In the first part of my series we talked about the role and duty of the fiduciary, and the important steps of acceptance and adherence to the fiduciary standard. In this segment we will look into how the plan is structured: what we call plan design. Whether you have a current plan or are thinking of starting a retirement plan, it is critical to understand the many choices you have as a plan sponsor. Most business owners and trustees do not fully appreciate the various types of plans available, the options within those plans, and how more than one plan works in conjunction with the others. Because I have these conversations on a regular basis, I can assure you that a low percentage of the people of the people I talk to have any idea about plan design. And there is plenty to discuss! Read on.
When I take a step back to try to understand why so many plan sponsors have such little knowledge about the subject of plan design and the many potential possibilities of structuring a retirement plan, I believe it is primarily due to the high percentage of financial advisors who choose to focus the majority of their practice on individual investors. The average advisor may have only two or three retirement plan clients. I call them “one-off” advisors. They have a good book of individual clients, and two or three of those clients ask the advisor to “manage the retirement plan,” which they do. But because of this lack of focus or concentration, they simply do not speak the language of the qualified or non-qualified plan. To the average retirement plan sponsor, it may seem logical that a financial advisor who does a good job with individual asset management would also be effective with retirement plans. But that isn’t always the case. I believe this misunderstanding leads to a great disservice to both the organization who sponsors the plan and to the participants. Plan sponsors usually wind up with something that is sold to them by someone who represents a product. I call it a “401(k) in a box.”
I’ll step away from my soapbox but I cannot emphasize enough how important it is to understand this distinction.
Because there are too many specific types of plans to list, with as many options available in those plans, I will attempt to touch on a few examples, in order to get the conversation started.
At a high level, the first thing a retirement plan advisor must understand is what the organization is trying to achieve with their retirement plan. For example, are we trying to attract and retain quality employees? Are key employees highly compensated? Will the plan offer employer contributions, and if so, will they meet one of the many safe harbor requirements to pass testing? If not, will the highly-compensated employees even be able to fully participate, and if so, will the standard contribution limits of the qualified plan even be enough? Has a non-qualified plan been considered? And if so, what are the pros and cons of informally funding or not funding the plan? Each of the answers to these questions will lead to more questions.
Another goal of the plan may be to help employees retire, or to increase the participation or savings rate. There are some tools such as auto-enrollment or auto-increase that are wonderful to use, in order to help effect the outcome in a positive manner. So why do so few plans have these features selected? I believe there is a lack of understanding in how these features work, and what results they produce. I get the same resistance when the ROTH option comes up in our discovery meetings. Once the plan sponsor understands how the ROTH option works, how easy it is to administer, and that the participant, and not the owner or trustee, may want the option to utilize the tool, we tend to make headway.
In my next blog I will discuss in more detail the topic of selection and monitoring of investments in retirement plans. For the sake of the plan design discussion however, we need to determine first the type of investments to include. For example, do we want a guaranteed annuity option, a money market or stable value fund? Should we offer active or passive managed funds, or both? Other decisions to be considered are whether or not to offer managed advisory services that charge the participant an extra fee or brokerage windows that allow unlimited investment selection outside of the plan. There are pros and cons, fees, risks and potential rewards for each of these choices. And if the broker or advisor is not a fiduciary, who will actually provide the plan sponsor advice as to which of these options is best suited for their particular plan participants? If you ask the plan provider, and they happen to package their own stable value fund or target date funds for instance, are you able to understand the conflict of interest when discussing the best fund choices? These are all very important questions and the choices you make can either increase or decrease your liability to the plan participants.
One of my favorite discussions to have with small business owners centers on what I call “owner benefit.” Most small business owners work their entire lives building their respective businesses. They sock away the usual plan limits of the qualified plan inflated a few thousand dollars every couple of years. But they rarely understand how to maximize their allowable contributions, due to the perceived limitations of the plan. For example, if there are 30 employees, they typically would not consider a profit sharing contribution. 1/30 of the total profit is appealing to few business owners. Maybe they even underpay themselves and try to limit payroll taxes. As a result, they pull money from the business through distributions and pay enormous taxes. One of my first questions is, “If you had an investment vehicle that is tax-efficient, would allow you to put away in excess of $200,000 per year and would also benefit all or most of your employees, would there be any interest in exploring it?” I am often asked whether this is a new option or why their current advisor or CPA has not discussed this in the past. I assure them it is not new. By using the profit sharing plan, specifically a new comparability, age weighted or social security integration allocation, coupled with the 401(k) feature, and by adding a cash balance plan, owners have the opportunity to tax defer up to $265,000 in 2016.2 This is always a good time to bring the CPA into the conversation for the necessary tax advice.
Lastly, I often get calls from organizations to start a new plan. Should they start a 403(b), a 401(k), or a SIMPLE IRA? What are the costs of administering each of these options, the regulatory requirements, participation rates, options and restrictions for both the participant and the organization? I am surprised (not really) as to what answers plan sponsors get from the various advisors and plan providers they call or are referred to for advice and/or quotes. This is an important topic and plan sponsors need to understand not only the options and limitations that exist for the organization looking to start the plan, but also with those they call for help. For instance, are they calling a 401(k)-only provider and asking if they should start a 401(k) or a SIMPLE IRA? I think we know the typical answer because I hear it all of the time. “You should start a 401(k)” they are quickly told.
Good advice needs to be unbiased. Conflicts need to be disclosed. Complex and important decisions such as how to effectively manage or start a retirement program requires all parties to have a clear understanding and discussion about the many options available. They must be willing to spend time asking and answering pertinent questions and not rushing to solutions. And they must have a clear understanding of the needs and direction of both the sponsoring organization and its principals.
If you would like to discuss how Fragasso Retirement Plan Advisors helps our clients better understand plan design options and how to tie them to the needs and goals of your organization, please call for a consultation. Take action!
In my next blog we will discuss investment selection and monitoring. I promise it is not as easy as it seems, or as easy as some make it out to be. Stay tuned!
1 IRS IR-2015-118: The annual compensation limit under Sections 401(a)(17), 404(l), 408(k)(3)(C), and 408(k)(6)(D)(ii) remains unchanged at $265,000.
Read more blogs from this series!
Retirement Plan Success Series: Part 1: So you are a fiduciary!
Retirement Plan Success Series: Part 3: Retirement Plan Fees and The Matrix