Since January 1 2006, employers offering 401k retirement plans to their employees have been able to amend their plans to accept contributions on an after-tax basis, similar to Roth Individual Retirement Accounts (Roth IRAs).

Designated Roth contributions grow with tax-free earnings and are distributed at retirement without triggering any future income tax liability.  Although the Roth 401k option was intended to expire on December 31, 2010, the Pension Protection Act of 2006 extended the program indefinitely. Here are some things to consider:

BENEFITS FOR EMPLOYEE-PARTICIPANTS

The Roth 401k combines elements of both a Roth IRA and a traditional 401k plan.  The Roth 401k:

  • Does not limit participation by income, unlike the Roth IRA
  • Allows participants to contribute on an after-tax basis, like the Roth IRA, up to the amounts permitted under a traditional 401k.

Therefore, higher income employees who are ineligible to open a Roth IRA can instead contribute to a Roth 401k at higher amounts than are permitted in a Roth IRA.   By contributing to a Roth 401k plan, employees can contribute on an after-tax basis without being taxed in the future.

ROTH 401K REQUIREMENTS

For an employer to offer a valid Roth 401k plan:

  • The employer must also offer a traditional 401k plan.  Designated Roth accounts cannot exist without an accompanying pre-tax elective deferral plan
  • Participants must be able to designate some or all of their elective deferrals as Roth 401k contributions
  • The employer must include designated Roth contributions in the employee’s gross income (IRC 402A(a)(1))
  • Roth contributions must be tracked and their records kept in a separate account, with any applicable earnings and losses allocated to that Roth account

EMPLOYER CONTRIBUTIONS

Employers may not make contributions to a designated Roth account.  Any employer contributions, such as matching or profit-sharing contributions, must be treated as pre-tax contributions and added to the participant’s pre-tax account.  (However, special rules apply for in-plan rollovers to a Roth accounts)

DISTRIBUTIONS FROM ROTH 401K ACCOUNTS

As with a traditional 401k plan, participants may only receive distributions from their Roth 401k accounts on (if permitted under the plan’s terms):

  • Terminating employment
  • Death
  • Disability
  • Reaching age 59 1/2
  • Determination of hardship

In addition, unlike the Roth IRA, Roth 401k plans are subject to the IRC’s minimum required distributions requirements during the participant’s lifetime

 

ADDITIONAL CONSIDERATIONS FOR ROTH 401K PLANS

Employers may choose to offer the following optional features in Roth 401k plans:

  • Automatic enrollment
  • Employer matching to the accompanying pre-tax account.
  • In-plan rollovers
  • Plan loans.  All of the participant’s Roth and non-Roth accounts are combined when applying plan loan rules

So, who should consider taking advantage of the new Roth in-plan conversion rule?  Here are a few of the most compelling examples:

  • Young savers:  If you are just starting out in your career, you are likely in a lower tax bracket and have a smaller account balance.  Converting some or all of your existing pretax account will set you up for more than 40 years of tax-free compounding.  Just make sure that the move does not bump you into a higher tax bracket.
  •  Someone saving for somebody else:  Assets in a Roth account are bequeathed income-tax free to a spouse or the next generation.  This right allows the recipient to extend the tax-free compounding for many more years.
  •  Someone with a lot of deductions or a large loss:  If you find yourself with a large tax deduction such as a business loss, charitable contributions, or even medical expenses, the taxable income generated by an in-plan Roth conversion is a creative way to fully utilize some or all of these deductions.  A sudden drop in your 401k account value (think 2008) might also present a window of opportunity to convert to a Roth, pay taxes on a greatly reduced amount, and then withdraw the resulting rebound tax-free years later.
  •  Someone concerned about being in a higher tax bracket in retirement:  Many American workers today find themselves in a historically low tax bracket.  So paying taxes on your retirement savings at today’s low rate hedges the possibility of higher tax rates in the future.
  •  Action steps:  First, while Roth in-plan conversions are part of the new IRS rules for retirement plans, they are not automatically available to everyone.  Your employer must amend its plan to allow for them.  If you’re interested in taking advantage of a Roth in-plan conversion, step one is to ask your employer if they have taken the necessary steps to make them available.

While it’s critical to spend the requisite time making sure that you’re saving enough and properly invested for retirement, the tax efficiency of your retirement investment strategy deserves some attention as well because it can have a profound impact on your ability to retire comfortably.  Hence used properly, a Roth in-plan conversion is a powerful new tool that can help you achieve your goal of financial security in retirement.

 

 

 

 

 

 

 

On June 11th, I participated in a webinar titled “DOL Consolidates Its Strengths In Revolutionizing ERISA plan Enforcement” arranged by Fiduciary Doctors LLC and the Valley of the Sun United Way – with distinguished guest Mary Rosen, Associate Regional Director of the Boston Regional Office Of the United States Department Of Labor. (DOL)

As my area of competence is financial planning and investment advice, not 401k compliance, I took a lot of notes.  Here are the highlights:

  • The definition of a 401k plan fiduciary is based on what Ms. Rosen called  “Discretion of control”. That is - someone with any control over the investments and/or administration of the plan.  Another way to consider who is a fiduciary is anyone who “touches the plan in any way:  payroll coordinator, HR executive, investment committee, member et cetera.
  • VC letter stands for “Voluntary Compliance letter”; essentially a way to come forward if your 401k plan has been out of compliance – rather than waiting until it’s discovered.  It seems analogous to a child telling his parents about something that happened in school before the school calls them – and it lessens the fines/penalties.
  • The DOL apparently does their own criminal as well as civil investigations.
  • There has been over one billion dollars of civil enforcement pertaining to 401k and other benefit plans including:  assets restored, protected and correcting prohibited transactions et cetera.

Regarding 401k plans, there are steps that plan sponsors can take to “minimize bad outcomes” according to Ms. Rosen:

  1. Make sure you discharge your fiduciary duties in an acceptable way.
  2. READ your plan document and understand what it says.
  3. Understand your roles with the plan and what is required from ERISA (To act prudently, solely in the best interests of plan participants and pay reasonable fees to name a few).
  4. If you don’t have expertise in a particular area you can delegate – BUT delegation is also a fiduciary act so it needs to be done prudently.
  5. Documentation goes a long way if there is an investigation so document as much a possible.
  6. Regarding disclosures – 408(b)(2) AND 404(a)(5) a 401k plan sponsor needs to understand the information received – if they don’t they should question the provider or consult with an advisor.
  7. Provide investments with reasonable fees – if investments have high fees with no alternatives the 401k plan sponsor could be liable.

The call closed with the moderator asking about a change in the definition of a fiduciary for plan advisers – Ms. Rosen said it’s still a work in progress but couldn’t be specific.  So keep an eye out for that…all in all a useful call with helpful information for a financial advisor or employer who sponsors 401k or other qualified retirement plan.

 

 

  

 

 

 

 

 

 

 

Recently, I took on the fiduciary duty and liability of selecting and monitoring the investment lineup for a 401k retirement plan acting as a 3(38) “defined manager”.  

Selecting the equity and fixed income choices was manageable:  made sure I hit all the Morningstar style boxes; large, mid, small – US companies, foreign, fixed income, et cetera.  Kept costs down by choosing mostly index products, carefully and selectively adding some actively managed funds and featuring a robust choice of “target date” managed funds.  So far so good:  But where it started to get sticky was when it came to the “safe choice”.  Do we go with a stable value fund or a traditional money market??

Turns out I ended up going thru  a long maze of research which included:  phone calls with experienced and well informed Stable value providers, a host of Google searches and web sites – as well as a conversation thread on two LinkedIn groups – (The 401k Association and The Fiduciary Society For Ethical Financial Practices)

So what did I learn?  I learned there are basically two “camps” or “schools of thought” when it comes to the proper safe choice investment in a 401k plan;

One camp is convinced that stable value is the way to go – in fact a recent article suggests that if stable value is NOT the safe choice it should be a fiduciary breach!  This camp points out that the returns of stable value are considerably higher than money market fund.  Certain research also suggests that stable value returns have enjoyed higher returns than money markets for a very long period of time.  So if you can offer participants higher returns with the same – or arguably less – risk, why not?

Not so fast argues the other camp;  pointing out restrictions, penalties and incipient costs. One LinkedIn commenter suggested they are as “dumb as annuities” and a “throw back to group accounting”.  

Also is a “better” safe option really in the best interest of plan participants?  Should advisors be touting a stable value fund because it earns 1.0% or  1.5% instead of 0.1%?  Is that fear mongering that will scare participants away from what most of them really need:  a long-term growth oriented portfolio?

Other naysayers of stable value point to the benchmarking and fee negotiation – as the underlying insurance contracts in stable value funds force a group annuity structure exempt from fee disclosure.  Further, the record keeper is often the manufacturer of these insurance contracts making them severely conflicted.  These flaws, some suggest,  fly directly on the face of fee disclosure which is the core of the stable value problem – not an issue of retirement readiness.

If you are a fiduciary, advisor or a sponsor of a 401k retirement plan, have you looked at this issue? What are your thoughts about Stable Value or Money Market as your 401k Safe Choice?

 

 

 

 

 

 

 

 

We are constantly hearing  about the  ”Do’s” and Don’ts” in life.  As someone who can’t seem to get enough information; reading every book, magazine or web site I can get my hands on, I always seem to come across  Do’s and Don’ts:  DO eat right and exercise DON’T drink or smoke.  DO speak kindly to your spouse  DON’T text while driving, et cetera..

And while I can’t say I obey all of these all the time, I DO have a few them to share with 401k Retirement Plan Sponsors (Companies that offer 401k retirement plans)

DO:  Make sure you have an effective Investment Policy Statement (IPS) An IPS is a non-legal document that reflects the overall objectives and guidelines of your 401k plan and opens a channel of communication between the 401k advisor and 401k plan sponsor so important issues for either party can be clarified.  It’s one thing to say something, it’s another to put it in writing.  An IPS accomplishes the latter.

DON’T:  Assume you are not a fiduciary:  This sure is a timely topic huh?.  If you are using an insurance based or broker sold 401k plan you may have literature or other marketing material that gives the appearance that the provider is assuming fiduciary liability.  It’s not the case:  Unless you have contractually delegated the fiduciary duty of selecting and monitoring investments to a registered investment advisor via a 3(38) agreement - if you are involved in the plan decision making in any way – you are a fiduciary and can be liable for wrong doing.  You can also delegate administrative duties to a first party administrator serving as a 3(16) fiduciary.

DO:  Offer consistent and robust education (Face to Face) Living the information age, it’s easy to mistake information for wisdom or guidance.  There are a plethora of on-line 401k education tools but in the end – nothing beats face to face advice.  Especially when market drops are sudden and severe – and investment decisions are made viscerally – participants need proper perspective and sometimes a message of faith.  And you just can’t get those from a screen or tablet – only from an empathetic and trustworthy human being in person.  Further – numerous studies confirm that enrollment & education that is conducted face to face yields much better results than webex, webinar, face time, skype or anything else like that.

DON’T:  Have an expensive fund lineup:  A penny saved is a penny earned.  And lower fund expenses means more earned for participants.  I’m not saying to automatically go for the lowest cost plan / investments / adviser / record-keeper.  But make sure you peel away all the layers of the plan and understand exactly what the fees are and what services are being provided for them.  In today’s world you can get a top-notch plan with top-notch service for about 1% of fees “All in”.  So if your 401k plan’s fees are higher – you probably should shop it.

So Don’t exercise if you really don’t want to – But if you run a 401k plan Do have an IPS and face to face meetings but please Don’t assume you are not a fiduciary or have expensive funds.

 

 

 

 

 

 

It used to be pretty simple:  Graduate college, get a good job, work at the same company until age 65.  Then came the retirement party:  A gold-plated wristwatch – and banishing off to a condominium in the sun for a handful of years of shuffleboard and bingo.  Like the movie On Golden Pond.

But as the boomer generation continues its migration to and through retirement, the whole “concept” of retirement seems to be changing – at least for some.  Many of today’s retirees want to stay more engaged than those of previous generations:  working full or part-time, volunteering, travelling, learning, et cetera.  This is a good thing… I have noticed my own parents change for the worse… not long after they stopped working to enjoy full “retirement”.  Staying engaged after retirement is a good thing… as long as we have enough financial resources to last our lifetime!

In fact recent research from AIG and Sun America revealed that today’s retirees are dividing into about 4 (four) categories:

19% of retirees:  “Comfortably content”

These are the “Golden Years” folks.  Many in age segregated communities in warm weather climates.  Free from most responsibilities, looking to enjoy the fruits of their labor and they are financially secure.

22% of retirees:  “Live for today”

More active than Comfortably content; interested in more travel, new hobbies and “adventure” in retirement BUT modest net worth hence very worried and anxious about finances.

33% of retirees:  “Sick and tired”

Living a retirement “nightmare”.  Low net worth, poor health and pessimistic about the future.

27% of retirees:  “Ageless explorer”

Youthful, optimistic and adventurous.  Say they will never “feel” old.  High net worth as a result of making smart financial decisions.  They are sort of like the “live for today” group but with greater financial security.

Most people probably want to be in the “Ageless explorer” category.  And along with some good luck and a little health - sufficient financial resources will pave the way for this new kind of retirement.

And in the  25 years I’ve been rendering financial advice, I have yet to find anything more effective than dollar cost averaging –  over a very long period of time – into a 401K or Retirement portfolio comprised mostly of equities and a little fixed income.  It’s a boring and simple approach but it works better than anything I have seen.  The “get rich slowly” approach.  

Please share any other ideas you may have about how to financially prepare for a longer retirement!

 

 

 

 

 

 

In the first part of this post we shared two things smart employers know about their 401k: 1) Lower fees = better results and 2) auto enrollment (and auto escalation) works.

Now let’s review two more things they know.

Most Providers Are Not Fiduciaries To Your 401k Plan:

Previously I shared a story about when I was fooled by an insurance company.  Being a bit Naïve by nature, when I saw a document titled “Fiduciary Warranty” that was created by a big powerful company, I thought it meant they were a legal fiduciary to the 401k plan.  I later learned that while many providers offer lots of investment suggestions and other support, most will not take on any fiduciary risk with you.  Unless you have leveraged an ERISA 3(38) defined manager – by contractually delegating the fiduciary duty of selecting and monitoring investments to - you and your support staff are on your own.

Better Communication = Better Results.

Participants want guidance.  And 67% of 401k plan participants now expect their employer to play a role in providing this advice.  Clear and consistent communication and advice will boost participant engagement every time.  And its most effective when employers are sensitive to both how and where the employees want to receive information (On-line, face to face, in groups, one on one, et cetera).

As the tsunami shift from defined benefit retirement income (i.e. pensions, social security) to defined contribution (401k, profit sharing, personal investing) continues - the 401k concept needs to keep improving.  And lower fees, auto enrollment (and escalation), transferring or sharing of liability and clear and consistent advice and communication goes a long way in that regard.

 

 

 

 

 

 

 

 

 

 

 

For many of us, a 401k will be the cornerstone of our retirement income plan.  With traditional defined benefit pension plans going the way of the pay phone and typewriter – Americans are now charged with making smarter retirement planning decisions – ready or not.

But with a 401k plan it takes two to tango.  The Employer (sometimes referred to as “plan sponsor”) which includes all of those involved in decision making.  And the “participant” – an employee who is not involved in 401k decision making.  We need smart decisions from both employer and participant to make the most of the plan.  Here are two things smart employers know about their 401k:

Lower fees = Better Results

Obviously.  Markets are unpredictable while costs are forever.  And the jury is out:  study after study reveals higher costs leads to worse performance.  I’m not saying that cost should be the only consideration – or that you should go straight to the lowest cost provider.  Nobody makes any purchase decision based only on the price.  But in today’s world you can have a great 401k plan for around 1% all in expenses (administration, recordkeeping, investments, advice & fiduciary protection) More than 1.5% is unnecessary and more than 2% is excessive.

Auto enrollment (and escalation) works

The only thing people hate more than making  decisions is changing them!  That’s why having employees automatically enrolled in your 401k plan is effective.. you’re harnessing the most powerful force in the financial universe… inertia!  And while auto enrollment has brought millions of new savers into retirement plans , most employers set the default rate at 3% and because of…. inertia, it stays there!

Which brings us to auto enrollments sister:  auto escalation.  Here you automatically increase your participants’ contributions to coincide with a raise or possible a work anniversary.  But this is a trickier one because many plan sponsors fear that automatic deferral increases will be viewed as “coercive” – which is why less than half of the companies offering auto enrollment in their 401k plans extend to auto escalation.  But it still works.

In the next post we will hit “two more” things smart employers know about their 401k plans,

 

 

 

 

 

 

In parts 1 and 3 of this series we discussed 401-k retirement plan fees and how important it is – for both employer and participant – to keep them reasonable.

Generally there are two types of retirement plan fees and expenses.

1.  Recordkeeping and Administration

2.  Investment expenses

Let’s explore #2 . When it comes to evaluating investments,  it’s critical to remember:  markets are unpredictable… while expenses are forever.

In the end, the lower your costs, the greater your share of the investment return.  And research suggests that lower cost investments have tended to out perform its higher cost alternatives.

There are two ways to improve participants returns. The first is to earn higher returns than the average investor by finding a winning manager or a winning investment strategy (an “alpha” or “skill-based” approach). Unfortunately, research shows that this is easier said than done . The second way is to minimize expenses. And study after study reveals a common thread:  higher costs lead to worse performance for the investor.

The illustration below compares the ten-year records of the median funds in two groups: the 25% of funds that had the lowest expense ratios as of year-end 2012 and the 25% that had the highest, based on Morningstar data. In every category we evaluated, the low-cost fund outperformed the high-cost fund.
Average annual returns over the ten years through 2012

 

Notes: All mutual funds in each Morningstar category were ranked by their expense ratios as of December 31, 2012. They were then divided into four equal groups, from the lowest-cost to the highest-cost funds. The chart shows the ten-year annualized returns for the median funds in the lowest-cost and highest-cost quartiles. Returns are net of expenses, excluding loads and taxes. Both actively managed and indexed funds are included, as are all share classes with at least ten years of returns. Source: Vanguard calculations using data from Morningstar.

 
Indexing can help minimize costs

If—all things being equal—low costs are associated with better performance, then costs should play a large role in the choice of investments. As the chart below shows, index funds and indexed exchange-traded funds (ETFs) tend to have costs among the lowest in the mutual fund industry. As a result, indexed investment strategies can actually give investors the opportunity to outperform higher-cost active managers—even though an index fund simply seeks to track a market benchmark, not to exceed it. Although some actively managed funds have low costs, as a group they tend to have higher expenses. This is because of the research required to select securities for purchase and the generally higher portfolio turnover associated with trying to beat a benchmark.

Asset-weighted expense ratios of active and indexed investments

 

Notes: “Asset-weighted” means that the averages are based on the expenses incurred by each invested dollar. Thus, a fund with sizable assets will have a greater impact on the average than a smaller fund. ETF expenses reflect indexed ETFs only. We excluded “active ETFs” because they have a different investment objective from indexed ETFs. Source: Vanguard calculations, using data from Morningstar Inc.

Look: Employers that offer 401-k plans have more choice today than ever. “Open architecture” platforms give plan participants endless investment choices. And since we can’t control the markets - and it makes sense to focus on things we can control – reducing costs via ETFs and index funds is a worthwhile endeavor for anyone who sponsors or participates  in 401-k plans today.

 

 

 

 

 

 

In the first post we talked about expenses and fees in 401-k plans and how important it is – both for employer and participant – to keep them reasonable.  And in today’s world anything more the 1.5% in total – is unreasonable.  More than 2% is now excessive.

Fees charged for these plans come under particular focus as the Department Of Labor (DOL) aims to create greater transparency through regulatory disclosure under 408 (b)(2) and 404(a) of the employee Erisa act.

Probably the most in-depth research on this topic comes from Deloitte consulting and the ICI (Investment Company Institute) via a report entitled Inside the Structure of Defined Contribution/401(k) Plan Fees:  A Study Assessing the Mechanics of the “All-In” Fee. 

I love the title of the study, particularly the phrase “All-In” Fee because that is what you should be looking for.  In a nut shell, here is what the report reveals:

  • Many fee structures and arrangements exist in the defined contribution marketplace.
  • Plan size (in terms of number of participants) was found to be a significant driver of a plan’s ‘all-in’ fee.  Larger plans tend to have lower ‘all-in’ fees as a percentage of plan assets.
  • A correlation also exists between the ‘all-in’ fee and the average account size in the plan. Plans with larger average account balances tend to have lower ‘all-in’ fees as a percentage of plan assets.

There are three general groups of services that define contribution plans typically procure.  First, defined contribution plans generally require certain administrative services such as compliance (to make sure the plan is administered properly), legal, audit, Form 5500, and trustee services.  Administrative services also include record keeping services, which maintain participants’ accounts and process participants’ transactions, and often also include educational services, materials and communications for participants and plan sponsors.  Investment management services are a second category.  Investment options are offered through a variety of investment arrangements such as through mutual funds, commingled trusts, separate accounts, and insurance products.  In some plans, investment services include the offering of company stock or a self-directed brokerage window as an investment option.  A third set of services occurs in some instances when the plan sponsor seeks the professional services of an investment consultant or financial adviser and/or financial advice services for participants.

Totaling all administrative, recordkeeping and investment fees, the median participant-weighted ‘all-in’ fee for plans in the 2011 Survey was 0.78% (Exhibit 2) or approximately $248 per participant.  The data suggest that the participant at the 10th percentile was in a plan with an ‘all-in’ fee of 0.28%, while the participant at the 90th percentile was in a plan with an ‘all-in’ fee of 1.38%.

 

 

 

 

 

 

 

Hopefully, this information can be a starting point for you to benchmark the Fees in your own 401-k plan -  Are your Fees more or less than the 0.78% median?

In the next and last post we will dig into the Investment Management portion and how to find great low-cost investment choices.

The full report can be found here.

 

 

 

 

 

 

 

 

 

 

Did you know excessive fees levied on 401-k plans can drastically reduce the size of your retirement nest egg – even when market performance is satisfactory?

Also, were you aware that excessive fees are also a concern for 401-k plan sponsors who have a fiduciary (legal) duty to avoid choosing service providers (investment advisors, brokers, lawyers, record keepers, etc..) whose fees are unusually high?

Do you know how much is too much?

Anything more of 1% a year (for all services)  is no longer necessary.  More than 2% is excessive.

Because it’s tricky to figure this out by yourself, a plan review  will reveal what the total fee is for your 401-k plan.  And if you are paying more than 1%, there are ways to reduce your fee without compromising the quality of the plan and services rendered.  And in the next two posts we will explore how to do that.