ARE YOU AT RISK AS A FIDUCIARY?

Evidently so.  In a District Court opinion (Reich v Hosking 1996) the trustee could be held liable for monitoring the day to day activities of the plan.  The action involved failure to document participant loans, failing to make timely deposits and a loan to the employer.  All of these “mistakes” were hidden from the trustee.  Guess who was held liable?

Although this case does not represent the normal relationship between an employer and the plan, this employer must have made self dealing loans and then failed to document the loans properly.  The result was this case.

The court said that a trustee is to be held to a higher standard of awareness and behavior.  By delegating these responsibilities to a vendor or another fiduciary did not absolve him of the risk.  The court said the trustee should have investigated the plans activities.  The trustee could have contacted the custodial agent to investigate possible violations.

The court claimed the trustee violated ERISA by not taking a more rigorous approach - actions it said that a prudent trustee would have taken.

Does this portend problems for a regular 401(k)?  It is important to make certain deposits are being made on a timely basis, loans repayments are being applied correctly.  The trustee needs to be certain the plan vendor is capable of performing all of the tasks required of the plan.

In addition, the trustee needs to make certain the investment choices are appropriate.  This means monitoring the performance annually and having a reasonable benchmark for comparison. If this is done regularly, the safe harbor of 404(c) will probably protect the fiduciaries of the plan.
Payouts to former Employees may disqualify your plan.

When an employee terminates, there can be an ongoing cost to maintaining their account within the plan.  To solve this problem, employers often try to limit the rights and benefits available to terminated employees.

No more. IRS audit guidelines clarify that these practices can violate the consent rule that applies to participants with vested benefits of more than $3500 and could cause the plan to be disqualified.  A disqualified plan is a disaster.  All tax deductions are reversed and new taxes, plus penalties are assessed to participants and the employer.  How would you like to refile your taxes return for the last ten years?

Participants must consent to a distribution before it can be made and a consent is not considered valid if the plan penalizes the participant for not agreeing to take their money.  This means the plan can not impose more constraints (called significant detriments) on those elect to remain in the plan than on those who elect to take an immediate distribution.

One way to solve this problem is offer the terminating participants the choice of retaining a plan that mirrors your plan.  This rollover IRA can be low cost, it can have all of the same investments and reports quarterly, just like your plan.  But all expenses are paid by the participants from their rollover IRA.

Certain practices will certainly be considered to impose “significant detriments” Some of the more notable detriments are:

1.   Limiting investment options - The plan trustees offer a restricted form of investment that is less attractive than regular plan investments.

2.   In-service distributions - This one is confusing at best. But it is in the regulations

3.   Time limits - The employer says you have 60 days or you have to wait until retirement to take your money.  This is prohibited.

A plan audit will determine whether you plan is bordering on the edge of this concern.  Make certain y ou know whether or not your is potentially subject to disqualification.

Do you know your Fund Style?

Under 404(c), trustees are eligible for the “safe harbor” exemption for being sued by employees for plan performance.  However, to qualify, the plan must offer three distinctly different investments. One would think that would be easy.  But is it?

In a recent Morningstar study, 20 of the largest fund families were not doing an especially good job of adhering to their stated fund investment objectives.  This is called “style drift.” In fact, “adhering to stated investment objectives” is something many fund managers try not to do, in an effort to distinguish their performance from other similar funds.  Several years ago, Magellan’s Jeff Vinick sold a large percentage of the stock portfolio and bought bonds.  He guessed wrong about interest rates - sounds a little like the Orange County debacle doesn’t it.  As a result, the whole Fidelity family became more aware of “tighter investment objectives”.

As an employer, trustee, fiduciary, there is a lot of trust, the vendor is doing what they say they are doing.  But there is no assurance unless you specifically ask the questions and investigate the evidence.

Ask these questions:

1.   Does our plan have three separate and distinct investment styles?

2.   Can you demonstrate how they are different?

3.   Is this documentation supportable under audit?

Most 401(k) participants have no knowledge or awareness of the plan investments.  When the enrollment team makes their presentation, choice will be made on the most superficial of reasons.  The herd mentality will prevail.  Who is responsible?

As plan sponsor it is critical you reduce your exposure.  It the investment policy statement calls for a growth stocks in small cap companies, you certainly do not want the fund investing heavily in bonds.  That’s what Magellan did.

Be careful!  As fiduciaries, you want to make certain the investments you offering your employees will match the expected risks they are taking.  There is enough risk inherent in equity funds, it seems unfair to make those risks higher because the money managers are under pressure to perform.

How to Measure Fund Expenses

When we ask plan sponsors about their plan expenses, the initial answer always relates to administration expenses.  The primary criteria for selecting 401(k) vendors is cost.  The second most often cited criteria is performance.

Unknown to most plan sponsors, they are linked.  One of the most common delivery systems is still the unbundled - allocated method.  This vehicle combines a mutual fund with a TPA.  The TPA provides all of the administrative services for a published fee schedule.  In many cases the base fee is $25-$30 annually per employee.  On top of the base schedule are the ad hoc fees for services beyond the scope of administration.  For instance, extra test, loan administration, 5500 filing etc.

When an employer is scanning the horizon for a 401(k) plan, it is presumed all plans are equal and that the lowest fees from a reputable provider is best.  How do those fees get so low?

In order to provide all of the services required to keep a 401(k) plan in compliance, the administrator needs at least $50 per participant.  As the plan grows, the costs escalate.  How then can a TPA do it for on $25-$30?  The answer, they can’t.  And more important, they aren’t.

Most of the Mutual Funds will negotiate a backend payment to the TPA based on fund expenses.  If you carefully read the prospectus, you will find that fund expenses fall into five primary categories.

1.   Sales Load - The “load” - “no-load” controversy has existed for years.  The issue is whether the invested funds should have a percentage (5% graded) deducted from each contribution before it is invested.  Or should each contribution be added to the investment account with no deduction.  A sales load is the charge a fund makes before the contribution is credited to the investment account.

2.   Management fees - Each fund reduces the assets of the funds by a percentage ranging from .25% to 2.00% annually.  This fee pays for the money manager and his staff.  According the Morningstar, the average management fee for an equity fund is 1.50%.  This means the gross return will be reduced by this management fee.

3.   12b-1 fees - The SEC allows each fund to reduce the assets by a 12b-1 fee to offset market and promotion costs.  Often this fee will be paid to a third party (the selling representative or a TPA) as an annual commission trail.

4.   Expenses - Each fund is allowed to recover the cost of administrative expenses.  The smaller the fund, typically, the higher the expenses.  A portion of this fee can be paid to the TPA.

5.   Contingent Deferred Sales Charge - A fund will deduct from the assets, upon redemption, an amount based upon a declining schedule.  The problem is that this charge is applied to every contribution, so there may always be some redemption charge if the plan sponsor elects to change investment funds.

How can you, the plan sponsor, differentiate between these charges and pick the best combination for your fund?  The most important step is not to lured by “low” administration fees.  While the cost may be “low” to the employer, it is like to be quite high to the plan.

We have done studies for employers with $3,000,000 of assets and discovered the total fees (loads, management fees, administration etc.) could be $750,000 higher for some vendors. In other words, the plan participants would see a significant reduction in their accounts to cover these additional higher expenses. This study assumes the assets continue to grow at 7% each year and that a steady stream of contributions continue to be made by employees.  Imagine trying to defend an ERISA lawsuit where the plan paid over $750,000 more in fees when it could have been avoided.

There is a lot at stake in the “low” cost game.  A BTA “plan audit” will determine if you are over paying for plan services.  It is worth the time and effort to determine whether your plan will meet the prudent fiduciary standard.

What rate of interest can a plan charge for Participant loans?

A California law was passed that exempted qualified plan participants from the usury laws of the state.  These are the laws that regulate the amount of loan interest rates a lender can charge a borrower.

Concurrently, the California Appeals Court ruled, in a lawsuit related to interest rates on participant loans, that ERISA preempted the law just passed by the legislature.  The State Court also held that ERISA does not preempt state usury laws.

Evidently, a plan charged a participant 11.5% for a loan, even thought the state caps these loans at 10%.  The participant sued to recover the difference.  However, it isn’t likely to end here.

The US Supreme Court, in a decision (New York State Conference of Blue Cross & Blue Shield plans v. travellers Ins. Co. 1995) held a state law was not preempted when its relationship to the plan was too “tenuous and remote” to affect plan administration.  This phrase was also in the California Appeals Court decision.  I wonder if the Supreme Court will get this one?

IRS allows direct rollover of participant loan to another plan

Often, employees will change positions within a family of companies.  What happens if there are different 401(k) plans record keepers and investments?  

What happens if the employee who transfers has a participant loan?

A group of employers with this problem asked the IRS if they could transfer employee accounts as direct rollovers to the new employer’s plan.  They wanted to make certain the participant would not have to make the 20% withholding payment and that there was no penalty for distributions prior to age 59½.

In PLR 9617046, the IRS okayed the direct rollovers and held the transfer of the unpaid loan to the new plan did not result in  a renewal, extension or re-negotiation  of the loan.

Mandatory 401(k) Election may cause problems

Have you heard about - “Negative 401(k) elections”.  What is it?  Plans who are having problems meeting the ADP tests will sometimes resort to requiring a payroll election that automatically enrolls a new participant in the 401(k) unless he/she elects to not participate.  In essence, the salary deferrals are made unless they specifically say “stop, I don’t want to participate.”

In some cases, the election is a condition of employment. Not good!  Although the IRS and the Department of Labor have given their blessing on this method, it is in fact aggressive. Some form of “negative elections” may run afoul of state labor laws.  However, the Department of Labor says that those state laws are preempted by ERISA.  This may be headed for the courts.

But here’s another side to this issue.  The IRS could hold that a forced election conflicts with 401(k)(2)(A).  This section refers to an employee’s election to defer. Is a mandatory deferral an election?  Another problem could be 404(c), the ERISA safe harbor for trustees.  This refers to elections made by the employee.  Does that mean that mandatory deferrals are not included in the safe harbor?  What happens if they perform poorly?

Are there other ways to increase participation?

Some employees are attracted by better benefits, while others just need to trust the plan and understand the benefits.  Our experience shows poor participation is most often the result of poor communication.  The plan has not been “sold” to the employees.  If an employee really understands the value of the plan, there is not reason why they would not participate, unless they are financially destitute.  Here’s an  illustration.  If the employee is currently saving $100 per month from their after tax income, they could be saving $139 by putting the same $100 in the 401(k).  If there is a 25% match, the result is even better - it becomes $174.

If benefits are the issue, review your compensation policy.  Should bonuses be use to create or increase the match?  Is the vesting period too restrictive?  Maybe you should consider a 2 year vesting schedule.  Sometimes, nothing will attract them because they just want cash.

One way we have found to improve participation is to educate the management team.  Hold briefings for them and impress upon your top people the importance of retirement.

The retirement crisis facing America is obscure and not well defined.  Most people believe they will have an adequate retirement benefits if they have $125,000 by age 65.  With inflation and current standards for retirement, I wonder how far $1000 a month will go 20 or 30 years from now, especially if social security is nonexistent.

The WHATs of Retirement

If you haven’t seen the BTA Advisory Group retirement calculator, ask our representative for a copy.  This interactive program allows you to model the amount of income and capital you will need at retirement.  Unlike many programs, you input your current assets and savings rate.  You can change your investment assumptions to fit the asset classes you currently hold.

Then by adjusting the tax rate, investment returns and additional savings, you can model the impact on your retirement planning.  The software is available to any BTA client for the asking.

The BTA Advantage Program

BTA has just started a worksite counseling program called the BTA Advantage for participating clients.  Many 401(k) participants have financial needs beyond determining how much they need to save in their 401(k) plan.  To meet this growing need, we have established a new service.

How does this work?  Your employees can enroll in the counseling program for a small annual fee which can be deducted from their payroll monthly or they it can be deducted from their 401(k) account.  In some cases the employer is paying for the benefit as part of the overall benefit package.

What do they get?

1. Tax planning.  Our counselor will review their current tax situation and help them determine if there are ways they should take advantage of employee benefits plans, retirement savings plans or other benefit programs that would enhance their take home pay.

2. Budgeting - many families have never thought through the basic financial planning issues that would help them gain control over their finances.  Our counselor is thoroughly trained in helping families budget and save for education, purchasing a house, family expenditures and retirement planning.

3. Regular access for questions and research to help them with typical financial questions.

The most important part of the BTA Advantage is that the counselor will not be actively selling products.  The counselor is a salaried employee of BTA and will attempt to market products to participants.  This is “risk: free environment, solely aimed at providing competent advice to assist employees improve the quality of their lives.

About the Author:

Guy is a Fellow of The Business Forum Association.  He is Managing Director of BMI Consulting, a national consulting group with offices in 20 major cities.  He recently founded the Business Success Institute formed to train agents to be fee consultants for business succession planning.  He is also Managing Director of ALIMO a vertical and senior life settlement marketing company headquartered in San Antonio Texas. 

Guy graduated from Claremont McKenna College (BS/Economics-1967) and the University of Southern California (MBA Finance-1968).  Guy earned the Chartered Life Underwriter (CLU) in 1972 and Chartered Financial Consultant in 1981.  He also holds a Master’s degree in Financial Services (MSFS), a Masters in Management (MSM) and an RHU (Registered Health Underwriter).  He is also a Certified Family Wealth Counselor (CRWC).

A frequent writer and speaker, Guy has spoken all over the world.  He has written five books,  including “Why People Buy,” “Investment Alchemy” and “Baker’s Dozen - 13 Principles for Financial Success.”  The BOX™, an easy to understand discussion about the fundamentals of life insurance, has sold over 50,000 copies.   In addition, he has developed an 8 cassette business training album, called “Market Tune-up”, to assist professional agents in their quest to increase sales productivity.