Often when I first talk with plan sponsors for smaller plans, it is common for them to mention up front that they are very happy with their plan. I have no problem with that. It simply means they do not want to be solicited and that they happen to be loyal to their current providers. I get it! I don’t like to be solicited either and I have loyalties with firms and individuals that have been earned over many years.
But here’s the real problem. If you are a plan sponsor with less than $2 million in assets and fewer than 50 employees, the odds are quite high that your plan may have problems. Many of these issues for small plans are clearly recognizable thru a simple review of Form 5500, if you happen to know where to look. As a professional who regularly reviews hundreds of these forms each month, it is clear to me that small plans have far more problems than larger plans.
This clearly defies common sense or accepted wisdom. After all, lawsuits against plan sponsors typically involve larger, more visible organizations such as Citigroup, Boeing or Yale University. Many sponsors of small plans place a very low probability on the prospects of being sued, so they think they have fewer issues.
“For small plan sponsors, the threat of class action litigation is the least of your problems.“
For a you as a small plan sponsor, the threat of class action litigation is the least of your problems! In practice, it is far more probable that your smaller plan will be subjected to audits conducted by the DOL and Internal Revenue Service based on compliance and fiduciary issues. Many of these are errors of omission. The poison may be different, but the pain is the same.
I once heard a famous cardiologist make the statement: “The first time most people will discover that they have heart disease is just before their head hits the pavement.” Indeed, the first time many small plan sponsors discover that their plan may have serious issues is when they are notified that the DOL has selected them for audit.
The reasons for plan audits can range from certain answers to questions in Form 5500 to possible participant complaints. Increasingly, plan sponsors are selected randomly as the DOL has staffed up to function as a revenue generating agency of the government. Regardless of the reason, audits of all plan sizes result in a loss of productivity for the organization and fines and penalties being assessed in over 80% of all cases.
Most of the issues that surface with the Department of Labor are compliance related, including testing and allocation errors, late transmittals, insufficient fidelity bond coverage, lack of adequate records, applying incorrect compensation formulas, a history of corrective distributions, late filing of Form 5500 and, of course, excessive administrative fees. The corresponding effort to correct these errors, in addition to fines, penalties and possible disqualification, present a greater challenge for small plan sponsors for a number of reasons.
Feelings Will Fool You!
When my youngest son was 11 years old, he spent the summer in a junior golf program sponsored by a local municipal course. He was fortunate to win several age group tournaments and was interested in improving his game. He was then shooting in the mid-80’s, but I knew that if he wanted to improve his skills, he needed professional instruction. We were referred to a local golf pro, Johnny Falsetto, and he and Chris started working together for one hour a week.
One of Johnny’s favorite sayings in teaching his students was the phrase, “Feelings will fool you.” During his first lesson, Johnny did nothing but observe Chris hit balls for most of the hour. After each shot, he would simply say, “Hit another one”. After 50 minutes of this, I was seriously beginning to question whether this guy actually knew anything teaching golf!
At the end of the lesson, Johnny looked up and said, “Chris, to be honest, you have more natural talent than most kids that I have seen at your age. You’re already a good player, but if you want to be a great player, there’s a couple of things that we’re going to have to change”. Then he slowly delivered the challenge, “Chris, get prepared to be really uncomfortable for a while. Feelings will fool you!” After working with Johnny for about a year, Chris was routinely shooting in the low 70’s.
A Golf Lesson for Small Plan Sponsors
I think that this message delivered in this golf lesson applies to plan sponsors of smaller organizations. “Feeling good” about your plan providers without routinely reviewing their performance is not an option under ERISA. Complacency is the cause of many, if not most, of the problems that occur in small plans. In practice, they may delegate some of this due diligence to an experienced advisor. But at the end of the day they know they are personally accountable when things go wrong.
Here are some of the reasons why I think smaller plans have more problems than larger plans.
Smaller plans have less experienced human resource staff.
Larger organizations usually have the resources which allow them greater oversight of their retirement plan. They have the budget to hire human resource officers and employee benefit specialists who are tasked with the responsibility of overseeing the administration of their retirement plan. These professionals have a greater understanding of plan administration and therefore monitor providers more closely than small firms. As a result, they are able to address and correct many administrative and compliance issues before they become real problems.
In truth, plan sponsors have no other choice but to rely on their providers because they don’t know what questions to ask.”
In contrast, the administration and oversight of smaller plans is typically performed by office managers, managing partners or company owners. They are far more likely to rely on plan providers and simply trust that they are not making mistakes. In truth, plan sponsors have no other choice but to rely on their providers because they don’t know what questions to ask.
Going it alone, without the assistance of an experienced plan advisor, is a usually a recipe for disaster.
Larger Plans Are Subject to Audit Checks
Retirement plans with more than 100 participants are required to procure an independent audit from a CPA firm. They are expensive and time consuming but must be submitted along with their Form 5500. The audit’s primary purpose is to verify the financial status of the plan. However, in actual practice, it acts as a crucial check and balance that providers are correctly doing their job. They often reveal hidden plan costs and prohibited transactions that, if uncorrected, could result in penalties, litigation or possible plan disqualification. Smaller plans have a reduced chance of these issues being discovered.
Smaller plans have limited choices for TPA providers.
Because of industry pricing, smaller plans often go with bundled providers who provide TPA services through revenue sharing arrangements. These providers are paid through hidden fees buried in higher expense ratios for plan investments or expensive wrap fees. In the attempt to make the plan costs more affordable for plan sponsors, they have simply shifted higher fees on the backs of participants. Many of these small plan sponsors insist that they pay nothing for administration when in fact their participants pay a much higher percentage for fewer services than larger plans.
Hiring a good TPA is one of the most important decisions that you make as a plan sponsor. You are ultimately responsible for mistakes, errors and fraud which may occur due to their negligence or inexperience. The good news in the small plan market today is that there are many outstanding options for TPA services which are both cost efficient and accurate.
Smaller plans are more likely to experience administrative problems.
Plans designed by payroll providers, insurance companies and bundled mutual fund companies are often sold as a product. Design errors are frequent and TPA’s for these plans are often overburdened, have high turnover and lack a single point of contact. There is nothing more frustrating for a plan sponsor than having to speak to someone new each time there is a question or a problem. Often, there is really no one to consult for accurate fiduciary guidance.
I recently discovered a local TPA for a prospective client was 6 months late in filing their Form 5500. The TPA’s excuse was the unexpected death of a spouse for the employee assigned to the task. Although a tragic circumstance for the employee, it did not excuse the TPA of the duty to their client.
A late filing for Form 5500 is a huge red flag and this client now faces a higher probability of a future audit as a result. The fines for this error are also quite punitive- up to $2,140 per day. Additional IRS penalties for late filing are $25 per day up to a maximum of $15,000 per occurrence.
Late filing is an unforced error and a “rookie mistake” for any TPA firm. Short of the client itself being uncooperative or unable to supply the needed census data, it is simply inexcuseable.
My recommendation to this client? Regardless of your personal loyalties or friendship, you have no choice but to hire a new provider.
Larger plan providers, on the other hand, generally are more independent, have more checks and balances in place and have a single point of contact which enable them to proactively avoid most common errors. Because they generally have more training and less turnover, these providers are better able to spot plan errors and self-monitor each other. Many TPA’s provide access to ERISA attorneys to further assist with correcting issues that may arise from time to time.
Small plans are more likely to hire the wrong advisor.
What I see frequently with small plans is an advisor who is a family member or acts as the personal wealth manager or financial planner for one or more of the firm’s owners or managing partners. This is a dead giveaway to me that the plan may have more serious issues.
Their qualifications often do not match up with the job requirements of a true retirement plan advisor.
Mariners pitching coach
As a way of illustrating, suppose the Seattle Mariners were to hire a successful pitching coach. Without question, they will be looking for a candidate who knows a lot about pitching. This candidate must be able to communicate clearly and can spot and correct poor mechanics before they become ingrained habits and result in poor performance. Most good candidates will be former pitchers that had good careers in the major leagues.
Now suppose the Mariners needed to fill an open position for a batting coach. Their process would focus on candidates experienced with proper swing fundamentals and similar ability to observe and correct swing flaws. Usually, the best candidates have put up consistent hitting statistics as a player.
Having hired these coaches, it would be highly unusual for the Mariners to then rotate their pitching instructors to work with hitters or conversely ask the batting coaches to work with the pitching staff. Their roles within the organization are both unique and specialized.
So too the distinction between individual wealth managers and institutional retirement plan advisors. The job descriptions for these advisors are radically different. Baseball is highly specialized. So is the investment world. An arbitrage manager and a manager for a small cap value fund both purchase stocks, but for very different reasons strategies and holding periods.
Institutional investment advisors create and monitor plan investment menus and assist plan sponsors with fiduciary guidance and participant education. Wealth managers and financial planners assist individuals to achieve their own unique financial goals. They both understand financial instruments, but their job descriptions are unique and specialized.
Watch out for advisors who have conflicts of interest.
“Try this – I just bought a hundred shares!”
Hiring advisors who are directly or indirectly affiliated with other providers can present other problems. Some TPA firms like to package their plans with advisors who are apathetic to their higher fees.
These arrangements are highly unethical yet are more common than you might assume in the small plan world.
Psst… Here are a few of the red flags that will help you identify these “advisors”:
A pre-set investment lineup with proprietary funds and revenue sharing arrangements that benefit one or more providers or certain preferred vendors. I know a local TPA that has a majority of its clients using a high priced insurance company as its exclusive recordkeeper because of revenue sharing arrangements with that company.
Failure to provide written evaluations of plan investments. At best, their actual investment advice is re-active rather than pro-active, since replacing current investments may result in reducing the advisor’s total compensation.
No investment policy statement (IPS). Although not legally required, an IPS is part of a sound fiduciary process and serves as the basis for all future investment decisions. A sound IPS would in most cases shine a light on unreasonable fees or proprietary investments which benefit providers.
Failure to actually follow the IPS. A plan which has agreed on an IPS yet does not consistently follow the process is opening itself up for future liabilities. It would almost be better had they not had an IPS in the first place. If you have one, you better follow it.
The advisor does not provide on-going education regarding plan investments to the participants as required in Section 404 (c). Simply handing out investment materials or informational brochures does not meet this standard.
In contrast, larger plans more frequently hire advisors who are both fiduciaries and specialize in company sponsored retirement plans. Smaller plans should do the same.
An independent advisor experienced in ERISA can help you in your obligation to review the performance of your other providers. He knows the right questions to ask and can keep you out of trouble.
Small plan sponsors must be diligent in their oversight of providers.
This article has pointed out a number of reasons that smaller plans tend to run into more problems than those of larger plans. But it doesn’t have to be that way.Assembling a team consisting of independent providers is a practice that will pay off in the long run for small plan sponsors.
The next time you say that you are happy with your plan, make sure that you have subjected it to a professional review.
Because feelings will fool you!
Brian C. Rall
President – Strategic Retirement Partners, LLC
March 2, 2020
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.
For the past 8 years, I have had the opportunity to help hundreds of plan sponsors to design and manage successful 401(k) plans. In my opinion, successful plans for small to mid-size employers typically display the following attributes.
1. The costs, fees and expenses of the plan are reasonable.
Understanding the importance of plan costs, expenses and fees is one of the most important duties of plan sponsors and fiduciaries. When asked about plan costs, some plan sponsors actually think their plan is free. This perception is most common when their providers are paid by hidden revenue sharing arrangements.
One of the key services I provide to employers is an annual evaluation of overall plan expenses and a determination as to whether they are reasonable. Your plan is not required to be the lowest-cost in its peer group, but if your fees fall in the highest quartile, it is a red flag that cannot be ignored.
In reality, receiving more and better services as well as retaining providers who are better positioned to help a plan achieve its goals are all valid reasons to pay a little more. Hiring a provider because he or she is a family friend or because they have provided personal financial services to the CEO or owner are not sufficient reasons and may in fact increase your fiduciary liability.
Finally, if you or your advisor is not actively monitoring plan costs and documenting the process, you need to begin to do so. To the regulators, process trumps results!
2. A high percentage of eligible employees participate in the plan.
Employers who sponsor 401(k) and other retirement plans such as defined benefit cash balance plans for their highly compensated employees have made a substantial investment of time and money to provide this benefit. The best plans should have at least 85% of eligible employees who are participating in making payroll contributions.
These plans are effective in communicating the virtues of saving for retirement. In addition, they usually feature generous employer matching contributions that incentivize participants and build in automatic enrollment options for newly eligible participants.
3. New employees roll money into the plan. Departing employees leave their balances in the plan.
The best plans have characteristics that set them apart. A plan that has an open-architecture platform which provides access to outstanding investment options and low cost share classes becomes a magnet for other retirement assets.
New employees who compare these lower cost options to “retail” IRA accounts with limited investment menus are eager to combine other qualified accounts with their company’s 401(k) plan. When these employees terminate employment, they are comfortable in maintaining their plan balances because they view management as a friend, not an enemy.
4. Employees understand the plan.
The best plans effectively communicate how the plan works to their employees. These companies are intentional in communicating the benefits of participating in their plan to both new recruits and to retain their best talent.
These employers include a clear and simple description of plan benefits, with emphasis on employer contributions, vesting schedules and professional advice available to participants. More importantly, employees who are on track to achieving their retirement goals become the strongest advocates for participation.
5. The fund design and investment lineup has a home for everyone.
There are different types of investors in every plan.
Some want to be well diversified over the core funds lineup and need professional allocation tools to achieve a successful outcome.
Index investors are interested in utilizing low-cost index instruments in a variety of asset classes to properly diversify their accounts.
Some participants are opportunistic and look for unique specialty investments in the plan.
Finally, almost every plan has a high percentage of participants who don’t want to get into the weeds of investment allocation and prefer balanced, “do it for me” default options such as target date funds.
In addition, many professional service organizations which I assist offer additional “hybrid” plans in addition to a traditional 401(k) to allow highly compensated members to boost their levels of tax-deferred savings. These individuals often find themselves behind in saving for retirement in their early 40’s or 50’s due to lower compensation levels and debt reduction needs earlier in their careers. Combining a defined benefit cash balance plan with the 401(k) becomes not only a significant tax saving tool for these members but an important competitive advantage in recruiting and retaining talent for their firms.
In most cases, the greater the number of participants in your plan, the broader and more flexible your investment menu should become.
6. The leaders in your organization talk about the plan.
This trait can sometimes be difficult to measure. Companies that care about their human capital and talent take personal pride in their benefits package. These leaders not only find a way to talk about the plan at official corporate gatherings, but plan benefits are featured as a recruiting and retention tool in their everyday conversations. Mobile apps for successful plans can be used to instantly demonstrate that leaders are not only engaged with the plan, but well on their way to a successful retirement.
7. The plan’s fiduciaries understand their role and document their decisions.
Most plan sponsors need some fiduciary education and guidance in what is expected from them. Many simply rely on their providers and trust in the myth that they can outsource all of their fiduciary duties. In reality, this attitude can be extremely dangerous. Many providers are not acting in a fiduciary role to the plan, including plan advisors who are affilliated with broker dealer firms.
Plan sponsors should know and understand the details of their plan document and the disclosure notices which must be provided to participants. They should monitor plan investments and fees and have a process in place which documents these duties. If they do not have the knowledge or experience to carry out these responsibilities, they are required to hire experienced providers who do. In my experience, plan sponsors of the best plans have established a process for all of these important functions.
8. The investment advisor is a fiduciary and specializes in company sponsored retirement plans.
The best plans hire advisors who specialize in the expertise and functions most important to plan sponsors. These include plan design, creating Investment Policy Statements (IPS), selecting and monitoring of plan investments, provider search, monitoring plan expenses, fiduciary guidance and effectively communicating plan benefits to participants. In the best plans, the advisor usually takes a proactive role as the “point man” or plan quarterback.
Plans which hire advisors affiliated with broker-dealer firms are exposed to conflicts of interest which impact key decisions. If your advisor is paid based on revenue sharing arrangements with a mutual fund company or recordkeeper, you have a fiduciary duty to find a new provider.
9. Participants have access to tools and technology that help them stay on track to meet their goals.
Successful plan providers provide useful online tools that keep participants informed and on-track. Most recordkeepers today offer real-time access to participant information such as deferral rates, plan allocation tools, re-balance features and transparent fee disclosure. Mobile apps that allow participant access are now available from most recordkeepers. Advisory services that calculate and project monthly retirement income allow participants to make more informed retirement choices.
10. The plan sponsors and advisor have a written Investment Policy Statement that guides investment decisions.
Although not specifically required by ERISA guidelines, the best plans have adopted a written Investment Policy Statement which defines the criteria for all investment decisions. Investment asset classes are defined in this document and based on the demographics and investment sophistication of participants.
As an example, our plans evaluate each investment by 11 different criteria such as manager tenure, minimum net assets, net expense ratios, style and composition, 1,3 and 5 year performance as well as measures of risk such as alpha and sharp ratios. When current investments fail to measure up to these standards, they are placed on a watch list for further evaluation or deleted and replaced.
The best plans employ a rigorous and disciplined approach to investment decisions and document this process on a consistent basis. It is important to understand that ERISA does not hold plan sponsors or providers to a performance standard in regard to investment returns. But it does emphasize that there is an investment process that is consistently adhered to by plan fiduciaries.
This is not a complete list!
In reality, there are probably additional attributes that are shared by the best 401(k) plans. However, I have found these ten attributes to be universally shared by successful plans.
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.
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
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.
Your Insurance Company’s 401(k) Fees Are Too High!
The Cost of Cell Phones and 401(k) Services in 1985.
I purchased my first cell phone in 1985. It was a Motorola DynaTAC model and it was more or less permanently attached to the center console of my car. “The Brick” was not portable, provided only voice telephone service and cost over $9000 when it was introduced in 1984. Today, a smartphone fits in your pocket, provides an unlimited number of functions and (depending on the model) costs just a few hundred dollars.
If you were a small business or professional organization shopping for a 401(k) provider in 1985, you would have also had few, if any, choices outside of an expensive insurance company to provide recordkeeping, investment options and compliance services. Today it’s a different story for these smaller plans.
The availability of low cost 401(k) recordkeeping, administration and compliance services for smaller plans today is very much a reality. Despite this fact, a shockingly high percentage of these smaller plans are still managed by bundled insurance company providers and are among the most expensive 401(k) options for smaller businesses, including physicians, dentists and attorneys.
Why We Put Up With High Fees.
The question we should all be asking is why insurance company plans so expensive. And more importantly, why do plan sponsors continue to put up with these high costs?
My answer? Insurance plans are expensive because the insurance companies know they can get away with higher fees. And many of these plan sponsors either don’t know or don’t care. They should.
Despite all of the sophisticated and expensive marketing and enrollment materials they provide to plan participants, insurance companies are often the least transparent in regard to plan fees. In many cases, their fees are simply buried in annuity contracts with employers. And when employers decide to change providers, surrender charges can hold them hostage. This makes it nearly impossible for a plan sponsor to meet their fiduciary responsibility regarding reasonable fees.
Are My Plan’s Fees Reasonable?
Plan sponsors have a fiduciary responsibility to ensure that their 401(k) fees are reasonable. In practice, this requires that they calculate the “all-in” fees (service provider fees + investment fees) and compare these fees to 3 or more providers. This benchmarking process should be done on an annual basis.
Your fees don’t have to be the lowest available in order to be reasonable. But they must be justified based on the services received. At my firm, we work with 401(k) providers whose fees are transparent. In practice, lack of fee transparency is the most common red flag that your fees are too high.
What Do Variable Annuities Have to Do With High Plan Costs?
If your retirement plan’s provider is an insurance company, your plan’s investments are likely a variable annuity. Understanding the differences between a variable annuity and a mutual fund is key to unlocking the high fees typically associated with insurance providers.
Variable annuities are essentially mutual funds wrapped in a layer of insurance that renders the investment returns and income from the investment tax-deferred. This makes them an attractive alternative to certain individual investors who may be in higher tax brackets.
When used inside a 401(k) retirement plan, however, this is a distinction without a difference, since all investments returns inside of a 401(k) are already tax deferred. So, do variable annuities have other advantages when used in a 401(k) plan? Not really. But they present a number of disadvantages, including additional fees and onerous trading restrictions.
Wrap Fees, Surrender Charges and Commissions.
A retirement plan funded by variable annuities is structured so that participants do not directly own a mutual fund. Instead, they own “units” of an account that holds mutual funds owned by the insurance company. These units have a variety of wrap fees including investment management fees, surrender charges, mortality and expense risk and administration fees. Variable annuities also include a commission which is paid to the broker who sold them.
These fees can range from .25% up to 1.25% of assets, depending on the size of the plan. They are often estimated as a percentage of assets in 408b-2 fee disclosures, as opposed to stating the actual dollars that are being extracted from participants. Even more frequently, they are buried in dense and often confusing group annuity contracts with the employer. These hidden fees can be destructive to your long term financial health. A plan with total assets of $1 million invested in a group annuity with a 1.00% wrap fee would generate annual hidden compensation of $10,000 to insurance companies and plan advisors yet provide questionable participant benefits. And since these fees are variable based on assets, they are increasing over time.
Surrender Charges: Adding Insult to Injury.
One of the most devastating wrap fee consequences associated with plans funded with variable annuities are serious and onerous trading restrictions. Because annuity contracts are written with an expiration date, an employer who wishes to terminate the contract prior to expiration is subject to surrender charges often as high as 7%. While the industry defends these fees as an offset to the cost of setting up the plan, their true and obvious purpose is to hold plan sponsors hostage. They create a nightmare scenario for plan sponsors who wish to terminate their provider for poor performance or high administrative fees.
Revenue Sharing Arrangements: Hidden Fees
Revenue sharing arrangements are another source of hidden fees for participants. These fees are far from transparent and are often buried within the expense ratios of plan investments. Often identified as 12b-1 and sub-TA fees, these fees are used to indirectly compensate recordkeepers, custodians, TPA’s and advisors for services provided to the plan. Because the true cost of most plan services scale based on the number of plan participants as opposed to the total plan assets, these fees become increasingly expensive as plan assets continue to grow. They are seldom justified.
“I Own A Mutual Fund in My 401(k), Right?”
Variable annuities are often identified in marketing materials and other plan communications by their underlying mutual fund. This can lead some participants to conclude that they are investing directly in a mutual fund when in fact they are investing in variable annuity units subject to additional fees. As a result, plan participants who wish to invest in low-cost mutual funds may not realize that while the underlying fund has low fees, the unit expenses could be considerably higher. That’s not my idea of transparency!
Good News! You’ve Got Options!
Fifteen or twenty years ago, the smallest 401(k) plans had few options outside of variable annuities and bundled insurance providers. Today, the 401(k) landscape has changed. Mutual fund minimums have been reduced and lower cost share classes are available on most competitive recordkeeping platforms. Regulatory reform in recent years has mandated fee disclosure to both plan sponsors and participants. As a result, there has been an acceleration in the number of insurance companies who have sold or exited their 401(k) recordkeeping business in the past 5 years.
What Must I Do Now?
Insurance companies get away with high fees for two reasons: The first reason is that their fees are often intentionally hidden. True, fee disclosure reform has increased transparency somewhat in recent years, but insurance company fee disclosure continues to be among the most confusing and least transparent.
I have found that many, if not most, plan sponsors need help when it comes to properly identifying and benchmarking their 401(k) plan fees. You should ask your advisor for help if he is not already providing you with that service.
You should also understand how your advisor, as well as other 401(k) providers are paid for their services. Revenue sharing arrangements and insurance company wrap fees are often expensive and involve conflicts of interest that should be avoided.
Apathy and indifference among plan sponsors when it concerns high fees, however, is both expensive and inexcusable. Putting up with high 401(k) fees charged by insurance providers when there are far less expensive options available to smaller plans increases your legal liability, reduces participant outcomes and is a serious breach of fiduciary responsibility. Both you and your employees deserve better.
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!
