By using 401k plans, many small business owners can save money on taxes while providing themselves and their employees with a way to save for retirement. In the past decade 401k plans have earned a bad reputation which is totally undeserved. The problem is that high fees, poor investment choices and lack of basic financial education on how to manage their investments led to massive losses which turned many people away from 401k plans. A properly designed plan can be used as a long-term savings and investment vehicle for the business owner and employees. There are two main drivers for the long term performance of 401k plans – plan cost and investment performance. Unfortunately for most small business owners, cost is a distant second compared to the most important attribute of their 401k plan – investment performance, which primarily depends on investment choices, fund expense ratios and adequate investor education.
Plans available on the market
As is true with insurance products, most 401k plans today are sold. This would not necessarily be a bad thing if plenty of choices were available. Unfortunately, despite the abundance of plans sold through brokers, choices are very limited. The plans are sold by brokers as products, so a typical plan does not allow for much control and customization. The investment fees range from about 1.0% for an average mutual fund to as much as 4% for a plan that has insurance products. Typical annual fixed fees start at $3.5k for a 10-person plan, and other asset-based charges are added on top of the mutual fund fees, with the total asset-based charges of as much as 1.5%-2%. Some bundled plans are offered below average cost (with annual fixed fees as low as $500 for a 10-person plan), but for such plans the mutual fund fees can reach as high as 3%. If the business owner calls up a 401k plan broker, the choice they will have is between one expensive plan and another one, just as expensive. Brokers selling such plans are typically paid through revenue sharing by the mutual fund companies whose expensive funds they are selling, so they are not particularly interested in designing a low cost plan for their clients. This conflict of interest (and extreme costs) should warn the small business owners to stay away from broker-sold plans. Even when disclosed, it would take somebody knowledgeable to understand the true cost, and without having a side-by-side comparison with a low cost plan not available from brokers, this would be a very one-sided sale indeed.
In reality, a plan can cost a fraction of the price quoted by brokers if it is put together by a knowledgeable fee-only financial adviser who acts as a fiduciary for the business owner. Further down we will discuss the actual cost of a typical 401k plan and what a business owner can expect to pay.
Safe Harbor vs. Traditional
Unless the owners select a Safe Harbor 401k plan, they run the risk of having the plan become ‘top heavy’ when the plan assets contributed by key employees exceed 60% of the plan. To ensure that a plan isn’t ‘top heavy’, it has to be tested annually, and if it does become ‘top heavy’, steps must be taken to comply with the IRS requirements. To avoid this, most new plans go Safe Harbor, which means that they typically either contribute 3% to every employee or they match the first 4% of participating employee contributions. While some larger plans may avoid having to make matching contributions, evaluating whether to adopt a Safe Harbor plan is an important consideration for many small business owners.
Plan cost is typically shared between the owner and the employees. There is a tendency for some small businesses to pass on some of plan costs to the employees without properly disclosing this. Hopefully, recent regulations will change this practice, but even with disclosures, very few participants pay attention to the details. There are two major costs associated with opening and running a 401k plan. One is the mutual fund fees, paid by all participants. Another is administrative and record keeping fees paid by the business owner. The administrative fees include start up costs and Third Party Administrator (TPA) costs. While start up costs are a one-time expense, total administrative costs can be as high as $4k a year for a typical plan. While an existing plan can easily transfer administrative costs to the employees, this is really something to be avoided when starting a plan from scratch.
Bundled plans typically quote an average fund fee. However, a number like 1.5% hides the fact that many of the plan investments may be much higher – some as high as 3%. Investors themselves may not make the right decision and invest in high risk and expensive mutual funds. Some ‘balanced’ funds can charge as much as 3% in management fees making such funds unsuitable as a long-term investment vehicle. All mutual fund fees are typically paid by both employee and the business owner, so even if having high mutual fund fees can decrease out of pocket costs, the asset-based mutual fund fees are the ones the employers have to worry about more, not the fixed administrative costs.
For example, take a small business with 5 employees including the business owner. For the sake of simplicity, let’s ignore the Safe Harbor match. Suppose that all 5 participants will contribute $17,000 a year for the next 20 years into the plan, and that their annualized rate of return is a modest 5%. There are two choices: TPA #1, with a low administrative fee of $500 per year and average mutual fund fees of 1.5%, and TPA #2, with an administrative fee of $1500 per year and mutual fund fees of 0.2%. At first glance, one would be tempted to ignore the difference in mutual fund fees and to go with the lowest administrative cost TPA. Is that a wise choice? As the assets in the plan grow, after the first two years, TPA #1 with 1.5% mutual fund fees will be cheaper when investment returns are adjusted for the administrative fees. However, after 5 years, the TPA #2 with 0.2% mutual fund fees will net you $7k more compared to TPA #1, and in 10 years the difference jumps to $52k. After 20 years, if the participants continue to contribute $17k a year, the difference is a staggering $328k. Because most people participate in 401k plans for as long as they are working, it is fair to assume that high 401k plan expenses are something that everybody has to worry about. For an individual participant, mutual fund fees can cost more than $100k over several decades, and such costs can be minimized by using low cost mutual funds such as those offered by Vanguard (with an average expense ratio of 0.2% vs. the industry’s average of 1.2%).
Thus, fixed administrative fees are irrelevant when we consider the long term effect of higher mutual fund fees. Vanguard funds are typically not offered by the 401k plan brokers, so it is important to have access to a 401k platform that is customizable enough to allow access to Vanguard funds.
The most critical part of developing a 401k plan for a small business owner is to provide investor education for the owner and employees. An average investor underperforms the funds they invest in by as much as 5% per year – this was discovered by a University of Michigan study*. Morningstar’s latest study** showed conclusively that the best predictor of future performance is none other than the fund expense ratio, so everything else being equal, the lowest cost funds always wins in the long term. A well-designed plan should only provide a small number of low cost high quality funds as well as several conservative model portfolios, because investors get lost when there are too many funds to choose from.
In addition to providing access to low cost index funds (such as those offered by Vanguard), the participants have to be taught how to manage their investments and more importantly, what behavior they must avoid. For example, as much as 40% of S&P long term returns came from dividends. This number jumps to as much as 100% when we are looking at the past decade. Anybody trying to get in and out of the market wouldn’t see nearly as much gain as those who stay put. But staying put is impossible when your portfolio falls 50% or more (as the S&P did in 2008). Even the default choice for many investors – target-date funds (including those offered by Vanguard) are too risky for an average investor (with as much as 90% invested in stocks), so model portfolios in 401k plans have to be more conservative to save investors from themselves. It is also a fact that lower volatility portfolios can actually outperform higher volatility ones over the long term.
A new 401k plan does not have to cost much at all considering all the benefits the business owner will get. A typical low cost TPA charges as low as $1500 for a small business with 10 employees, and offer access to low cost Vanguard mutual funds. Most custodians charge asset-based fees to custody the plan funds, but such fees should be no higher than about 0.08%.
CPAs can play a vital role in educating their clients about the benefits and perils of 401k plans. How would a business owner be able to pick an appropriate retirement plan themselves? A CPA can assist the business owner by working with a fee-only financial adviser who specializes in low cost 401k plan design. Together, the financial adviser and the CPA can help the business owner get set up with the best plan for their business. The CPA can educate the business owner about the tax benefits of opening a 401k plan for their business. In addition to the usual tax deductions for salary deferrals, retirement plan expenses (such as administrative costs) are tax deductible for the employer, and new plans with fewer than 100 employees can receive $1500 in tax credits to offset the administrative costs of the plan. Working with a fee-only financial adviser can be of great benefit to the business owner. Not only will they get unbiased advice, but they will also get the best and the lowest cost plan for their business, including hand-picked investments and conservative model portfolios along with much needed education to help them get the best results out of their 401k plan.
*Ilia D. Dichev, “What are stock investors’ actual historical returns? Evidence from dollar-weighted returns”