Minimizing your risk when setting up a Retirement Plan
In my previous blogs, I talked about why a retirement plan might be best for your business and which retirement plan option might be best for your business. In this edition, I’d like to touch on some things you need to think about when picking a retirement plan for your business that will keep you out of trouble down the road.
As I mentioned in my last blog, “Qualified” plans that provide the greatest potential tax benefits must comply with regulations defined by the Employee Retirement Income Security Act or ERISA. If you can imagine the Department of Labor and the IRS getting together and having a baby, that child would be ERISA. As you can imagine, when your parents are two separate regulatory bodies, the rules can get complex. While complicated, the incentive to follow those rules would be some very attractive tax benefits! The expression “no free lunch” comes to mind.
So how do you avoid running afoul of the regulations and having to pay fines and penalties, or worse case, end up in court? Like so many things in life, getting off to a good start is critical. Based on what I’ve seen there are three key areas you need to watch out for when setting up your plan. Staying out of trouble in these three areas will go a long way toward keeping you out of trouble with regulators and your plan participants.
One of the requirements when establishing a plan is that plan assets are invested solely for the retirement benefit of participants. Where I see plan sponsors (the people who set the plans up for their participants) getting in trouble with this is where friends or family of the business owner are benefitting from the plan. For example, I ran in to one situation where the advisor to the plan was related to the business owner. That advisor was compensated from assets in the plan and her compensation was quite a bit more than other options available in the market. In this case, the owner’s sister in law was receiving the benefit of higher compensation and that was being paid for by the participants in the plan. This is a lawsuit waiting to happen! As a plan sponsor, you are held to a fiduciary standard of care. That means you must put the interests of the plan participants first. Having them pay above average fees to your sister in law is not putting their interests first, it’s putting your family members first.
The other area I see plan sponsors getting in to trouble here is when the plan is used as a bargaining chip. This usually happens when a bank or payroll company tells the business owner that if they put the plan with them, they will lower costs to the business or provide some other benefit to the business in another area. This is another example of the plan participants paying for something that will indirectly benefit the business owner. The other benefits provided are not free, and somebody is paying for them. If you want to stay out of trouble, it had better not be your plan participants!
The second major area I see plan sponsors getting in to trouble is with the requirement that there is a prudent investment process to select the investment options available to plan participants. Most business owners have no idea what a prudent investment process is and they end up just picking options off a menu provided by the service provider. Unfortunately, these are not always good options. The reality is that there are something like 13,000 different mutual funds out there, many investing in the same asset classes and having the exact same investment strategies. There are also lots of cases where the same fund can have multiple different fee structures. Wouldn’t you want to get the option that charged the least amount? Which one is that? Most plan sponsors don’t know if they’re getting the low-cost version or the high cost version.
There are also cases where the plan sponsor picks a fund that has been doing well recently, and then never looks at it again. Unfortunately, just because a fund does well for a while, that doesn’t mean it will always do well. Things change, and often plan sponsors forget about this stuff and leave plan participants with options that used to be good, but aren’t any more. Not good!
The final area I see problems, and by far the most common reason plan sponsors end up in court, is the requirement that costs are reasonable for service provided. The 401k industry was built on a practice called “revenue sharing” where the insurance or mutual fund companies would kick back a percentage of the fee they charged the plan participants to the other service providers in the plan. This practice made it easy to sell these plans to business owners, because it could be set up so that the business owner never had to write a check to pay for the plan, or if they did, it was for a very small amount. This created the illusion that the plan was low cost or “free”. Often, the plan sponsor had no idea how much the service providers were also getting paid by the insurance or mutual fund companies. This payment structure allowed some 401k service providers to charge a lot of money for their services, and all that money was money that the plan participants were paying out of their savings accounts.
The government realized what was going on and a few years ago and changed disclosure requirements to make sure plan sponsors had a better understanding of what they’re being charged, but there is still a lot of confusion. Making sure you really understand what you’re paying and how much the plan costs will go a long way to keeping you out of trouble.
Do you have any concerns about getting in to trouble with your plan? If you have questions about your situation and different options out there, let me know. I’m happy to help!