Is Your 401(k) Up to the Task?

A 401(k) may be the largest financial asset a family has. It can be a great tool to build wealth, or, depending on its structure, so defective it may not be worth your participation. 401(k)s range anywhere from excellent to awful. Unfortunately, it's up to your firm as a plan sponsor, and then you as an individual, to decide whether to select one plan over another, and then whether to personally maximize the opportunity that's presented or to pass and find better alternative ways to invest your retirement savings.

It's important to keep in mind that 401(k) plans are investment vehicles, and they should be judged accordingly. While there are some significant tax advantages built in, depending on the 401(k), those advantages can be quickly neutralized by excessive costs, poor performing funds, and insufficient opportunities to allow you to diversify and manage risk. They are definitely not all alike, and sponsors as well as participants should educate themselves on how they differ so they can make informed choices when it comes to selecting a plan.

Your personal investments represent your (and your employees') future financial strength, and retirement will be here before you realize. It takes a lot of capital to replace regular employment income as a family's income generator. A good 401(k) can be a great ally as you prepare for retirement; a lousy plan, on the other hand, could erode your ability to build for a decent and secure retirement. There's no time like the present. Now is a very good time to make sure your 401(k) plan is up to the challenge.

But, where do you start?

Improved Disclosure Is on the Way

New and much improved disclosures on 401(k) expenses and other information will help participants and employers compare and judge individual plans. The disclosure you are about to get under the new Department of Labor (“DOL”) regulations is a good place to start when evaluating your plan. But disclosure in a vacuum is worth zero. It's what you do with the information that counts. If the plan sponsors and participants don't attempt to understand and digest the new information, measure the plans against reasonable benchmarks, make informed decisions, and take action to adjust their strategies accordingly, all the disclosure in the world will
not help them choose a suitable plan.

The disclosure from each pension service provider to plan sponsors must include total plan expenses, methods of payment, services, fiduciary status, and potential conflicts of interest. For the first time, plan sponsors will have a complete picture of who is getting paid for each service and whether that payment is “reasonable” for each service provided. Additionally, each service provider must state whether it is acting in a fiduciary capacity, which requires it to make decisions solely in the best interests of plan participants. Shortly after receipt of this added information, plan sponsors are required to consolidate, summarize and share this information with their own pension participants so they, too, can make their own informed decisions about investing their retirement savings.

Make no mistake about it, this new disclosure is indeed critical information, and the disclosure requirement is long, long overdue. However, it's actually only one piece of the pie when it comes to evaluating one's plan. But it's a start, so let's begin with that piece of the pie as a first screen to see what we should learn, and then work on other parts of the plan to evaluate whether your plan is an A+, an F− or somewhere in between.

The easiest place to start is with costs. There are necessary services that must be paid for by a qualified plan that may make it more expensive to administer than a carefully managed personal account. Record keeping, plan administration, legal services, tax preparation, fund expenses, trading costs, compliance testing, accounting, statement generation, web services, custody and investment advice all cost something. So it is reasonable to have fees associated with each. However, each cost on its own should be reasonable. In addition, from the perspective of the participant, it's important that the total expenses
combined not be excessive as well.

Fortunately, today computers do a lot of the grunt work that formerly was performed by pension service provider staff, and economies of scale can kick in to make a well-run plan very economical. These should translate into more efficient and less costly service. Of course, a plan with many participants and small total assets will necessarily be more expensive than a plan with few participants and giant account balances. DOL doesn't suggest any range of reasonableness for plan expenses; instead, it expects plans to occasionally “test the market” to determine what's reasonable.

As an example, a typical well-run, very-small company plan with $1 million total balances and 50 participants might have expenses that come in at 1.3% of assets per year in total costs. Larger plans should be somewhat cheaper. So if your plan has total costs that exceed 1.3%, and you pay them, you might want to know why.

It's not unusual to come across retirement plans of the $1 million size noted above, with total costs exceeding 3.25% of plan assets per year. This level of costs is a devastating tax on participants' ability to accumulate reasonable future retirement savings. If your firm's plan has costs in that range, I wouldn't invest one penny over the amount the firm matches (if any).

It helps participants a lot, and makes a plan far more attractive, if the employer/plan sponsor pays plan expenses directly rather than having them deducted from participant accounts. That can have a dramatic positive impact on the costs the participants bear and ultimately on their investments' ability to build for future retirement security.

Next, you will want to ensure that your plan's investment adviser/administrator/record keeper acknowledges their fiduciary status in the new plan disclosures. This acknowledgement means that they are held to the highest standards of prudence in investment management, and they are required to make decisions solely in the best interest of plan participants. It's a total mystery to me why any plan sponsor or participant might consider a plan with anything less, but there are many plans out there that do not meet this level of prudence, and many firms and participants who don't know the difference. If the plan administrator won't make decisions in the investors' best interest, why would you need them?

Potential conflicts of interest are the next item of concern. As just one example, if a plan adviser is tied to a single mutual fund family, or only to fund families that pay the adviser in revenue-sharing arrangements, your universe of potential funds is vastly restricted; your costs may be higher than “reasonable”; and the plan may tolerate substantial underperformance of offered plan investments for extended periods rather than find better investment alternatives for participants.

Beyond Disclosure

Beyond the new disclosure requirements there are a number of qualitative considerations that can help distinguish great 401(k) plans from those that are of lesser quality. Other plan features are also important:

• Enough low-cost index fund options offered to effectively and economically diversify participants' portfolios around the world's equity and bond markets;
• Pre-defined target risk and target date solutions to assist management of participants' portfolios to meet their unique situations without requiring them to select individual funds or develop asset allocation models;
• Easily accessed online tools, calculators and educational materials to make number crunching and planning retirement simple and effective for participants;
• An easily navigated website allowing 24/7 access to account information, values, performance, loan initiation, investment and contribution changes, etc.;
• Periodic automatic rebalancing of individuals' accounts; and
• Call centers staffed with helpful advisers.

Take the time to evaluate your firm's plan from a plan sponsor and a participant perspective. Remember, it's your retirement savings going into it, and the quality of the investment vehicles and their performance results will determine whether or not you have a secure retirement. You simply can't avoid taking responsibility for making informed decisions. It is hoped, your plan will shine. If not, you have lots of options, some of which will be discussed in a future article in this publication.

Frank Armstrong, III, a member of this newsletter's Board of Editors, is the founder and president of Investor Solutions, Inc., a Miami-based Fee Only SEC Registered Investment Adviser with discretionary or advised assets of more than $500 million. An industry veteran and pioneer whose career spans 38 years, he's the author of four books on investment and retirement planning, speaks nationally and is widely quoted in the financial press. He may be contacted by e-mail at [email protected].

A 401(k) may be the largest financial asset a family has. It can be a great tool to build wealth, or, depending on its structure, so defective it may not be worth your participation. 401(k)s range anywhere from excellent to awful. Unfortunately, it's up to your firm as a plan sponsor, and then you as an individual, to decide whether to select one plan over another, and then whether to personally maximize the opportunity that's presented or to pass and find better alternative ways to invest your retirement savings.

It's important to keep in mind that 401(k) plans are investment vehicles, and they should be judged accordingly. While there are some significant tax advantages built in, depending on the 401(k), those advantages can be quickly neutralized by excessive costs, poor performing funds, and insufficient opportunities to allow you to diversify and manage risk. They are definitely not all alike, and sponsors as well as participants should educate themselves on how they differ so they can make informed choices when it comes to selecting a plan.

Your personal investments represent your (and your employees') future financial strength, and retirement will be here before you realize. It takes a lot of capital to replace regular employment income as a family's income generator. A good 401(k) can be a great ally as you prepare for retirement; a lousy plan, on the other hand, could erode your ability to build for a decent and secure retirement. There's no time like the present. Now is a very good time to make sure your 401(k) plan is up to the challenge.

But, where do you start?

Improved Disclosure Is on the Way

New and much improved disclosures on 401(k) expenses and other information will help participants and employers compare and judge individual plans. The disclosure you are about to get under the new Department of Labor (“DOL”) regulations is a good place to start when evaluating your plan. But disclosure in a vacuum is worth zero. It's what you do with the information that counts. If the plan sponsors and participants don't attempt to understand and digest the new information, measure the plans against reasonable benchmarks, make informed decisions, and take action to adjust their strategies accordingly, all the disclosure in the world will
not help them choose a suitable plan.

The disclosure from each pension service provider to plan sponsors must include total plan expenses, methods of payment, services, fiduciary status, and potential conflicts of interest. For the first time, plan sponsors will have a complete picture of who is getting paid for each service and whether that payment is “reasonable” for each service provided. Additionally, each service provider must state whether it is acting in a fiduciary capacity, which requires it to make decisions solely in the best interests of plan participants. Shortly after receipt of this added information, plan sponsors are required to consolidate, summarize and share this information with their own pension participants so they, too, can make their own informed decisions about investing their retirement savings.

Make no mistake about it, this new disclosure is indeed critical information, and the disclosure requirement is long, long overdue. However, it's actually only one piece of the pie when it comes to evaluating one's plan. But it's a start, so let's begin with that piece of the pie as a first screen to see what we should learn, and then work on other parts of the plan to evaluate whether your plan is an A+, an F− or somewhere in between.

The easiest place to start is with costs. There are necessary services that must be paid for by a qualified plan that may make it more expensive to administer than a carefully managed personal account. Record keeping, plan administration, legal services, tax preparation, fund expenses, trading costs, compliance testing, accounting, statement generation, web services, custody and investment advice all cost something. So it is reasonable to have fees associated with each. However, each cost on its own should be reasonable. In addition, from the perspective of the participant, it's important that the total expenses
combined not be excessive as well.

Fortunately, today computers do a lot of the grunt work that formerly was performed by pension service provider staff, and economies of scale can kick in to make a well-run plan very economical. These should translate into more efficient and less costly service. Of course, a plan with many participants and small total assets will necessarily be more expensive than a plan with few participants and giant account balances. DOL doesn't suggest any range of reasonableness for plan expenses; instead, it expects plans to occasionally “test the market” to determine what's reasonable.

As an example, a typical well-run, very-small company plan with $1 million total balances and 50 participants might have expenses that come in at 1.3% of assets per year in total costs. Larger plans should be somewhat cheaper. So if your plan has total costs that exceed 1.3%, and you pay them, you might want to know why.

It's not unusual to come across retirement plans of the $1 million size noted above, with total costs exceeding 3.25% of plan assets per year. This level of costs is a devastating tax on participants' ability to accumulate reasonable future retirement savings. If your firm's plan has costs in that range, I wouldn't invest one penny over the amount the firm matches (if any).

It helps participants a lot, and makes a plan far more attractive, if the employer/plan sponsor pays plan expenses directly rather than having them deducted from participant accounts. That can have a dramatic positive impact on the costs the participants bear and ultimately on their investments' ability to build for future retirement security.

Next, you will want to ensure that your plan's investment adviser/administrator/record keeper acknowledges their fiduciary status in the new plan disclosures. This acknowledgement means that they are held to the highest standards of prudence in investment management, and they are required to make decisions solely in the best interest of plan participants. It's a total mystery to me why any plan sponsor or participant might consider a plan with anything less, but there are many plans out there that do not meet this level of prudence, and many firms and participants who don't know the difference. If the plan administrator won't make decisions in the investors' best interest, why would you need them?

Potential conflicts of interest are the next item of concern. As just one example, if a plan adviser is tied to a single mutual fund family, or only to fund families that pay the adviser in revenue-sharing arrangements, your universe of potential funds is vastly restricted; your costs may be higher than “reasonable”; and the plan may tolerate substantial underperformance of offered plan investments for extended periods rather than find better investment alternatives for participants.

Beyond Disclosure

Beyond the new disclosure requirements there are a number of qualitative considerations that can help distinguish great 401(k) plans from those that are of lesser quality. Other plan features are also important:

• Enough low-cost index fund options offered to effectively and economically diversify participants' portfolios around the world's equity and bond markets;
• Pre-defined target risk and target date solutions to assist management of participants' portfolios to meet their unique situations without requiring them to select individual funds or develop asset allocation models;
• Easily accessed online tools, calculators and educational materials to make number crunching and planning retirement simple and effective for participants;
• An easily navigated website allowing 24/7 access to account information, values, performance, loan initiation, investment and contribution changes, etc.;
• Periodic automatic rebalancing of individuals' accounts; and
• Call centers staffed with helpful advisers.

Take the time to evaluate your firm's plan from a plan sponsor and a participant perspective. Remember, it's your retirement savings going into it, and the quality of the investment vehicles and their performance results will determine whether or not you have a secure retirement. You simply can't avoid taking responsibility for making informed decisions. It is hoped, your plan will shine. If not, you have lots of options, some of which will be discussed in a future article in this publication.

Frank Armstrong, III, a member of this newsletter's Board of Editors, is the founder and president of Investor Solutions, Inc., a Miami-based Fee Only SEC Registered Investment Adviser with discretionary or advised assets of more than $500 million. An industry veteran and pioneer whose career spans 38 years, he's the author of four books on investment and retirement planning, speaks nationally and is widely quoted in the financial press. He may be contacted by e-mail at [email protected].