After 30 years of working with 401K plan participants, I’ve come to a few conclusions about what makes a plan work especially well. I’ve said many times that I would gladly contribute the maximum into the world’s worst 401K plan. But why not make your company 401K – perhaps your most important benefit program – more effective and valued? The changes I advocate, both structural and operational, ensue when companies more wisely and prudently choose their plan providers. You can begin this process by coming to appreciate the possibilities at your disposal. Knowledge means not having to serve up canned 401K to your employees for dinner.
Being somewhat of a fitness buff, I’m often asked what the most effective piece of exercise equipment is. My answer invariably is: the one you will be willing (even excited) to use. Similarly, the most effective 401K plan is one that employees will be willing (even excited) to participate in. How can we position them to feel this kind of enthusiasm about their 401K?
The Three Parties to a 401K Plan:
- Plan Sponsor – the employer, but more specifically the trustees and decision makers
- Plan Providers – the investment institution, compliance and recordkeeping group, investment advisor, possibly an audit firm, law firm and potentially other parties.
- Plan Participants – those eligible employees who invest in the plan
It’s well known that a 401K plan must exist to benefit its participants. As a practical matter, though, plan providers report only to the sponsor, who has the power to hire and fire. Participants may never even meet a provider. Only you, the sponsor, report to the participants.
Plan providers are very good at presenting plans that meet compliance requirements, keep investment fees low and survive a DOL (Department of Labor) audit. If your plan assets are over $5 million you are likely a sought-after target of plan providers bearing slightly stronger investments and slightly lower fees. Unfortunately, finding compliant, slightly better plans is not the hard part (although, sure enough, many or most plans still pay far too much in expenses).
Two Attributes that Make the Plan Work for the Participants:
- Simple investment choices that are understandable
- Well justified confidence that the plan will work for them
My experience is that participants DON’T GRASP the choices. Moreover, owing to human nature, they are very apt to resist or work against the process. Human nature is not generally your friend in the intimidating world of investing, especially to people who are fairly new to the idea of accumulating wealth.
Choice, Choice and more Choice
It’s tempting to offer participants 12 to 20 choices on a 401K menu. Isn’t more of anything better? Won’t people be impressed with more choices? The answer is yes, to an extent, but also, resoundingly, no. The reason they likely won’t be impressed is not even that investment choices have become so heavily correlated. The answer lies rather in the psychology of choice, which has been studied by scholars like Sheena Ivengar, a professor of business at Columbia University and the author of The Art of Choosing. The paradox is that lots of choices do impress people but at the same time cause confusion and paralysis. Think of how a chocolate lover might walk into a shop featuring dozens of gourmet chocolates and feel anxiety rather than giddiness. This is doubly stressful when you find yourself far afield of your areas of expertise: can you imagine needing a knee replacement and watching as the surgeon lays out two dozen prosthetic knees for you to learn about and choose from?
What’s Good for the Investment Advisor and What’s Good for the Participant
Somewhere in the process, someone played the role of investment advisor and created that menu of investments (called the core funds). An investment advisor would never present a list of funds to a client and walk away, leaving the client to make choices. The essential next step is to create meaningful portfolios of those funds, which I call investment models.
Most plan providers do permit the creation of investment models. These are the ultimate choices that I feel must exist at the participant level and must carry simple, expressive names. Participants do not have to choose models, but I find they nearly always do.
In my experience, I have had outstanding results with models I call aggressive, moderate and conservative. The point, of course, is that people can readily grasp these names. My suggestion, based on years of working in the field, is:
- Aggressive: 100% stock funds
- Moderate: 75% stock funds (mirroring aggressive) and 25% stable, fixed return
- Conservative: 50% stock funds (mirroring aggressive) and 50% stable, fixed return.
- Optional: Fixed: 100% stable, fixed return. This might be a single fund, not a model
No matter what profession you are in, it’s likely that outsiders would be fascinated by crazy outcomes you see in a week at work. I can say, categorically, that the people who appreciate simple model names are often the most financially astute people in the company – and those who don’t are often the ones who would appear to be least prepared. Regardless, presenting models to participants is a vital, unequivocally winning strategy.
The Power of a Monthly Newsletter
Many advisors subscribe their clients and 401K participants to generic, third-party newsletters. These publications are usually professionally written and address financial topics of “general interest”. In my experience, they are useless. I have long written monthly newsletters that address my firm opinions about market direction and analysis, while including client/participant investment returns.
What I have found is that investment clients and 401K participants greatly appreciate these newsletters principally for two reasons: they assure clients that I am doing my job diligently and they show clients how they are faring financially. Put another way, clients value these newsletters much more for the message they implicitly send, than their content. Many clients and plan participants have told me that they love receiving the newsletters but don’t usually read them – or that they jump to the section on their returns. You can’t outsource personal involvement – and you don’t get it from a generic newsletter.
Plan participants differ in the amount and type of contact they prefer. Some don’t want contact if they feel that a competent, involved person is steering the boat. What I have found works most effectively is periodically to schedule a group meeting with individual sign-ups on half hour intervals following that meeting. The common denominator is people seeking comfort or assurance that they are on track or can get on track to meeting their goals. In some sessions, participants bring their spouses or ask for longer meetings; other sessions are brief, serving more as a mode of getting acquainted than communicating substance. In some cases, clients want to talk about outside investments that they are unhappy with. All of these outcomes are healthy; they mean the plan is working.
Making Safe Harbor Painless
Safe harbor provisions are usually an important part of plan compliance. Most employers know that this requires contributing money to eligible employees. What many don’t realize, however, is that this can be folded right into your compensation plan. There is nothing wrong, for example, with stating that employee compensation will henceforth be paid as 97% cash and 3% into the plan. Or, otherwise planned pay increases could be directed into the plan.
Dispelling Misconceptions, Myths and Misuse; Common Questions
There are many reasons why people do not participate, participate minimally or (worse yet) sabotage their 401K accounts. Some think of their 401K accounts as if they were checking accounts (loan and hardship privileges). Some simply don’t understand the power of the plan – from tax benefits to matching contributions. In any event, for a plan to be truly effective, a participant must always consider a range of caveats and principles:
- Get in the Game: If you are not participating, figure out a low amount (even if it is ridiculously low) and start out at that level. Once in the game, you will likely find it easy to increase it.
- Take Maximum Advantage of the Match: If the match is 50% then your $1.00 turns into $1.50, compared with perhaps $.65 after taxes in your paycheck. You have more than doubled your money immediately.
- Should I Be Aggressive, Moderate or Conservative: The three factors that determine the answer are your temperament, your time horizon and your net worth. The smaller your net worth, the more aggressive you ought to be. Similarly, a longer time frame dictates being more aggressive. Finally, if you lose sleep over your risk exposure, you should be more conservative. Ultimately it is less your choice of model than your level of participation that determines how much you have at retirement.
- Pay Taxes Now or Pay Them in Retirement, What’s the Difference: A “never taxed” 401K or IRA worth $1 million pays out $70,000 annually in taxable income (at 7%); an after-tax account of $650,000 pays out $45,500 annually in taxable income (at 7%). Which would you prefer? Which will actually happen? Automatic pre-tax payroll deduction works!
- I Need to Put that Money into Susy’s College Fund: This is a worthy goal but be aware that a college fund in her name will be considered dollar for dollar available in a student need calculation, whereas the 401K balance is not disclosed.
- The Stock Market is Tanking so I will Stop Contributing: You are confusing two different things. Your contribution is there to create a tax benefit (by lowering your income). You can always specify that the money should go into something safe.
- The Stock Market is a Casino – Rigged Against Me: The stock market has always recovered losses and moved on to make money. The only thing that causes concern is the lengthy period of recovery after a bear market. A good advisor will watch for the statistical prelude to a bear market and provide options for defending.
- A Plan Loan Costs Nothing Because I am Borrowing from Myself: The cost of the plan loan is the growth that you forego while the money is gone, before you pay it back. It could be a little or it could be a lot. You might be lucky and pull out the loan just before a bear market. A home equity loan may be cheaper, and the loan interest may be deductible as well. Possibly the biggest danger is that if you terminate employment, the plan loan must be repaid immediately. This could really hurt.
- I Need to Make a Hardship Withdrawal: You need to do what is necessary but be aware that the cost will probably push 50 cents on the dollar between the hit to your income taxes and the 10% hardship penalty. That is a crippling cost.
- I Will Withdraw My Plan Balance When I Retire: That would certainly be a tax disaster. What you would do instead, is roll the plan balance over to an IRA, then begin drawing income out of it using a method and investment allocation designed to preserve principal and create income. There is real strategy to this. I prefer the “two-bucket” approach.
Should I Enable Plan Brokerage Accounts?
Many provider plans offer a brokerage account option, for a nominal annual fee. This means that a participant could open a brokerage account, offering most any available public investment (excluding private placements and certain other illiquid, specialized investments).
This can be a highly useful tool in the hands of a competent investment advisor because more specialized investments can be rotated into more focused, flexible and powerful models – which will not be static. Examples abound: When a participant opens a brokerage account, low-cost and commission-free ETFs (exchange-traded funds) become available to her, providing very low management fees; he gains access to sector funds, which allow exposure to trends (e.g., info tech in 2017); and she might utilize peer-to-peer funds that offer higher, stable interest rates (but which are not suitable as core funds due to quarterly liquidity).”
There are diminishing returns to smaller brokerage accounts and I feel they make sense only when accounts exceed $50,000 to $100,000.
Regardless of the above, it’s uncommon for investment advisors to include this option, partly because they do not understand the full power of it and partly that it represents more work and no additional revenue.
Broker, Insurance Agent or Registered Investment Advisor (RIA)?
When I made the change to RIA, in May 2000, I wanted to stop being a captive employee of a financial institution. Regardless of how brokers and agents present themselves or how fervently they profess independence, they remain loyal to those institutions. RIAs, because they are independent entities, have no such loyalties – they can deal with virtually any institution.
Turnkey or Á La Carte Plan?
An á la carte plan assembles plan providers from different institutions, representing, for example, recordkeeping, plan administration and online account access. A turnkey plan utilizes the same institution for all the parts. This could even include payroll. For so many years, it was difficult to engage the better turnkey providers unless your plan was very large. Even in 2000, $100 million was not an uncommon minimum plan size. All of that has changed. Most turnkey providers are interested all the way down to $1 million.
The benefit to an á la carte plan is that it is a system of interchangeable parts. If you like the investments but don’t like the administrator or recordkeeper (or vice versa) you may act to change out the piece you don’t like.
The benefit to a turnkey plan is that it is overall simpler, generally less costly and possibly less prone to operational problems.
But more importantly, the factors that make the plan successful have much more to do with the advisor’s role than with the plan structure. Complexity, like a bloated investment menu, does not add value.
How Do You Find the Right Investment Advisor?
Running an effective, well-utilized and appreciated plan, requires superior advisor involvement. You simply can’t arrive at the right destination by starting the journey with the wrong advisor.
Sadly, many investment advisors are interested more in maximizing volume and fees – and don’t feel comfortable around participants. They pitch investment institutions to plan sponsors; outsource participant presentations and relationships; reappear infrequently (only as compliance may demand); and move on to the next company. The fees keep coming until you lose the business – and plans do exhibit inertia. A prevailing attitude among plan sponsors is “I may not like it but if I start a dog and pony show I’ll likely wind up back where I started”.
A better idea is to start at a different level: approach a number of the better financial institutions directly, inquiring about which advisors might match up with your desire for a more effective plan. You are now armed with some of the terminology and some of the defining features that make a difference. Your employees are depending on you.
I Can Help
My advisory firm may not be within your geographic area, but I may nevertheless be able to help you, using my extensive contacts and understanding of the 401K landscape.
Fidelity Investments is an independent company, unaffiliated with Kay Investments Inc. Fidelity Investments is a service provider to Kay Investments Inc. There is no form of legal partnership, agency affiliation, or similar relationship between your financial advisor and Fidelity Investments, nor is such a relationship created or implied by the information herein. Fidelity Investments has not been involved with the preparation of the content supplied by Kay Investments Inc. and does not guarantee, or assume any responsibility for its content. Fidelity Investments and Fidelity Institutional Wealth Services are registered service marks of FMR LLC. Clearing, custody, or other brokerage services may be provided by National Financial Services LLC or Fidelity Brokerage Services LLC. [eReview number 680021.1.0]