For a couple of years now, 401(k) plans have been required by the Employee Retirement Income Security Act of 1974 (ERISA) to regularly issue to participants and beneficiaries certain plan-related and investment-related information. Participants are now often looking for help in determining what all this information means and what they should be doing about it. What they find is an abundance of guidance on a wide range of plan topics.
Participants are beginning to take a more active role in managing their retirement accounts, and this in turn has led to heightened scrutiny of 401(k) plans. There has been an uptick in legal action against employers whose plans are perceived as not measuring up.
If you are an employer with a 401(k) plan, you might be curious as to how your participants are looking at your plan based on what they are reading. Furthermore, you might want to consider what you should be doing as a result. Avoiding legal action is a top concern, but there are also other matters that can impact your business.
In a survey of recent articles targeting 401(k) plan participants, the following common advice appeared. Listed below each section is a tip for Employers.
Periodically reassess your risk profile. As time changes, so does your risk tolerance. The younger you are, the more risk you can generally tolerate. You cannot achieve your retirement goals without taking on a healthy amount of risk during your lifetime. As you near retirement age, the less risk you can generally tolerate. Other factors in risk assessment include consideration of health issues and medical costs, the availability of other resources to fund retirement costs, your income, and your emotional ability to handle risk.
What you should be doing: Make sure your participants’ investment education includes how to determine their current risk tolerance and when and how it will change over time. Since their investment option choices need to be appropriate for the amount of risk they are willing to take with their retirement money, they must be aware of their risk tolerance before they can determine the proper investment choices to make.
Diversify your investments. As a rule of thumb, invest no more than 15% of contributions in any one fund to reduce risk.
What you should be doing: Make sure your participants learn all the ways they can diversify investments as part of their investment education. This includes such topics as asset classes (stocks, bonds, cash alternatives), investment styles (such as growth or value), international versus domestic investments, and sector funds (such as technology or retail). They should learn how to put together the proper asset allocation based on their risk tolerance and number of years until retirement.
● For participants who want to be less involved, your plan could offer one or more of the following investment options:Funds of funds – These are diversified by their very nature since they invest in mutual funds. A drawback, however, is higher expense ratios. This is because their fees include management fees for both the fund of funds itself, and for the underlying funds.
● Risk-based portfolios – These focus on risk tolerance, and they change their holdings based on the volatility each asset class. For instance, someone younger would invest in an aggressive portfolio, while someone nearing retirement would invest in a conservative portfolio. As long as participants have chosen the proper portfolio to invest in based on their risk tolerance, the risk is maintained at that level, providing diversification within the portfolio.
Review your investment choices at least annually. Consider ratings by Morningstar or similar organizations. Compare an investment’s 3, 5, and 10-year return rates to the performance of the investment’s benchmark. Compare an investment’s expense ratio to the expense ratios for similar investment options available in your plan. For most investments, if the expense ratio is over about 1%, you want to make sure there is a good reason to be in that fund (high returns). The best investment options to choose are usually those with the lowest expense ratios – especially index funds and institutional class shares. Class A shares usually have the highest expense ratios since they participate in revenue sharing arrangements that push fees to the participants rather than to the employer. The worst investment option to choose is company stock since investing in a single stock is high-risk.
What you should be doing: Review your plans investment choices at least once a year to make sure they are performing better than average and have reasonable fees based on the returns they yield. Try to avoid funds that participate in revenue sharing arrangements. When possible, replace offerings in Class A shares with offerings in institutional shares. If you offer company stock as an investment choice, make sure your participants are aware of the risks involved as part of their investment education.
Periodically rebalance your investments. After initial investment choices are selected for contributions, investment gains and losses upset the selected balance over time. About once a year, transfer existing balances to reestablish the appropriate split you want for each chosen investment option.
What you should be doing: Make sure your participants learn about rebalancing as part of their investment education. Most participants are either not aware of their ability to do this, believe it is too difficult, or are psychologically unable to do it since it involves selling their investments that have been doing the best and investing more in their investments doing the worst. Without rebalancing, however, they don’t stay within their risk level and can potentially incur huge losses. Participants should be told to take the emotion out of rebalancing by establishing a set date on which to do it each year.
For participants who would rather make the process automatic, your plan could offer one or more target date funds. As one nears retirement age, the underlying assets are gradually rebalanced from higher risk to lower risk. As long as participants have chosen the fund closest to the year of their retirement, the proper risk for their age is maintained. However, these funds typically have lower returns since their underlying assets are often index-based.
Maximize your company match. If your employer offers to match up to 5% of annual compensation, make sure you are contributing at least a 5% deferral. Otherwise, you are leaving money on the table.
What you should be doing: If your plan has a match feature, make sure to keep reminding participants of it to boost deferrals. If your plan does not offer a company match, consider doing so. It not only attracts employees to your plan, but it also encourages them to stay on the job to earn vesting in the match.
Consider if Roth deferrals are right for you. These are paid with after-tax dollars. In general, if you are young, in a low income tax bracket, or think your tax rate will increase in the future, Roth deferrals are better for you than pre-tax deferrals. The benefit is that the withdrawals are tax-free, so all gains and reinvested dividends are never taxed. Even if you think your tax rate will decrease in the future, having money in both pre-tax and Roth accounts will provide tax diversification, thereby giving you more options to reduce your tax bill in retirement.
What you should be doing: If your plan does not offer Roth deferrals, consider adding them. As Baby Boomers retire and are replaced with a younger workforce, many employees will be more suited to investing in Roths. This option has been available since 2006, and more people are understanding the benefits of it. As this trend continues, employers offering such an option may be seen by prospective employees as having a valuable benefit that some other employers don’t offer.
Don’t take a plan loan. Loans usually require the payment of origination fees and annual loan maintenance fees. There is an opportunity cost for taking a loan that is equal to the missed market gains you would have earned had you not taken the loan. As you repay a plan loan, you are replacing investments made with pre-tax deferrals with investments made with after-tax dollars. When you eventually retire, these dollars will be taxed again upon withdrawal. If you leave your job before repaying a plan loan, the outstanding balance will likely become a taxable distribution subject to penalties if you are unable to immediately pay it off.
What you should be doing: To help participants save for retirement, it is best to not offer plan loans in the first place, or, if you do, stop offering new loans. If you insist on allowing plan loans, make sure your participants learn about the downside as part of their investment education. To discourage plan loans, consider limiting them as follows:
●Limit loans to only participant deferral balances.
●Limit each participant to 3 plan loans over the course of the plan’s life.
●Only allow one outstanding loan at a time.
●Require a certain amount of time to lapse, such as 6 months, between the payoff of an old loan and the start of a new loan.
Please contact Levin Swedler Kennedy – Certified Public Accountants if you would like any additional assistance with your 401(k) plan.
Written by: Debi Ondrik, CPA