Any size business can offer powerful 401(k) benefits, but as with most things, the better informed you are, the better decisions you can make. And this adage is never truer than when it comes to your money. While a good 401(k) plan can have a positive impact on a business and its individual employees, there are also some significant landmines to watch out for when evaluating and choosing a provider. Whether it’s unclear or hidden costs, undue risks put upon an employer or just smart investments to add to a 401(k) portfolio, what works for the provider doesn’t always work best for the employer and the employees.
Read on for the top 5 things to know when it comes to your 401(k) plan.
1. Fund Expenses Matter a Lot – Review Them and Keep Them Under 1%!
Most people are aware that there are certain 401(k) expenses that they need to pay. While the costs paid by the employer to administer the plan often gets the focus, probably the bigger need is to check out what all employees, including the owner will pay in investment expenses. Investment expenses typically include fund expense ratios, advisory, recordkeeping, administration and/or trustee expenses. Fund expense ratios are often the biggest expense of these. So you know, employees in small- and mid-size company plans are often subjected to paying 1.5% to 3% in fees annually on their 401(k) account balances. It may not sound like a lot, but over a career this can literally cost each employee hundreds of thousands of dollars.
Paying 1% Less Can Make a Big Difference!
This example shows the effect that expenses can have on your 401(k) retirement account over a career of 40 years by comparing the costs of paying 1% versus 2% on investments and how savings may accumulate. It assumes the investments have a fixed annual 7% return before expenses with no distribution or tax considerations and does not imply future returns. The example assumes each employee has a salary of $75,000 in year one and receives a 3% merit raise each year on-going. In addition, the employee contributes 5% of her salary each year and receives a 3% of salary company matching contribution.
The reality is, there’s no need for fees to exceed 1% all in, regardless of the size of your company or your plan’s asset balance. There are providers out there that offer low-cost plans and service. And, to re-emphasize, by staying below the 1% threshold, employees can accumulate tens, if not hundreds of thousands, dollars more savings over a thirty- or forty-year career.
2. Index-based Funds Have Historically Beat Actively Managed Funds, so Why Are Most 401(k) Plans Chalk Full of Actively Managed Funds?
Piling on point #1, Most 401(k) plans are built with actively managed mutual funds as a large component, but actively managed funds have a ton of costs associated with them: research that needs to be done, the costs of trading stocks and bonds within the fund, there are manpower hours, and even marketing costs that are passed through via 12b-1 fees, or worse, front- or back-end loads. It’s not uncommon for your provider to be paid with revenue sharing from actively managed funds.
With each extra dollar of expense incurred, the fund still has to overcome these expenses to outperform its benchmark index (usually the success measure of the fund). Index funds don’t have these loads or revenue sharing nor all the research costs and why they tend to have significantly lower expense ratios than actively managed funds. Considering this, it makes sense that historically the vast majority of actively managed funds have failed to beat their index over a 5-year period and even fewer over 10 years.
10-Year Performance of Actively Managed Funds Versus Benchmark Indices
|Fund Category||Comparison Index||Percent of Funds Underforming Index*|
|Large-Cap Core||S&P 500||97.38%|
|Mid-Cap Core||S&P Mid-Cap 400||92.03%|
|Small-Cap Core||S&P Small-Cap 600||96.72%|
*Source: SPIVA (Standard & Poor's Indices Versus Active Funds) U.S. Scorecard, End of Year 2019, S&P Dow Jones Indices.
While a provider may be better compensated with actively managed funds, you aren’t. Every dollar in expense is one less dollar in the markets to help your money grow.
In the same vein, some 401(k) plans also include variable annuities, but in reality, they add little or no value over other options when building for retirement. Annuities could make sense as part of your portfolio, and maybe more so after retirement, but not in your 401(k). The costs and issues in managing the plan in your employees’ best interest far outweigh the need for providing annuities in a company’s retirement plan. They’re expensive, typically charging 1.25% to 1.60% mortality and expense fees on top of the fund expense ratios. The participant can expect to pay >2% for annuity products.
3. You Have All the Risk on Your Shoulders, and Your Provider Probably Doesn’t
When you provide 401(k) benefits as an employer, you have a duty to run the plan in the best interest of your employees. Those duties include monitoring investment options made available, making changes as appropriate, providing guidance materials to members of the plan, and more. But while 401(k) providers often give employers a list of funds from which to select their company’s fund line-up, many won’t actually shoulder the responsibility for them. That means the very investment expertise the rep is supposed to be providing is really fully on the employer. And if employees complain or the business owner is audited, the responsibility falls solely on the employer to correct any issues.
Additionally, many providers offer their own funds or insurance annuity products within the 401(k) products they sell. This makes it difficult for them to take an unbiased approach in providing the best investment options for their customers. Using an independent investment advisor that can take an objective look at all the offerings on the market and select high quality funds by asset category may offer some solid upside compared to a biased fund line-up.
So how can you solve for all of this? Choose a provider that will serve as an ERISA 3(38) advisor on your plan. These providers share some important fiduciary duties on your plan and will not only take on the burden of managing the fund line-up and ensuring that the investments remain the right ones for a company’s plan, but they’ll also be on the hook for any investment line-up issues that may arise. This can provide a lot of protection and make your plan a whole lot easier to manage.
4. Know the Service (or Lack of Service) You Will Receive
Some providers offer a decent digital experience, but don’t pick up the phone or respond to you or your employees emails quickly. Some providers are the opposite with a poor digital experience but will take a call. Some don’t offer or will have you pay for employee education meetings, and others don’t even offer a kick-off meeting. You really deserve it all: a low-expense plan that offers service for you and your employees every step of the way. Give our previous blog a read on “What 401(k) Plan Services Your Business Will Need and Value” so you are clear on what services you expect and can ask the right questions before you pick your provider.
5. Pricing Won’t Lower Unless You Re-negotiate
A typical plan will have some admin costs and investment service expenses. Often these costs are set so they are what they are unless you go back and re-negotiate them with your provider. That re-negotiation may require added commitments, so be aware of that. You may want to look for providers that offer automatic pricing discounts, so as your plan grows in value, your plan costs lower more. This simplifies the need to be negotiating with your provider, and at the same time, know you are getting fair pricing.
Choosing the right retirement plan shouldn’t be hard—and it’s not, if you know what to look out for. Small-and mid-size business employers are simply looking for ways to manage costs and provide a better plan for their employees—but 401(k) plans can be fraught with conflicts of interest that can have a negative effect on their performance and ultimately undermine an employer’s ability to deliver a great plan for their company. Finding the right provider can help avert these issues and even simplify and lower the costs of a 401(k) plan. Focus on investment diversification and keeping fund expenses and participant fees low so your money can work harder and build over time. In the long run, you’ll be glad you did.