Over the last few weeks, I have had the opportunity to review two different 401(k) retirement plans; each one having over seventy available investment options.  Participants had to develop their own personal allocation by choosing from dozens of different investment options, many of which were in the same investment category or asset class. It seemed to me that this large number of choices for each participant had the potential to become an overwhelming task that could actually create a situation where a participant was likely to become less diversified, rather than more.

For example, if a plan has several different large stock growth mutual funds available, how does the average participant determine which large growth fund makes the most sense for them? If a participant selects more than one large growth fund, are they more diversified? The average participant actually has no way of knowing which of the multiple large growth funds available makes the most sense for them to choose, and he or she is very likely less diversified by choosing more than one fund in a given asset class.

One interesting study that examines how investment decision-makers, such as qualified retirement plan participants, are impacted by more choices is, “The Psychological Costs of Ever Increasing Choice: A Fallback to the Sure Bet,” written by Sheena S. Iyengar and Wei Jiang of Columbia University in 2005.  This study drew upon information attained by examining nearly 650 retirement plans with approximately 800,000 participants.

The above referenced Columbia University Study has a number of very interesting observations and conclusions.  One of the most fascinating conclusions drawn from this study was that having a large number of choices from an investment standpoint induced retirement plan participants to refrain from making any choices even when it was costly to do so.

Further, the availability of a significant number of investment choices actually motivated retirement plan participants to choose less risky investment options. The attitude of the typical participant seems to be, “This is not what I do.There are too many choices here. I think I’ll just play it safe.” The selection of less risky investment options, such as money market accounts and stable value funds, may be appropriate for some participants. However, this could be a costly allocation decision for participants with a long time horizon in front of them from an investment standpoint.

One of the most dramatic conclusions made by this particular study was that having too many investment choices actually created a situation where participants were more likely to completely opt out of a pension plan. This tendency to opt out when there are a large number of choices was even proven to be true when there were clear monetary advantages to participate, such as an employer matching contributions.  As options increase, the probability of participation declines.  I personally found this to be an incredible observation.

This recent and rather extensive study provides some compelling observations for plan sponsors to consider when building a fund menu.  Clearly, participants must have a fund menu that enables them to develop an appropriate allocation based on their personal goals, time horizon, and risk tolerance. However, excessive choices actually decrease the likelihood that participants will develop a prudent investment mix.

Another practical administrative challenge for plan sponsors who have a large number of investment choices on their menu is the ongoing need to monitor those investments based on a prudent fiduciary process.  It is reasonable to expect that if you have a significant number of investment choices and have a reasonably high standard for performance of those investment options, that you will need to make rather frequent changes to your investment lineup.  Changing investments on a frequent basis can be costly in a variety of ways including administrative fees associated with changing a fund, the necessity to place the plan into an administrative blackout, and the possible need to communicate the change to retirement plan participants.

In conclusion, having too many choices has proven to actually decrease participation in defined contribution plans such as 401(k)s, even when participants are incented to participate through a matching contribution.  Further, participants that make investment allocation decisions when there are a significant number of choices available are more likely to weight their allocations toward fixed income and cash equivalent investment options. This bias toward less risky investment options when there are a large number of choices occurs even when the end result may not be the most reasonable long-term investment decision for the participants.

A ‘best practice’ for retirement plan sponsors building an investment menu is to first determine which investment categories make the most sense to include in their fund lineup and then select well-managed mutual funds that fit into those asset classes.  These mutual funds can then be monitored carefully, based on a prudent fiduciary standard of care and replaced when necessary.

To stay up-to-date on prudent practices as a retirement plan sponsor, or to share this information, please register for our newsletter by using the registration form located in the sidebar of this blog, or subscribe to our RSS feed. As always, we appreciate your comments, which can be added below. For compliance reasons, comments are monitored and reviewed as soon as possible before posting.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC. Investment advisory services are offered through HBK Sorce Advisory LLC. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPLE. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.

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Chris Carosa, of the Fiduciary News Blog, recently wrote about an ongoing industry conversation that he refers to as a “401(k) Fee War.” In this article, Chris references the significant attention being paid to mutual fund expenses for 401(k) investment options.  As an industry observer, I too have noticed that the attention being paid to mutual funds fees as well as other asset-based charges assessed to participants has increased dramatically in recent months.

In his article, Chris reminds his readers that the assessed fees associated with servicing a retirement plan need to be reasonable. Chris also points out the current lack of specific regulations on these fees. That being said, retirement plan sponsors are wise to pay attention to the fees being assessed by fund complexes and other professional service providers to their participants.

My intended audience for this blog is not professional advisors, such as myself, who are obsessed with the pension market and monitoring trends on a weekly basis, but rather company owners who are otherwise busy professionals with limited time to dedicate to company sponsored benefits. Because my readers may not be familiar with the details of ERISA (Employee Retirement Income Security Act) and the fiduciary duties that are required of retirement plan sponsors, I thought it would be useful to provide a real world example of the impact these can have on a participant’s future retirement benefits. Realistically, even small variances in asset-based charges assessed to participant account balances can have a significant impact on a participant’s future benefit.

For example, assume that two participants each contribute $250 per month to the same 401(k) investments. The only difference is the net rate of return available to each respective participant. For this example, investor A earns 8% and investor B earns 7.5% because investor B purchased mutual funds that have higher expense ratios. Based on these assumptions, investor A will have $239,342 at the end of a 25 year period of time.  Investor B, who earned 7.5% over the same 25 year period, will have $220,686. As you can see, paying an additional 0.50% over that 25 year period resulted in investor B ending up with $18,656 less than investor A.

You can take this example an additional step forward by examining the difference in future benefits for these two participants due to the difference in their account balances at retirement. Assume, for example, that they each draw down their respective portfolios over a 20 year period at a 7% rate of return. Investor A could draw almost $150 per month more than investor B. Over this 20 year retirement the total difference in benefit is more than $30,000. For many retirees this is a meaningful number.

If you start to apply this thought process across multiple participant accounts, you can begin to appreciate why it is so important for plan sponsors to pay attention to the underlying expenses assessed against their participants. Clearly, not all investment expenses are bad or imprudent. However, if the same or comparable investment options are available less expensively, then plan sponsors should take action to reduce those costs.

In conclusion, the “401(k) Fee War” is likely to rage on. Unfortunately for plan sponsors, remaining neutral will not be an option. Fees impact participant performance and subsequent retirement benefits. Consequently, plan sponsors need to pay careful attention to the cost associated with providing investments and other services to participants.

To stay up-to-date on prudent practices as a retirement plan sponsor, or to share this information, please register for our newsletter by using the newsletter registration form in the sidebar of this blog, or subscribe to our RSS feed. As always, we appreciate your comments, which can be added below. For compliance reasons, comments are monitored and reviewed as soon as possible before posted.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC. Investment advisory services are offered through HBK Sorce Advisory LLC. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPLE. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.

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As the number of small businesses in the U.S. grows, the number of retirement plan choices seems to grow as well.  Two popular retirement plan options for smaller businesses seek to avoid the complexities that go along with establishing a qualified retirement plan such as the 401(k). These two options are the SEP IRA (Simplified Employee Pension) and the SIMPLE IRA (Savings Incentive Match Plan for Employees).

Each of these choices enables employers to make contributions for participants directly to individual retirement accounts or IRAs. Contributions made to either the SEP IRA or the SIMPLE IRA are always fully vested to the participant. Employers establishing either type of plan are relieved of the more onerous compliance and reporting requirements required by traditional qualified retirement plans.

One of the key differences between the SEP-IRA and the SIMPLE IRA has to do with the type of contribution that can be made to the participant accounts. With the SEP IRA the only type of contributions allowed into participant IRA accounts are those made by the employer.  Contributions to the SEP IRA are made on a percentage of compensation basis.  Contributions made to SIMPLE IRAs include both employee salary deferrals and employer contributions. In the case of the SIMPLE IRA, the employer contributions can be made either as a matching contribution based on the employee’s salary deferral or as a percentage of compensation made to all eligible participants.

Again, regardless of which of these two types of plans employers choose, they will avoid the cumbersome reporting and disclosure requirements associated with qualified retirement plans which fall under IRC Section 401(a).   A careful examination of each option will help businesses make intelligent decisions regarding which plan to choose.

The SEP IRA

As previously  noted, contributions to SEP IRAs are employer only. In other words, there is no employee salary deferrals allowed into participant accounts. Currently, an employer can contribute up to 25% of an employee’s compensation annually to a SEP IRA. This percentage limit is not to exceed $49,000. This differs from profit sharing plans in that employers can contribute up to 100% of a participant’s compensation up to $49,000. Unlike profit sharing plans, contributions made to SEP IRAs cannot be weighted toward a particular class of employee or given to certain employees based on age. SEP contributions must be made in a uniform manner based on each employee’s compensation.

The only opportunity to weight SEP IRA contributions towards certain employees is found in the ability to integrate SEP IRA contributions with social security. This social security integration allows employers to contribute more toward employees that make in excess of the social security wage base, which in 2009 will be $106,800. Individuals earning in excess of this amount may end up with a slightly larger employer contribution amount. Beyond this ability to integrate employer contributions with social security, there are no other opportunities to allocate SEP IRA contributions toward more highly compensated or key employees.

As you would expect, contributions made to SEP IRAs on behalf of each respective participant are not currently taxable income to the participant. Furthermore, the earnings on assets held inside of SEP IRAs grows on a tax-deferred basis. Ultimately, as participants make withdrawals from SEP IRA accounts,   those withdrawals are taxed as ordinary income.  As is the case with a traditional IRA, withdrawals made from SEP IRAs prior to age 59 ½ are subject to a 10% penalty in addition to ordinary income taxes.

As with many types of retirement plans, distributions from SEP IRAs can be rolled to a traditional IRA. Again, employees own and control 100% of contributions made to their participant IRA account immediately after the contribution is made. Consequently, due to this immediate vesting, employees can always leave the business and take 100% of their account balance with them.

Similar to a profit sharing plan, contributions made to a SEP IRA on an annual basis by the employer are completely voluntary.  Although the maximum contribution is 25% of an employee’s compensation, there is no minimum contribution required on an annual basis.  Consequently, employees are well advised not to rely completely on the SEP IRA to fund their personal retirement goal.

Another unique feature of the SEP IRA is the fact that it has the longest waiting period of any retirement plan available to a small employer. Employers electing to do so may prevent employees from being eligible to participate in the SEP IRA until they have completed at least three years of service with the employer. Thus, if an employer is in an industry which possesses  a large number of short-term or seasonal employees with significant turnover, a SEP IRA may be more advantageous.

As is the case with most other  retirement plans, employees participating in collective bargaining units and nonresident aliens do not have to be covered under a SEP IRA. Also, employers establishing a SEP IRA after 2001 may be eligible for a business tax credit of up to $500 if the SEP IRA is a startup retirement plan for that business.

The SIMPLE IRA

SIMPLE IRAs are only available to employers with up to 100 employees. Contributions made to SIMPLE IRA’s can also be either employee salary deferrals or some form of employer contribution. The service requirement for participation in the SIMPLE IRA is two years. In each of those two preceding years, employees must have at least $5,000 of earnings. In the current year, participating employees must be expected to earn at least $5,000 of income.

In the year 2009, employees can make contributions of up to $11,500. If the participant is over the age of 50 there is a catch up contribution available that allows employees over the age of 50 to contribute up to an additional $2,500 on a pretax basis into the plan. Unlike the SEP IRA, the $11,500 maximum contribution is not limited by a percentage of the employee’s compensation. Employees can contribute up to 100% of their compensation with an $11,500 maximum contribution limit. Theoretically then, employees earning $11,500 could contribute 100% of that amount to their SIMPLE IRA participant account.

Employers must make contributions to the SIMPLE IRA on behalf of eligible participants in one of two ways. The first is a matching contribution based on the participant’s salary deferral amount. This match is dollar-for-dollar up to the first 3% of the employee’s contribution. Consequently, if employees contribute 3% of their salary to the SIMPLE IRA, the employer must match that amount.  The employer has no obligation to match any employee salary deferral in excess of the 3% maximum. Employers not wishing to make a matching contribution must make a non-elective contribution of 2% of compensation for all eligible employees. This non-elective contribution must be made to employees meeting the two-year service requirement regardless of whether not they contribute any of their personal compensation to the plan. And employers may not make both a matching contribution and a 2% non-elective contribution. They must choose one of the two options.

Similar to 401(k) retirement plans, employee seller deferrals made to SIMPLE IRAs are made on a pretax basis. Employer contributions, both the match and the non-elective contribution, are not currently taxable to the employee. Businesses adopting a new SIMPLE IRA after 2001 are also eligible for the $500.00 business tax credit mentioned in the previous discussion about the SEP IRA. This tax credit was put in place by Congress in 2001 as an incentive for employers to establish new retirement plans.

Like the SEP IRA, contributions made to participant accounts by the employer in the SIMPLE IRA are fully vested to the employee. Consequently, employees can immediately withdraw contributions made to the SIMPLE IRA on their behalf, both seller deferrals and employer contributions. These distributions, like those made from the SEP IRA, are immediately taxable to the employee as ordinary income.  Also, similar to both the SEP IRA and traditional IRA, if these distributions are made prior to age 59 1/2, the participant will be subject to a 10% IRS penalty on the entire amount withdrawn. The penalty for early withdrawal from SIMPLE IRA is potentially even more severe. If participants choose to withdraw their SIMPLE IRA balance during the first two years, they may incur a 25% penalty tax.

From the employee’s standpoint, one obvious advantage of the SIMPLE IRA versus the SEP IRA is the ability to make salary deferrals on a pretax basis.   This may allow employees to develop a systematic savings program on a payroll deduction basis similar to what they would be able to establish if they had a 401(k) retirement plan available to them.

Small business owners should consider a SIMPLE IRA versus a SEP IRA when the amount of self-employed income available to them to contribute to the plan is comparatively small. For example, if an individual owns a small business and works in that business on a part-time basis, an excellent alternative may be the SIMPLE IRA. If the small business owner earns $11,500 per year or less that entire amount could be contributed to the SIMPLE IRA. If however, this small employer had established a SEP IRA, the maximum contribution would only be $2,300.00. This is because the maximum contribution to the SEP IRA would be 25% of the amount earned or $2,300 ($11,500 X 25% = $2,300).

In conclusion, both the SEP IRA and the SIMPLE IRA can be very effective choices for small employers looking to establish a retirement plan that is simple to administer. SEP IRA works best for employers who are able to generate a higher amount of revenue and who wish to contribute at a higher limit.

SIMPLE IRA, on the other hand, works very effectively for employers who may have less revenue and wish to have more of the total contribution to the plan coming from employee’s salary deferrals. SIMPLE IRA is also an excellent choice for people who manage smaller businesses in addition to their other employment.

Because of the complexities in the retirement plan arena, many times it makes sense to consult a financial adviser or tax professional prior to establishing a retirement plan for the small business owner.