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!
