Konstantin Litovsky
[Editor’s Note: This is a guest post from Konstantin Litovsky, a financial advisor specializing in small practice retirement plans. While this is not a paid post, he is a paid advertiser on this site. Part 1 ran yesterday and discussed practice demographics, plan design and plan architecture for small practice plans. Part 2 discusses investment management, describes essential services for small practice plans, and also offers recommendations on the criteria that can be used by practice owners to select the best small practice plan providers]
Investment management
Most of the assets in small practice plans belong to the practice owner and most of the practice owner’s assets will be invested in the plan, so it is important for the owner(s) to receive good investment advice.
1) If your practice has a participant-directed plan, the plan sponsor should provide employees with adequate information to make good investment decisions. Small practice employees are generally not sophisticated investors, so to get the best results (for as low as $15 per employee per year) employees can be provided with personalized advice though one of a number of companies that offer access to live financial planners who can talk directly with each of the plan participants. Large companies rarely offer this level of service, opting for electronic communications and re-enrollment.
An even better solution for a small practice is using a pooled plan. Because investments are managed by an ERISA 3(38) fiduciary (‘investment manager’), not only will you eliminate your fiduciary liability with respect to providing education to plan participants, but by taking responsibility for the investment management process, an ERISA 3(38) fiduciary will also eliminate your fiduciary liability as far as investment selection and management for the plan.
2) Most large and small plans alike pay asset-based fees for plan services. In a small practice plan, the cost of asset based fees is borne mostly by the owners, since most of the plan assets belong to them. While small plans often pay some of the highest asset-based fees, there is no need to have any asset-based fees in your plan. There are plan service providers (including investment advisers and TPAs) who specialize in working with small plans and who charge a flat fee for their services. Asset-based fees are a bad deal for any retirement plan, and you can and should eliminate all asset based fees (aside from the fees charged by low cost index funds) from your plan.
3) Many record-keepers are now offering fiduciary services that are known as ERIA 3(38) and ERISA 3(21). Do you really need these services? DOL has very specific instructions for plan sponsors, including this one: “lacking that expertise, a fiduciary will need to hire someone with that professional knowledge to carry out the investment and other functions.”
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[Editor’s Note: I find it ironic that the government won’t pass laws that require financial advisors to have a fiduciary duty but has no problem putting that burden on practice owners.]
A 3(21) fiduciary is a co-fiduciary (with the plan sponsor retaining full fiduciary liability) and their role should be limited to providing participant advice. An ERISA 3(38) “investment manager” is a person who would be managing your plan’s investments on a discretionary basis (if you have a pooled plan) or selecting plan investments and managing model portfolios (if you have a participant-directed plan). While some would argue that ERISA 3(38) fiduciary is nothing more than a gimmick and that small practice owners should have no fear of lawsuits for fiduciary breaches, the role of a good adviser for a small practice plan cannot be overstated. [More discussion on 3(21) vs 3(38) fiduciaries can be found here.-ed]
Services essential for small practice plans
When a typical small company wants to start a retirement plan, they usually do the following:
- Find the biggest and most well-known record-keeper, many of which also offer TPA services including plan design and administration.
- Provide a census to the record-keeper and get a single plan design illustration.
- Sign the contract, set up accounts with the record-keeper, enroll the employees and consider everything done.
It would be great if every plan was this easy to set up, but for a small practices this is rarely the case. There are many missing steps in this approach, some of which can make a big difference for a small practice. Here are some of the critical services that are rarely offered to small practice plans:
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1) An analysis showing whether the 401k plan is better for your practice vs. a SIMPLE IRA, including an estimate of how cost-effective the proposed 401k plan design is given your tax bracket and employee contributions as compared to SIMPLE IRA and/or other plan designs.
2) Access to the TPA (a person) who actually designed your plan so that you can ask questions about your plan design and plan options and get a speedy response. When working with large record-keepers you will talk with a salesperson who might know something about plan design, but they will not work in your best interest to find the best solution for you.
3) Address ‘controlled group’ and ‘affiliated group’ concerns. IRS wants all eligible employees to be covered by a retirement plan, and if you own or co-own multiple practices with employees or have multiple entities within a single practice that separate employees from the owners, you have to make sure that the retirement plan does not exclude eligible employees. This can be a complex issue so your TPA and adviser will have to help you make this determination.
4) Design study. A small practice owner will need to know for sure which design will work best under various types of assumptions about the future. You don’t want to end up with an expensive plan that you will end up dropping later. You also need to consider whether a participant-directed or a pooled plan will work best for your practice. A design study is a key step before you can make a decision to adopt a plan.
5) Include plan features with practice owners’ personal needs in mind. For example, if you want to make ‘backdoor’ Roth contributions, your plan document has to allow incoming rollovers, and if you want to do in-plan Roth conversions, outgoing rollovers must also be allowed.
6) Have your plan design re-evaluated if there are changes in practice demographics. This is something a good TPA should do periodically and proactively. Any plan design inefficiencies and problems should be addressed quickly.
7) Consider whether a Cash Balance plan might work for your practice. Many practices will eventually open a Cash Balance plan, but one has to be very careful because the providers who sell these plans might not have your best interest in mind, and you might not get the best design that addresses your personal needs. Even younger owners (38-40) with employees might benefit from a Cash Balance plan despite what you read elsewhere, but you will need to work with an independent actuary/TPA as well as an adviser who understands plan design and how to put it all together.
What actually matters for a small practice plan?
Record-keepers can be better or worse, but the choice of a record-keeper is not as important for a small practice plan as it is for a large plan. Here’s what really matters for small practice retirement plans:
1) Hire the right retirement plan adviser who would act in a fiduciary capacity (that is affirmed in writing), provide you with ongoing advisory and support services and charge you a flat (and not an asset-based) fee. Your record-keeper and your Third Party Administrator are not fiduciaries. You need to always make sure that your adviser and plan providers do not have any conflicts of interest and that they are acting in your best interest – otherwise you can end up with a plan that might not be a good fit for your practice.
2) Hire the right Third Party Administrator. Record-keepers come and go, but a good TPA stays. Your TPA (together with your adviser) will make sure that you have the best design and that your plan stays compliant with all of the rules and regulations. A good TPA who has experience working with small practices also knows how to design plans for small practices in such a way as to avoid any potential future issues. Your TPA will also stay on top of any changes to your practice demographics and will tell you when a new plan design is warranted. Record-keepers often make mistakes, and you will be responsible and potentially penalized (as a plan fiduciary) for any mistakes they make. Having a standalone, independent TPA is important to make sure that your plan is operating smoothly and that any mistakes are caught early.
3) Educate yourself as much as possible on retirement plans. For example, any asset-based fees can be a significant cost for your plan, so you will need to understand the value of paying flat fees and replacing any asset-based fee providers, even though at first glance it might seem that the asset based fee is not significant because your plan does not have much assets. Also, open architecture providers who are specialists in working with small practice plans can provide better value especially if you want extra oversight and personalized services for you
What do you think? Who do you use as a record-keeper, third party administrator, and/or plan advisor? Do you feel a plan advisor is warranted? What did you pay for your plan? Comment below!
I wish I could convince my practice to leave AUM model. Does that mean, owners bear the cost of all the flat fees or how does it get spread to employees?
Those with the largest balances would be paying the most in fees, so yes, generally the owners will bear the brunt of the fees in an AUM model. Paying a flat fee (owners still pay) for the plan should also be a tax deductible expense for the plan/employer. So if you pay the flat fee your investments should grow more and you should get a little more of a tax benefit.
No, that’s not really how it works. Ask yourself this. When you pay AUM fees, the fees come out of your compounded return. You get no tax deduction of any sort and you get your return clipped. That’s a one big ouch when it comes to long term cost.
Now if your fees (which are flat) come out from your corporate account, NOT from your investment account, you get the benefit of two things:
1) Compounding is now working for you, not against you and
2) Your fees are now 100% tax deductible, saving you as much as 50% in taxes!
So in fact, switching to a flat fee model is a no brainer. What we typically do is show a very detailed cost comparison, so that the practice owner knows exactly how the costs will diverge going forward over several decades.
Because the practice owner is paying the majority of the fees, they should care whether they will save hundreds of thousands over several decades by switching to a flat fee model. So the first step would be to convince your practice owner that there is a problem in the first place, by starting with this link:
http://litovskymanagement.com/2015/05/cost-of-fees/
Once they see that they are overpaying significantly, we can then show them how their expenses can be decreased by working with a fiduciary adviser who will help them decrease their plan expenses significantly (even if it means going to a different platform/TPA to get access to low cost index funds).
If the fees are paid out of a tax-deferred account, they’re also 100% tax deductible.
AUM fees can be converted to a flat-fee model with a simple multiplication. Multiply assets by fee percentage and if that’s more than the flat fee guy, then go with the flat fee guy. If less, then go with the AUM guy. Usually, the flat fee guy will win this, especially if you have a reasonably sized portfolio.
I’m sorry, my omission – the AUM fee is tax-deductible, that is true.
But you can’t convert AUM to a flat fee model! That would give the entire advantage to the AUM fee. You have to look at the long term since AUM fee is not just a percentage of your assets, it is a compounding percentage, so you have to compare the flat fee vs. AUM fee over time, and that will give you the total return comparison which is a lot more accurate than doing this for a single year.
So in fact, even if you have ZERO money in your plan a flat fee will beat almost any AUM fee charged today over several decades.
Sure you can compare it. Year one, AUM fee is lower, stick with your AUM guy. Year two, still lower, stick with him. Year three, flat fee is lower, switch guys. It works for both your own personal asset management as well as your practice retirement plan. Or are you saying someone can’t switch to you in a couple of years? 🙂
That’s not how it works in practice because high end advice is not (yet) a commodity. Switching advisers because of a lower fee does not guarantee that you get better value – if you have comparable or better services for a lower fee, then you can switch (though doing this every year assumes that you have a stack of high quality, low cost advisers who compete with each other, which is not the case, at least not now), but a lower fee rarely if ever guarantees that you will get a better service.
I actually don’t want to see my prospective clients switch advisers like they were sox – this tells me that they are only looking for the cost and not the underlying value. Delivering high value comes at a cost, and my point is that it can be done more cost effectively for the client with a flat fee vs. AUM fee, because AUM fee rarely if ever includes all of the services necessary that the client will require. With retirement plans this can’t be more obvious.
Bottom line is this: if your fee is tied to your assets, then the advice will probably be limited to these assets, which is a bad deal for most practice owners because it takes decades to build a good level of assets (therefore most will be priced out from receiving advice from AUM managers), while they still need high quality and affordable advice. By the time they have the assets, the AUM fee will be prohibitive. So it makes sense to find a good flat fee adviser and stick with them.
“I find it ironic that the government won’t pass laws that require financial advisors to have a fiduciary duty but has no problem putting that burden on practice owners.”
That’s because financial advisors have lobbyists and are fighting being fiduciaries.
Practice owners do not and are not.
What’s more frustrating to those of us who want to do the right thing for our clients is that many doctors/dentists themselves don’t understand that the AUM model hurts them the most, so they keep referring their friends to very high expense firms just because they are ‘nice guys’. The tide is not turning just yet, but thankfully there are more options for the practice owners to get the best of everything cost-effectively.
Kon,
I understand that you like your flat fee model best and it can make a lot of sense, however, to some of the untrained readers of this blog they would infer that someone who uses an AUM model is not a fiduciary. Flat fee vs AUM is a business model decision it is not a way to differentiate who is a fiduciary and who is not. I myself may go that flat fee route someday (as I do now for my financial planning engagements) but it is wrong to infer that your advice is more fiduciary than an advisor who uses an AUM model. You are picking the same investments, you just may charge less than an AUM when the accounts get really big.
In fact, I believe the only “fiduciary” duty you have is for having a series 65 license, that is the same license that most advisers need to charge an AUM fee. The series 65 license is about being a fiduciary, not which business model is more “fiduciary”.
This is a serious question; I know that people will say that it takes no more time/effort to work on a 10 million portfolio Vs a $500,000 portfolio but is there more liability? How is that taken into account with a flat fee? Do you have one flat fee for all clients or does it “slide” based on account size? It would seem to me that clients who only have $500,000 managed by you are subsidizing the $5 million clients that you may have. Does your E&O cover all of your clients? Again, these are serious questions as I know you are very passionate about your fiduciary status.
I think this is exactly what I’m saying. Just saying that one is a fiduciary does not make them so! In the retirement plan space, there are plenty of 3(38) ‘fiduciaries’ who have a contract that limits their liability, and allows them to charge high asset-based fees without regard to the value they deliver, and the fact that they are not doing more work for their fee. There are ways to price services, but they have to do with the amount of work done, and not with the asset level.
I think that a real fiduciary should be able to deliver value in the best interest of the client, and selecting a flat fee compensation model is part of being a fiduciary. There is nothing that can convince me otherwise. I’ve started with an AUM fee, and I saw very early on that charging AUM fees will limit my ability to act in a fiduciary capacity in multiple ways:
http://litovskymanagement.com/2012/08/no-aum-fees/
So my bottom line is this: I care about delivering value to my clients while being fairly compensated. AUM fees in my opinion don’t make one a fiduciary, and neither does being a Registered Investment Adviser (and getting Series 65). Even a contract that says that one acts in a fiduciary capacity is not enough to be a fiduciary because of the conflicts of interest I described in the above article.
There is certainly a good case for flat fees, I get that. I would prefer to implement a net worth fee in the future, in my view that negates all the conflicts of interest. I just don’t know how the liability would work when charging a client the same amount for a $10 million account as I would a $400,000 account. That certainly wouldn’t seem fair to the masses with less than $500,000 in AUM or net worth. There is no free lunch, well I guess for the bigger account there is.
Does your flat fee include asset management or can you just do a flat fee financial plan and allow your clients to invest on their own with Vanguard, TDA eta? Also, does your flat fee, say $4,000, in your example come with a term guarantee? Your illustrations assume the AUM fee going up every year due to asset size but it looks like the $4,000 fee stayed the same, or am I wrong on that and you included some sort of inflation increase for the $4,000 fee. Why does the AUM advisor choose the higher price mutual funds/ETFs, that seems off base too.
Also, to assume that everyone will be able to take advantage of the tax deduction with the 2% of AGI floor is not feasible, how much does your example earn per year while deducting the entire $4,000 fee?
The AUM fee is ‘flat’ in the sense that it does not go up by itself, but with the asset growth. A flat fee also will experience some growth over time, but that’s a tiny amount vs. the exponential growth of the AUM fee. Also, all business owners can deduct retirement plan advisory services as a business expense.
The fee does not depend on assets, that’s the point. What if a client has no assets to speak of (which is the case with many young doctors and dentists)? Many retirement plans are startups, and have no assets either. That’s why I don’t consider the assets. It is all about the type of work that has to be done.
This is not an example that will work for everyone, but the general idea is sound. However, as I mentioned before, the bottom line is that the value has to be higher than the fee that is charged. Just because a lower fee is charged does not mean that it is worth it.
Another point of this article is that there is no such beast as a ‘comprehensive retirement plan adviser’. This does not exist in nature. It is basically a marriage of an ERISA 3(38) fiduciary and a wealth manager fiduciary, and this is what a small practice retirement plan requires.
Also, it is important to point out that personal financial planing and retirement plan advice are two distinct services, one governed by Investment Advisers Act and one by ERISA.
My small practice of 10 physicians has what seems to be a pretty unique Profit Sharing Plan. The closest thing I can compare it to is pooled account, but we each pick our own “brokerage house” to invest with. I chose an account with Vanguard since that’s all I would be investing in. I am the only one with money in this account, though it is in the name of the two trustees and not mine. The whole situation names me feel a tad uneasy since my name isn’t on my statement when it comes. Anyone familiar with similar setups?
I think that this is a ‘brokerage only’ plan. It is possible that the original partners are the original trustees, and nobody explained to them that as plan sponsors they have fiduciary duty to their employees and to other plan participants. A very bad idea if you have any non-partner employees, and employees who don’t know what they are doing. In any case, having a ‘brokerage only’ plan is a bad idea from the fiduciary standpoint. The practice might as well just get a participant-directed plan if all of the physicians want to manage their own accounts. Having different accounts available to different people is a problem in and of itself because less sophisticated investors will make much worse decisions than the more sophisticated ones, and plan fiduciaries will be responsible for any discrepancies, as well as for selecting investments and educating participants, and if that’s not happening, it means that the practice owners/partners/fiduciaries/trustees are not meeting their fiduciary obligations, which can lead to problems down the line.
This is a great and timely article for me. I became a trustee recently and didn’t know what I was getting myself into. We had a pooled account in the past but went to hiring at TPA and at the moment have a central place for investment with a fiduciary manager but many people self direct and are not pleased at the prospect of losing that option. I see this as a liability for me and am curious what options there are – if any – to allow self directed accounts and zero my liability. Not surprisingly the places where these people hold their money will not be fidicuaries! We are looking into forcing people back into a system where we offer more choice to people used to self directing and having a 3 38 oversee that. Big houses like aig etc can offer advice, be 3 38 I think, and offer investment options.
As of now, we have rather limited choices with a ho hum AUM 3 38 and many people do not want to put their money there.
Are there options? If I knew now what I knew a few months ago I would not have signed up for trustee!
Thanks for any help here.
It seems like now you have a participant-directed plan. If you have a multi-physician group, I would not recommend a pooled plan (although I’m a big proponent of pooled plans for small practices). It also sounds to me that you might be paying way too much for advice and services as well. We’d be happy to take a look at your plan and to see what can be improved, as it is impossible for me to know the details without looking at everything closer. Please feel free to get in touch: my email is [email protected].
Hello Mr Litowsky
I am a dental S corporation with 3 employees. I am about to open a Safe Harbor 401k plan at Vanguard. They charge a flat service fee , $3,450/year, no asset base fees. Other fees are for optional services, flat fees. It looks a high service fee for me , but may be better in long term than an asset base fee.I would like to maximize my contribution. What do you thing about this option?
Vanguard does not do administration – they outsource this to Ascensus. It is Ascensus that charges this fee. Vanguard itself does not provide you with any services. So for example, here’s what you will not get:
1) Good plan design and access to a high quality TPA. What if you want to contribute more than $18k a year? A Safe Harbor will definitely not be enough. They do not have a high quality TPA who can do what I described in this article, including ongoing plan design upgrades if/when changes in demographics warrant it. They will also not provide you with a more innovative design that can maximize your contribution while minimizing your employer contribution. Sometimes we are able to decrease employer contribution by literally tens of thousands a year for a small practice with the right demographics, and this is by far the biggest cost you will pay, not administrative cost!
2) Plan investment management and participant education. You will be responsible for investment selection, development of model portfolios and employee education. Not something I’d want on my plate unless I was in the business of providing such advice.
Can you do significantly better? I believe so. In the case of Vanguard 401k, you are basically paying for a recordkeeper, while you should instead be paying (a flat fee) for a good adviser and a good TPA! Also, who says that a participant-directed plan for a small practice is the only way to go? A pooled plan may be more appropriate:
http://www.dentaltown.com//Dentaltown/Article.aspx?i=393&aid=5411
You are indeed right that paying a flat fee is much better than paying asset-based fees, but paying for quality advice that provides significant value is always better than paying for no advice!
Thank you.
The problem is I do not have access to information for a reliable TPA! I have a 401k plan from John Hancock, but has been opened by my previous employer, I did not make any contribution at it anymore. I chose Vanguard because of general opinions of having overall low costs . I do not want to miss the deadline of October 1st for 401k . Is there anything else that we can investigate in future? Stick with Vanguard now and analyze for the other options next year?
Thank you.
Sure, I might be able to help you. It is possible to get a plan even after October 1st deadline as I described in the article, so that’s never a problem. The biggest problem is getting into something that may not be the best plan for you (and having to close it down later for various reasons). Why have a 401k when a SIMPLE might do, unless you really do want to contribute more than ~$40k a year (together with your spouse)? Please feel free to get in touch: [email protected]