[Editor’s Note: This is a lengthy, but extremely useful guest post by Konstantin Litovsky whose firm provides flat-fee comprehensive financial planning and retirement plan consulting to small business owners. He would like to thanks Nora Bethman, CEBS, QKA, ERPA, Douglas Carlsen D.D.S., and Nina Litovsky for their help in reviewing this article. We have no financial relationship.]
Whether you have are looking to open a new plan or upgrade the plan you already have, there are four things you need to consider that can significantly improve the quality of your plan: having the right plan design, minimizing plan cost, managing your fiduciary liability as a plan sponsor and selecting the right plan services that can both minimize your fiduciary liability and help plan participants achieve better investment results.
Small Practice Retirement Plan Design
While larger businesses can adopt a single plan that does not change over time, smaller businesses might go through several retirement plans depending on the owners’ personal and business needs, thus you need to be aware of your retirement plan options and take action when change is necessary. If your practice has employees, you may want to maximize your own contribution without having to spend too much on employee contributions. For most practices, a New Comparability (also known as cross-tested) 401k plan with the maximum contribution of $53k ($59k for those over 50) will be a good starting point. If you want to contribute significantly more than $53k a year, you might consider a Defined Benefit plan or a Cash Balance plan if you have employees and/or partners.
Selecting a Third Party Administrator
The first step in establishing your plan is to find a good Third Party Administrator (TPA). When working with a TPA, you need to be clear what TPAs do and what they don’t do. TPAs do a lot of necessary work for your plan including plan design, administration and recordkeeping, but you can’t expect them to provide every service that your plan requires. Most TPAs specialize in working with 401k plans, a small number work exclusively with Defined Benefit Plans (DBP), and some work with both. A typical TPA might start you off with a standard Safe Harbor 401k plan since that is the most common type of plan they work with. Most TPAs don’t work with Defined Benefit plans, and they will not tell you that your practice might be a good candidate. A typical TPA might not even offer you a New Comparability analysis unless you specifically ask for it. It is not your TPA’s job to recommend that you upgrade your plan when you can afford higher contributions. Your TPA will not provide you with investment advice so don’t expect them to help you select and manage your investments. An independent, stand-alone TPA is always the best choice, provided that you work with a retirement plan adviser who can evaluate which plan can work for your business and whether it makes sense to upgrade your current plan. A good adviser can direct you to the right TPA, and together with the TPA they can make sure that you have the best plan that fits your personal and business needs.
Some plan providers offer a one-size-fits-all plan with a single plan document for every company that adopts this plan. Such plans can be inflexible since it is not possible to customize the plan document to come up with a plan design that may be a better fit for your practice.
(Updated 9/9/16 — Some older plans might not even allow for a cross-tested design as the profit sharing is allocated on a pro-rata basis. Others might include options that you do not necessarily want to allow in a small plan, such as loans and hardship withdrawals (each of which would incur extra administrative cost and added compliance burden).
When choosing a plan, you need to consider the total cost of your plan including the cost of mutual funds. What determines the cost of retirement plans, and how can you minimize plan cost for your practice?
To properly evaluate whether a particular plan provider or adviser is offering the best deal, you need to understand how they are making money. There are really only two ways in which plan service providers make money: fixed fees and assets under management (AUM) fees. Fixed/flat fees may depend on the number of plan participants and the types of services offered. For example, TPAs charge a one-time set-up fee or a fixed administrative fee that increases with the number of plan participants. Custodians charge a custody fee which is an AUM fee of around 0.04%-0.08%, but never higher than that. There shouldn’t be any other fees charged by a TPA or custodian. On the other hand, advisers to plans and mutual funds charge AUM fees. AUM fees are always bad for you. According to a Deloitte study, [Study is no longer available online – ed] the smallest retirement plans pay the highest AUM fees. AUM fees can be minimized by selecting low expense ratio index funds and by using advisers who charge flat/fixed fees for their services that are not tied to plan assets. While AUM fees can be cheap when your plan assets are low, such fees become a significant expense as your assets grow, so a detailed side-by-side analysis has to be performed to evaluate which compensation model can minimize your plan expenses (assuming the same services are provided to the plan).
Revenue sharing should not be an issue, but it is, especially when you are not sure whether your adviser or investment committee selected a fund because of revenue sharing from this fund or because this fund is actually the best choice for your plan. We do not believe that actively managed funds can outperform indexes, and high quality index funds offer no revenue sharing of any kind because their expense ratios are already very low, so there is no reason at all to use funds that offer revenue sharing.
Bundled vs. Unbundled
Bundled plans offer all-inclusive (‘all-in’) services, which can be convenient because you don’t have to worry about locating multiple providers for your plan. However, this convenience comes at a price. When you adopt a bundled plan there is rarely an option to make changes either to the plan document, TPA selection or mutual fund lineup, which can be a big disadvantage if you want to redesign your plan or use mutual funds that charge lower fees. Usually, such plans have limited fund choices and multiple layers of fees. While the fee disclosure rules have made it easier to identify the fees charged by bundled plans, there is rarely adequate fiduciary oversight to help you minimize your plan’s expenses.
Unbundled means that the plan is assembled from different pieces that can be customized and replaced as needed. There are many high quality independent providers who can integrate seamlessly and who work together just as well as providers working for bundled plans. With maximum flexibility and transparent cost structure, unbundled plans can be made much cheaper than bundled ones. It takes knowledge and skill to put together a high quality plan, so an unbundled plan managed by an experienced plan adviser is ideal.
This excellent article discusses the concept of fiduciary liability in great detail. The following is a summary of several important takeaways for plan sponsors.
LaRue v. Dewolff (2008), plan participants are able to sue plan sponsors for monetary damages for breaches of fiduciary duty, which includes higher than normal fees, using higher expense funds to offset administrative cost, lack of adequate participant education, and lack of documented procedures for complying with ERISA. If a participant experiences losses and subsequently sues the plan sponsor, the plan sponsor is fully liable for monetary damages. Whether large or small, it only takes one employee to sue to cause significant financial liability if your plan is not managed properly.
In Braden v. Wal-Mart Stores [link no longer available – ed], the plaintiffs were awarded $13,500,000, and the settlement also describes the steps the company would have to take, including:
- Retaining an investment adviser who has acknowledged ERISA fiduciary status in writing, and to review the adviser annually for conflicts of interest.
- Providing web‐based investment education to plan participants.
- Eliminating retail mutual funds, funds that pay 12b‐1 fees, and funds that provide revenue sharing to plan’s trustee or record-keeper from the plan investment options.
- Adding more passively managed funds.
You may think that you don’t need to worry about fiduciary liability because your plan is small. The Department of Labor (DOL) has stepped up investigations of plan sponsors of all sizes. The DOL routinely goes after plan sponsors to recover losses due to fiduciary breaches. The good news is that taking care of your fiduciary liability is easy and shouldn’t cost much at all. A retirement plan is supposed to be operating for the benefit of the employees, not just the employer, so if this is indeed the case, plan sponsors do not have to fear fiduciary liability. All that is necessary to run the plan for the benefit of the employees is to offer the right level of services to the plan, and to have a documented fiduciary process.
Fiduciary Adviser Safe Harbor
Fiduciary Adviser Safe Harbor allows the plan sponsor to appoint a Fiduciary Adviser who provides investment advice to plan sponsor and participants, thereby limiting plan sponsor liability. There are two types of Fiduciary Advisers that should be considered, though in reality, only one will afford your plan the full benefit. The 3(21) fiduciary will be a co-fiduciary in an advisory role, meaning that the final decision for investment selection rests with the plan sponsor. A 3(21) fiduciary will typically not provide portfolio management services. Often, the 3(21) contracts are written in such a way as to relieve the adviser of any real fiduciary responsibility for your plan. A 3(38) fiduciary (or ‘investment manager’) will accept liability for investment selection, monitoring and portfolio management. Only a 3(38) adviser will relieve the plan sponsor of their fiduciary liability for making investment management decisions.
Some plan sponsors think that they do not need a fiduciary to help them with plan design, investment selection and management, and other plan services. They contend that this costs too much and that they can do all of this themselves to save money. They may ask themselves, “Why bother with a fiduciary adviser?” Plan sponsors need to remember that as fiduciaries they are financially liable for any fiduciary breaches or mistakes, and that the longer their plan is in operation, the higher the risk that something can go wrong if the plan is not managed properly. A good 3(38) investment manager, in addition to helping your plan with investment management, should be able to help the plan sponsor develop a process which should not only limit the plan sponsor’s fiduciary liability, but also help the plan sponsor save money by lowering plan expenses and helping plan participants achieve better investment results. The following are some of the services that the adviser for the plan should provide:
- Creation of Investment Policy Statement to document investment selection and portfolio management guidelines.
- Due diligence for minimizing plan costs.
- Due diligence for investment selection.
- Discretionary portfolio management, model portfolio creation and maintenance.
- Ongoing monitoring of plan and investment performance.
- Education and investment advice for plan participants.
Even when the above services are provided to the plan, the plan sponsor still has the duty to monitor all service providers to make sure that they are doing their job. So the fiduciary liability of the plan sponsor can never be completely eliminated. While traditional wealth management firms might charge a significant asset-based fee for the above services, it is not necessary to pay asset-based fees for any of your plan’s services. Asset based fees cost much more when plan’s assets grow quickly, so it is important that your plan’s asset-based fees are minimized. Today, more advisers charge fixed/flat fees for their services, and this could be the most cost-effective option for your plan.
Fiduciary Adviser vs. Investment Committee
Some plans are managed by a provider who offers ‘all-in’ (or bundled) services, including plan design, administration, recordkeeping and investment advice, and the provider charges an ‘all-in’ asset-based fee. Such providers (usually an insurance company) often have an investment committee to make investment recommendations. What are the benefits of having an investment committee vs. a 3(38) investment manager? Typically, ‘all-in’ providers do not act as fiduciaries for your plan. An investment committee is at best a co-fiduciary, meaning that the plan sponsor retains all of its fiduciary liability for investment selection and performance. Having an investment committee might be worse than not having one. Would you trust the management of your portfolio to your colleagues? Investment committees are not trained in investment management. The members of such committees are not portfolio managers, and make the same mistakes the general public makes. They are apt to chase performance instead of relying on a single low-cost index fund allocation. The issue here is not only that advice coming from such committees may be subpar (which won’t help the plan participants achieve better investment results), but won’t limit the fiduciary liability of the plan sponsor either. To provide adequate fiduciary services for the plan you need to hire a real fiduciary – someone who can serve in a 3(38) capacity as an investment manager. Some ‘all-in’ providers also offer 3(38) services to their plans. You need to be very cautious of such arrangements. The 3(38) fiduciary has to be independent from the plan provider so that they can do what’s necessary to minimize your plan cost and to provide the highest quality services to your plan.
Helping Plan Participants Do Better
A retirement plan can be a costly way to receive a tax deduction if your portfolio is not managed adequately. Your plan needs to offer the right level of services to make sure that plan participants accumulate enough savings for retirement because most plan participants will not do well on their own. The most recent DALBAR study found that in the 20 calendar years ending in December 2011, the Standard & Poor’s 500 Index had a 7.8% compound rate of return, while in the same period, the average investor in US equity mutual funds earned just 3.5%. Dentists and other medical professionals often view themselves as being above average in all respects. That may be true for their professional lives, but when it comes to investing, being overconfident leads to the type of results that DALBAR has discovered – that a typical investor significantly underperforms the market, whether investing in stocks or bonds.
The problem of investment performance is compounded when a plan has employees who might be much less sophisticated than the business owners when it comes to investments. As a business owner, you cannot simply assume that just because you provide your employees with a retirement plan that they will make the best decisions when it comes to investing their money. This is why having professionally managed model portfolios in a 401k plan is critical. Using managed portfolios not only limits your fiduciary liability, but also allows your employees to achieve better investment results. In the case of a Defined Benefit or a Cash Balance plan, the pooled account where all of the participants’ money is held has to be professionally (and conservatively) managed to avoid over- or under-funding the plan.
How to Run a Successful Retirement Plan
Here are some guidelines on how you can have a successful plan, especially if your practice has employees:
1) Work with a competent TPA and/or an adviser to make sure that your plan is designed to address your personal and business needs, and that your plan is upgraded in a timely fashion when your needs change.
2) Minimize your plan’s asset-based fees. When hiring plan providers including TPAs and advisers, make sure that AUM fees you pay are necessary and competitive. While paying AUM fee for portfolio management may seem like a deal with no assets in the plan, the fees you pay will grow quickly as your assets grow. Whenever possible, use flat fee providers so that your fees are not tied to plan assets, and always be aware of what your fees will be in the future.
3) Use index funds and risk-managed model portfolios. Lower cost index funds beat higher cost actively managed ones, and higher cost funds take away your return without any added benefit. Studies have shown that a small number of high quality investments work best, and model portfolios that manage risk can help investors stay the course during market crashes. With professionally managed portfolios, plan participants will achieve much better results than if they manage their own investments.
4) Provide individualized investor education. Make sure that your employees have access to the best advice available to help them with their investment management. One-on-one advice can also protect you as a plan sponsor from fiduciary liability as general advice is not sufficient when it comes to helping employees make the best investment decisions.
5) Make sure that your plan advisers don’t get paid to sell products, and that all of their recommendations are made with your best interest in mind. As a plan fiduciary, you are responsible to make sure that your plan is run in accordance with existing laws and regulations. While you can outsource much of your fiduciary liability by selecting an appropriate adviser, you are still liable for making sure that the adviser you select is doing their job.
What do you think? Have you implemented or changed your retirement plan? Do you agree or disagree with Mr. Litovsky’s recommendations? Comment below!