[Editor's Note: This is a guest post by Konstantin Litovsky, one of my regular advertisers who has helped a number of regular WCI readers make changes to their workplace retirement plans. He is also a frequent participant in the comments section on the blog and has frequently answered questions for me via email. This is not a paid post (I don't do those) but we obviously have a financial relationship.]
When we talk about retirement plans, specifically the 401(k) plans, we always have in mind participant-directed plans in which all plan participants get their own personal account and are responsible for managing their own investments. It turns out that participant-directed plans aren’t the only 401k plans available. A common type of plan that was popular back in the 80s – called trustee directed or ‘pooled’ 401k plan – is staging a comeback, and for some very good reasons. In this article, we’ll discuss pooled 401k plans and explain why they might be a better choice for smaller practices than participant-directed 401k plans.
Participant-Directed Vs Pooled Plans
In participant-directed plans, every plan participant gets their own account and is responsible for managing their own investments. In participant-directed plans, the plan sponsor is ultimately liable for plan performance, as well as for investment selection and participant education. Participant-directed plans require the services of a Third Party Administrator (TPA), a custodian and an investment adviser (either a 3(21) or a 3(38) fiduciary).
Pooled plans have a single trust account managed by the plan sponsor (the trustee). All plan contributions are co-mingled and are tracked by the TPA. A discount brokerage such as Ameritrade or Vanguard is typically used as a custodian. Plan participants do not get to manage their accounts and have no say in the investment direction of the plan investments. The investments in a pooled account can be managed by an investment manager (a 3(38) fiduciary), and no other services that are typically provided by participant-directed plans (such as enrollment meetings, participant education, and individualized advice) are necessary.
Why Use A Pooled Plan?
Since 2008, participants are able to sue (and are increasingly suing) plan sponsors for fiduciary breaches due to high investment costs, lack of education, bad investment choices and investment losses. Because smaller plans rarely get the benefit of quality fiduciary advice, they are exposed to liability due to fiduciary breaches. A pooled 401k plan can be a great way to reduce your fiduciary liability. As long as you have a 3(38) investment manager taking care of the investments, your own liability for managing investments is eliminated, and because there are no participant-directed accounts, there is no other liability for you as a plan sponsor (other than prudent selection of the investment manager). There is no need to worry about 408(b)(2) fee disclosures, QDIA selection and disclosures, fee benchmarking, participant education and advice – services that a plan sponsor for a typical participant-directed 401(k) plan has to provide for the benefit of the plan participants. Please note that not all 3(38) investment managers will want to have discretionary control over your pooled plan investments, and anything less than an investment manager who is a 3(38) fiduciary will not eliminate your fiduciary liability for investment selection and management.
In addition, having a plan with a professionally managed investment portfolio can help you and your employees achieve better investment results, especially if you do not want to worry about managing your own investments. In a participant-directed plan every participant has their own account, so they have to manage their own investments. Even with the best advice provided to participants, each participant still has to follow through and make the right choices. Having a single managed account eliminates this problem, and all plan participants will benefit from getting their investments professionally managed.
It costs less to manage and maintain such a plan. Because there are no participant services to provide, a pooled plan will save you time, paperwork and money – there are no asset-based fees for custodians (Employee Fiduciary charges 0.08%), you can use a stand-alone low cost TPA for administration, and a discount brokerage such as Vanguard can be used as a custodian/record-keeper. Vanguard has one of the best selections of low cost index funds available, so that alone will ensure that your investment expenses are low. Investment management in such plans can be offered for a flat fee (rather than an asset-based fee), and because the money is in a single account, the cost of managing assets in pooled plans is lower than in participant-directed plans.
A Pooled Plan In My Practice?
Pooled plans will not work for everyone, but a practice with one owner may be a good candidate for this type of plan. All plan participants will get the highest level portfolio management services (the next best thing to hiring a wealth manager), and since there is only one account, your employees will be thrilled because most of them have no idea how to manage their investments. A pooled plan is a better deal than simply having a 3(38) fiduciary oversee plan investments in participant-directed plans. A typical 3(38) fiduciary might pick investments within a plan, but they rarely offer discretionary portfolio management (or managed model portfolios) inside participant-directed plans, and if discretionary investment management is offered, the cost is usually high (typically via an asset-based fee). While there are some 3(38) investment managers who can provide competitively priced investment management services for participant-directed plans including investment selection and model portfolio management, most advisers offering 3(38) fiduciary services will not provide individualized advice to plan participants, which is one of the best ways to limit your fiduciary liability while helping your employees achieve better investment performance inside a participant-directed plan, Thus a pooled plan is probably the best and the most cost-effective way for a small practice to get the benefit of a professionally managed retirement plan with the highest fiduciary liability protection possible.
All Participants Have The Same Portfolio
It turns out that having the same portfolio for a 30-year-old and for a 60-year-old is not a problem. Having a single conservative allocation for all plan participants can be a good idea over the long term, and it is not necessary to be overexposed to stocks or to have an aggressive portfolio for younger employees. This counter-intuitive result comes from the fact that a conservative portfolio might provide better risk-adjusted return than a very aggressive one. While the actual outcome depends on many factors, we can demonstrate this effect with the Vanguard Monte Carlo simulator that uses actual historical data. (Try using a 100% stock allocation portfolio and comparing it to a 50% stock allocation portfolio.)
Over the past 30 years, a 50% stock/50% bond allocation turned out to be as good (or better) than a 100% stock allocation assuming periodic withdrawals, so if someone retired 30 years ago, a 50:50 portfolio would have done as well (and possibly even better) than a 100% stock portfolio, and with significantly less risk. While a 100% stock portfolio might have done better if no withdrawals were made, periodic withdrawals make all the difference because 100% stock portfolio is much more volatile, so making withdrawals during market crashes would have taken away from future returns. A pooled plan is likely to see continuous contributions, which can help rebalance during the down years, but over time those contributions will be rather small compared to the value of the overall portfolio. In a pooled plan, withdrawals might be made from the portfolio for various reasons (and at various times), such as when an employee is terminated or when making hardship withdrawals, so another reason to keep a more conservative allocation is to avoid a situation where large withdrawals are made from a portfolio that lost value during a market crash (which can happen when a long-time or a highly compensated employee leaves).
One way to think about conservative vs. aggressive portfolios is that it is better to get close to ‘market’ return (represented by an index such as S&P500) with much less volatility than having the potential for a higher than market return but also for a much bigger loss, which can be a significant disadvantage when making withdrawals, especially during prolonged periods of market underperformance. While you might see higher returns with a 100% allocation, you will also see bigger losses, so a conservative allocation might actually do better because you don't have to worry about getting out of the market at the wrong time as much as you would with an overly aggressive allocation. While it may seem that getting out of the market is simple, doing so at the wrong time can lead to large losses over a prolonged period of time because recoveries can often take a decade or longer. Thus, a single conservative allocation can be a good solution for a pooled plan from both the plan operation and investment management perspectives.
Pooled Plans Aren't New
These plans have been around for a long time, but fell out of favor because in the 90s plan participants started to demand more control over their individual accounts. Market gains in the 90s created unrealistic expectations that anyone could manage their own portfolio like a pro, but the two recent bear markets have proven otherwise. A small number of dedicated and knowledgeable advisers including some CPAs and TPAs are using pooled plans with their clients, so pooled plans remain an open secret. Unfortunately, some advisers, including CPAs who provide investment management services, are using pooled plans as a way to charge high asset-based fees, which is not a good deal for the practice owners. This is not an ideal type of plan for larger companies where the owners prefer to manage their own accounts and can afford to hire the right fiduciary to oversee the plan, but smaller companies, especially medical and dental practices, can benefit immensely from what pooled plans have to offer.
[Editor's Note: Pooled plans are not that different from the defined benefit/cash balance plan my practice uses, except it is a type of 401(k). We put in $2500-15K per year, in it invested in a set asset allocation we have no control over (52% stock in our case), and upon leaving the group, it can be rolled over to an IRA. One of the biggest downsides is that it is hard to mix and match a plan like this with the rest of your retirement accounts. I prefer having more control over my own asset allocation, but most investors, probably including your employees, honestly don't know what to do with that control. It sounds paternalistic, but if they aren't willing to take the time to learn a bit about investing, they're better off handing the reins to somewhat else who will do something reasonable, especially if that asset management comes at a very low price.]
What do you think? Do you have a pooled 401(k)? Would you consider one? Comment below!