offered through SIMPLE platforms. In general, plan sponsors should use only those providers that they understand and who are transparent about their fees.
Transitioning to 401(k) can offer significant investment cost savings both immediately and over longer time periods. Working with an experienced 401(k) advisor acting as a plan fiduciary is highly recommended to achieve both positive participant outcomes and a well-documented investment process.
What Plan is Right for My Practice?
There is no question that a company sponsored retirement plan offers significant benefits including individual tax saving, employee recruitment and retention of key employees. For most law firms, physician and dental groups, a well designed 401(k) offers these important employee benefits and pays for itself through tax savings at a fairly modest level of owner participation.
For established firms or practices with highly compensated owners or partners who wish to contribute more of their compensation pre-tax for retirement, the addition of a defined-benefit cash balance plan can offer huge benefits and more than pay for the additional administrative expense.
However, if your retirement plan goal is to offer a payroll savings plan which primarily motivates lower paid employees to save for retirement, a SIMPLE may be your best option, despite it’s clear limitations. On the other hand, if you are considering transitioning from a SIMPLE to a 401(k), you should understand the steps necessary to be compliant and attempt to avoid possible distribution penalties and rollover restrictions.
If you are shopping for a plan, give us a call. We can help you put the pieces together that will result in the best plan for you and your employees!
Brian C. Rall
President – Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
In the past 30 years, I have had the opportunity to review hundreds of 401k plans sponsored by small to mid-sized employers. Although none of these plans are exactly the same, they can generally be characterized as falling into one of two categories: a product or a service. In almost every regard – investment options, plan design, plan costs and customer service – the best plan providers offer services at a much lower cost than providers who treat 401k as a product.
When I began my investment career in the early 80’s, cost effective 401(k) provider options for employers with few or no assets were limited to large mutual fund families and insurance companies. The business and tax advantages which motivated employers to sponsor these plans was a significant opportunity for providers who had expertise in offering pooled investment options (i.e. Mutual funds), data management (i.e. insurance companies), or both. Therefore, it was not surprising for these providers to treat 401(k) plans as a one-size-fits-all product, restricting investment options to proprietary funds (expensive) and to streamlined plan designs which featured hidden fees and were easier to administer.
As a plan sponsor, it is important to know whether your current providers treat your plan as a product or a service. Providers who treat 401k as a product have restrictions that lead to higher fees, lower plan returns, lower participation and poor customer service. While providers who treat 401k as a product are still very common, they should be avoided at all costs. On the other hand, providers who treat 401k as a service have fewer investment restrictions, consultative plan design and personalized customer service.
So how does your plan stack up? I would suggest the following 5 criteria will indicate whether your current plan provider treats 401(k) as a product or a service:
1. Restricted Investment Choices vs. Open-Architecture Investment Platforms
Mutual fund companies that bundle recordkeeping and/or administrative services with investment management typically restrict their plan investment choices to proprietary funds as opposed to the top funds available for each investment category. Often, these funds have hidden fees and higher expenses than more competitive funds. Insurance companies typically offer insurance products such as variable annuities with higher wrap fees and other expenses but disguised as mutual funds. Payroll companies often sell plans with pre-set investment options that are sponsored by both mutual funds and insurance companies. These pre-set plan lineups streamline their setup and administration yet represent less competitive investment choices and higher costs to participants. Plans like this are a product.
On the other hand, many independent record-keepers offer impartial investment fund advice through “open-architecture” platforms. These platforms allow plan sponsors or their advisors to access investment options based on quantifiable values of performance, volatility, fees and other criteria. They also allow access to index funds and target-date funds with significantly lower expenses than actively managed funds. Fee based advisors love open-arch platforms because they provide more fund choices at lower cost. These plans offer 401(k) as a service.
2. Retail vs. Institutional Share Classes
The mutual fund industry has evolved over the years in response to fiduciary concerns regarding fees. Share classes are essentially financial agreements between the fund company and the distributor of the fund (a broker, advisor or a retirement plan). As a result, investors can pay very different prices for the same fund depending on which share class they select. If your fund offers share classes other than R (retirement plans) or I (institutional) shares, you probably own “retail” shares and are paying higher expenses than you should. Ask your provider if these share classes are available for funds offered in your plan. If not, your plan is a product.
3. Hidden vs. Transparent Fee Structure
A 2015 study of 4,368 active retirement participants revealed that 58% did not know that they were paying fees on their employer sponsored retirement accounts. Translated, that means that nearly 40 million participants in qualified plans have little to no clue about plan fees. And for those that did know that they were paying fees, only one in four could accurately answer how the fees were calculated.
In my opinion, most of the confusion for participants involve indirect or hidden fees that are imbedded in the expense ratios of the plan investments. These can sometimes be difficult to identify and include revenue sharing arrangements with providers such as 12(b)1 fees and wrap fees associated with insurance plans. It is not uncommon to see indirect fees of over 1% for many bundled 401(k) plans, and even higher fees for insurance company plans. These additional expenses directly diminish investment returns and can have a profound negative impact on a lifetime of savings. Hidden fees indicate that your 401(k) plan is most likely a product. Transparent fees are an almost certain indicator that your plan is a service.
4. “Capturing A Few Signatures” vs Consultative Plan Design
A proper plan design must involve an exchange of important information between the plan provider and the sponsoring employer. This would include a recent census with hire dates and payroll information, identification of key and highly compensated employees, and understanding the specific employer motivations to establish and maintain the plan itself. Key decisions need to be made regarding employee eligibility, vesting schedules, employer match options, included compensation, contribution limits, among other important considerations.
Working with a provider who promises to set up your plan in 15 minutes by simply “capturing a few signatures” on the plan documents or checking a few boxes on a list should be a cautionary flag. You are probably being sold a product. On the other hand, working with a trusted advisor who is consultative and takes the time to guide you into the proper plan choices aligned with your business goals and values is a strong indicator that your plan is a service.
5. Call Center Support vs. Dedicated Relationship Managers
Sooner or later, you’re going to need help. It is important to understand the level and type of support available from your 401(k) providers. Those that provide 401(k) as a product offer support through call centers or require plan sponsors to open an online ticket for questions and issues. While this may work just fine for some day-to-day, non-urgent issues, when you sponsor a 401k plan there is a good chance that you will need urgent plan advice at least occasionally. The frustration and poor guidance that results from this impersonal and time-consuming support model is real and it can be costly.
When it comes to getting help with your 401(k) plan, you should choose providers who support their clients with a single point of contact where questions can be directed to a relationship manager who is accountable for a solution. Plans that offer this type of support have far fewer problems. Period. It indicates that your plan is a service, not a product.
It’s Time to Convert Your 401(k) Plan to a 401k Service!
With an increasing number of employers both scrutinizing fees and demanding higher levels of professionalism, there are far more 401(k) providers today who offer high quality services at reasonable and fully transparent fees. If you think it might be time for you to convert your “product” to a service, we can help.
Brian C. Rall
President – Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education to company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
Plan Sponsors Need to Understand the Hardship Rules
A 401(k) plan may allow participants who face certain types of financial stress or emergencies to request a distribution from their account balance. Allowing hardship distributions from your 401(k) may in fact be a plan feature that benefits certain participants who are financially distressed yet puts an added burden on plan sponsors to understand and properly implement IRS regulations. Failure to do so may subject them to severe consequences, including fines, penalties and plan disqualification.
In November of 2018, the IRS proposed changes to hardship distributions, including how and under what circumstances they could be received by participants. Beginning in January of 2019, employers were allowed to implement certain of these changes prior to them becoming finalized by the IRS.
Since I am frequently asked questions regarding hardship distributions by plan sponsors, we thought it might be helpful to review some of the most FAQ’s regarding these often misunderstood guidelines.
Are all 401(k) plans required to permit hardship distributions?
No. The decision to allow hardship distributions is an option available either when the plan is originally established or as an amendment to an existing plan. Keep in mind that individual plan demographics may work against allowing this feature if a higher percentage of participants may find themselves qualifying for these distributions.
What are the qualifications for a participant to request hardship distributions?
A 401(k) participant must satisfy two criteria in order to qualify for a hardship distribution:
He or she must have an “immediate and heavy financial need”.
The distribution should be “limited to an amount necessary to satisfy that need”.
What is the IRS definition of hardship for a 401(k) plan?
In addition to the employee’s immediate and heavy financial need, the definition includes those of an employee’s spouse, dependents and beneficiaries. Employers are allowed determine certain qualifying events of hardship under two options:
Use the IRS Safe Harbor definition.
Use a custom definition.
In the great majority of cases, plan sponsors elect to use the Safe Harbor option which lays out 6 events which qualify as a participant hardship:
Medical care for the employee, the employee’s spouse, dependent or beneficiary.
Direct costs related to the purchase of an employee’s personal residence, not including the mortgage.
Tuition, fees and room and board expenses for the next 12 months of post secondary education for an employee, an employee’s spouse, dependent or beneficiary.
Payment necessary to prevent eviction or foreclosure on a participant’s primary residence.
Funeral expenses for the employee, employee’s spouse, dependent or beneficiary.
Certain expenses to repair damage to an employee’s permanent residence.
How do we calculate the amount necessary to satisfy the immediate financial need?
The IRS regulations make it clear that the distribution may factor in the impact of taxes and penalties that may result from qualified hardship distributions. In addition, employers should make the determination that the employee could not reasonably obtain liquid funds from any other source.
In addition, employers are allowed rely on the employee’s written statement that the need cannot be relieved from other resources, including insurance or other reimbursements, liquidation of the employee’s assets, the employee’s wages after termination of all elective deferrals and plan or “reasonable” commercial loans.
What documentation should employers obtain as part of the hardship distribution application?
Employers are allowed to choose one of two options in regard to the proper documentation of all plan hardship distributions:
Traditional Substantiation:
Under this method, employers obtain the actual source documentsthat substantiate the need. This is the only method that is acceptable for non-safe harbor hardship qualification.
Summary Substantiation:
Employers rely on a written, participant-provided summaryof the hardship, provided that the summary includes certain, required information.
In every case, plan sponsors should retain these documents according to the document retention rules established under ERISA.
What are the financial consequences of hardship distributions on participants?
Hardship distributions can have severe and significant financial impacts upon participants in that they are included in gross income unless they consist of designated Roth contributions. Participants who have not yet attained the age of 59 ½ are subject to additional penalties of 10%. Finally, because hardship distributions cannot be repaid to the plan or rolled into another qualified plan, the compounding impact of future lost income due to these withdrawals can be significant.
What are the IRS proposed rule changes to hardship distribution regulations?
The IRS implemented a number of significant changes to the current hardship regulations and issued a proposal draft in November of 2018 outlining the changes. Plan sponsors were allowed to implement these changes on January 1, 2019 or alternatively, they may choose to wait until the changes are finalized.
Removal of the six month suspension rule following a participant distribution. Under current rules, participants are prevented from making contributions to the plan for a 6 month period. Employers have the option in 2019 to remove this suspension and are mandated to do so beginning January 1, 2020.
Current regulations limit the source of contributions eligible for distributions, excluding QNEC’s, QMAC’s, safe harbor contributions and earnings on elective deferrals. The new proposal lifts these restrictions. Implementation is optional, not mandatory.
Under current standards, participants are required to take a loan prior to requesting a distribution. The proposal eliminates this provision.
Employers currently must consider all relevant facts and seek relevant documentation. The proposal allows them to rely on written representations from participants that he/she has sufficient liquid assets to satisfy the need, unless the employer has knowledge to the contrary.
An additional qualifying event – expenses resulting from federally declared disasters– has been added to the safe harbor list of qualifying events.
What is the deadline for making plan changes based on the current proposed changes?
Employers can elect to rely on the proposed changes beginning this year prior to a formal plan amendment. However, the Treasury Department and the IRS expect that, if these regulations are finalized as proposed, plan sponsors will need to amend their plan’s hardship distribution provisions. As of this writing, the guidance is that most amendments will need to be made within the period ending the second year following the year that the rules have been finalized. (See section “Plan Amendments” in IRS Proposed Rule for details.)
In the interim, plan sponsors should consult their providers for guidance on implementation of these new proposed rules.
Concluding Thoughts for Plan Sponsors:
Hardship distribution provisions in 401(k) plans provide a valuable benefit to participants who may be experiencing temporary financial stress due to certain qualifying circumstances and to employers who may lose productivity from these employees. However, they put additional burdens on plan sponsors to properly understand the rules and have a process in place to implement their requirements. Best practices include proper documentation and retention for each request as well as full disclosure of the financial consequences to participants. Your plan providers should be consulted prior to giving specific guidance as they may require specific forms and disclosure documents that apply.
Plan sponsors electing to amend their plans to allow hardship withdrawals must do so during the current plan year and disclose the details of this change to participants by December 1 to have the changes take effect in the next plan year.
Brian C. Rall
President – Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education to company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
It is highly probable that your company’s 401(k) plan will be subjected to audits conducted by the DOL and the Internal Revenue Service at some point in the future. If you are not 100% certain what documents you will need, download this free copy of our “Fiduciary Audit File Checklist” and be sure!
