Three common problems with 401(k) Plans
As CFP® professionals, we see a lot of 401(k) Plans. It’s great when our clients have a Plan that’s designed to really help them save for retirement. But that’s not always what we see. And, as advisers to businesses offering 401(k) Plans, we get to fix a lot of problems and make everyone happier.
Top 3 issues we see with 401(k) Plans
The overly complicated Plan
401k Plans are too often made out to be these really complicated things. And, they can be, and under the surface. The administration and testing requires a lot of work – that’s what the advisor, record keeper and third party administrator (TPA) are for. These service providers keep up with dept of Labor and IRS rules and ERISA. That’s their job.
So, the top issue we have seen in over a dozen years working with small business 401(k) Plans is designs that nobody can remember – because they’re so complicated. What makes them complicated?
- Eligibility and Entrance. These plan features address when a newly hired employee is eligible to save into the plan and receive employer contributions, and then when they can actually start saving – “entering” the plan.
We’ve seen businesses with rules stating a new employee isn’t eligible to be in their 401k plan until they’ve worked there for a year, and then they can’t start saving into the plan until the next January or July 1. Really, there are very few reasons not to let your newly hired full time employees start saving into the plan on day one.
Think about how your plan’s eligibility and entrance rules look to prospective employees. Are they a disincentive, or a reason to join your team? And, consider how easy or hard it will be for your staff to manage to whatever rules you have in place. Who’s going to keep track of when each new employee needs to get the paperwork to start saving into the plan?
- Employer Contribution Formula. Most 401(k) Plans include some sort of employer contribution. Some are discretionary matching contributions which involce additional testing, but it’s more common for small employers to use a “Safe Harbor” formula to match employee contributions. But these get too complicated, also.
Most people don’t like to do math. These matching formulas require it, so we like to see a straightforward match like dollar for dollar on the first 4% of pay an employee contributes. Simple. Easy to remember. And, generous and competitive.
Bottom line for us at EVOadvisers is that employers need to think, “can my employees understand how this plan works, and can my team implement it without creating a ton of extra work?”. 401k plans should be easy, and they can be.
Cost Structure
Another area where plan design can have a big impact on business owners is paying for the plan. Too many plans have all of the costs of offering the plan debited from plan participant accounts – their employees pay for it, and so do the owners. That’s not so good for the people with the highest account balances – they’re paying most of the cost of the plan, and those costs erode their returns for their retirement!
We generally recommend the business pay all of the possible costs of the plan. This moves the cost from the non-deductible to the tax deductible column. That makes good sense from a cash flow and return standpoint. And, we lower those costs, too.
So-so Investment Choices and High Costs
46% of Americans work in small businesses. And, sadly, many of those small businesses that offer a retirement plan with a sad set of investment choices.
There are a lot of reasons for this.
Your 401k should let you invest in things you would actually want to own – that is, if you had the time, the knowledge and the tools to do the research and invest prudently.
But far too often small business retirement plans offer expensive investment choices – mutual funds with really high expense ratios.
- What are expense ratios?
Mutual fund companies have expenses. They have to distribute these expenses to their investors, and they do it by having a portion of the fund’s return reduced by some amount. This lowers the return the investor receives. A very simple example would be if a fund had a gross return of 6% in a year, and had a 1% expense ratio, an investor would get 5%.
What we see a lot of are 401(k) Plans offering funds with really high expense ratios, yet we know these funds may be offered with lower expense. Why the higher expense ratio? It may be an indication that the service providers are paid from these higher fees.
Worse, some plans don’t offer investment choices that are mutual funds with ticker symbols for anyone to research. They offer what are called annuity subaccounts – which can have really high expenses and poor performance, and sometimes there’s no easy way to research them well.
Also unfortunate is when we see plans that don’t offer a selection of funds that allow everyone to save appropriately for their own retirement- if they’re 22 or 62, they may need different allocations. Some plans just don’t offer enough of a chance to diversify. On the other end of the spectrum are plans that seem to offer every mutual fund in the universe. While well intentioned, lots of research shows that many people, when given a staggering range of choices, don’t make the best choice.
So, fund selection for a 401(k) plan is a lot like goldilocks and the three bears — too few choices, too many choices, and then there’s a selection that is just right.
How To Fix It
Small Businesses generally don’t have the time or resources to review their 401(k) Plan, and the thought of making changes to their service providers seems like a lot of work. It doesn’t have to be.
A really good 401(k) Plan should fit into your business plan, be tax advantageous for the business, help your employees lower the cost of investing, and offer a simple way to save prudently for retirement.
A first step is to pull back the covers on the complexity and the cost. Then, simplify and reduce costs, and add some service everyone should really have. Choosing an adviser to help with this should start with questions like “are you a fiduciary to us”, “how are you paid”, and “how long has your firm been working with 401(k) Plans”. Questions like these can filter out the salespeople from the professionals.
Start by simplifying the plan’s design – so the employees really get it, and so it’s simple for the employer to manage. Look at costs – what are the service providers paid, and what are the costs of investments, and do the investments offer a diversified and prudent selection for all of your employees.
And, that’s really what 401(k) Plans are about — improving retirement readiness for your employees.