How to Fix Your Company's 401(k)
Of all the moving pieces involved in running a successful company, employee retirement plans probably don't rank very high on your list of priorities. On one level, that makes sense--it’s not as if the inner workings of your company's plan are integral to growing revenue and profit margins, right? That said: Is your retirement plan any good? Does it have the right mix of investment options for your staff, delivered at a fair cost?
If you just shrugged out of indifference or because you don’t have a clue, well, you're blowing it. And here's why: Every dollar peeled off for internal benefits is a dollar not spent on building your business. If you’re not sure if you're getting the maximum benefit from this decision, that’s potentially a serious misfire on allocation of capital. More important, you’re also potentially screwing things up for your people. If you're unintentionally sticking your employees with high fees--an increasingly serious drawback to so many 401(k) plans today--their balances come retirement time will be tens of thousands of dollars less than what they would have been if your company's plan was packed with lower-cost funds.
Fortunately, there's something you can do about it--like, today. A set of new Department of Labor regulations kicked into action on July 1, requiring that employers sponsoring a 401(k) plan receive a breakdown of fees from the plan provider. The disclosure includes investment fees you and your employees pay on the underlying funds offered in your plan, as well as administrative fees. (Another part of the new regs is that all employees must get a version of the fee breakdown no later than August 30, and then you must provide ongoing disclosure--but your plan’s provider does the heavy lifting on this.)
Unfortunately, the disclosures can result in a 20- to 30-page data dump that can be tedious to wade through. Yet regardless of how fat the report is, it's important to do your best to carve out some time and read it. Really read it. And ask questions. Multinationals may have entire departments dedicated to making sure they are getting the best deal on employee benefits; smaller businesses have to be scrappier. Read the report. When you're done, you'll have a better idea if your plan is a good one or a dog--and if it's a dog, you'll know it's time to consider a switch.
In addition to exposing the new fee data, the new 401(k) disclosures present an equally important opportunity for CEOs to understand if their plan truly makes sense--for their company and their people. Here's what to look for:
1. Determine your "all-in" cost.
There are two broad sets of ongoing fees that come with your 401(k). The biggest chunk is a fee that goes to the investment company managing the underlying portfolios--which is bundled up into what's known as an expense ratio. The sneaky thing about annual expense ratios is that they never show up in a statement; they're deducted from a fund’s gross assets. Investors see only their performance net of fees. Good news, though: Expense ratios are included in the new data disclosures, expressed as a percentage of assets. If your plan uses retail mutual funds, you can also find this data online for free at sites like Morningstar.
The second set of fees covers recordkeeping and other administrative costs. Combine the two, and you have what is known as the all-in cost. How does your "all in" stack up? A study last year conducted by Deloitte Consulting for the Investment Company Institute broke down median all-in fees by plan size. Though the overall median was 0.78%, the typical charge for plans with less than $1 million in assets was 1.41%. For plans that size, the lowest fees (at the 10th percentile) were 0.99%, and the higher end (90th percentile) was 1.83%. For plans with $1 million to $10 million, the median all in was 1.14%. At the 10th and 90th percentile, the medians were 0.80% and 1.60%, respectively. If your plan’s all in is at the higher end, time to start asking some questions.
2. Confirm you have low-cost index fund options.
There are two broad approaches to investing: Park your money in a mutual fund that's built to track an established benchmark, such as the S&P 500 index for U.S. stocks or the Barclays Aggregate for U.S. bonds. The other approach is active investing, where there’s a manager or an investment team in charge of making all investing decisions--what to own, when to buy, sell, etc. I realize active sure sounds more compelling; hire some smart guy, and you will whip the index. If only. I’ll spare you the deep data dive and cut to the chase: The vast majority of actively managed funds underperforms index funds. Pick any time frame and any type of fund (stock or bond, domestic or foreign, etc.), and index funds do better.
My definition of a good 401(k) is one that includes index fund options. Moreover, they should be cheap index funds, ideally with an expense ratio of no more than 0.50%, and preferably lower. If you have index funds that charge 1% or more, that's just too expensive for a passive investment strategy. I’d be asking some seriously sharp questions at that point.
3. Take inventory of your fund options.
More is not necessarily better in terms of the number of investment options your plan offers. Studies have shown that when there are too many choices, participants get confused or frustrated or just decide not to participate. If you really want to keep it simple--and simple, here, is incredibly smart and effective--I would make sure you have one broad U.S. stock index fund, one broad U.S. index fund, and a diversified international stock fund, preferably an index fund. That’s going to give your plan plenty of bang for the buck. If you also want to offer more specific funds, such as portfolios of small-cap stocks, emerging market portfolios, perhaps a TIPs fund, etc., that’s your call. But don’t go overboard with the number of options.
4. Consider a target-date fund.
Target retirement funds are becoming increasingly popular within 401(k) plans. When properly constructed, they can be a compelling option. Participants merely have to opt for the target fund with a date tied to when they expect to retire. That fund will then own a diversified mix of stocks and bonds appropriate for someone with that investment horizon. (Someone with a 2020 retirement fund will have a more conservative portfolio than someone with a 2050 retirement date.) That said, you must vet the underlying assumptions of any provider’s target retirement fund and make sure you are comfortable with the strategy. For example, some plans become very conservative as the target date approaches, while others retain more in stocks on the assumption that just because someone is retiring on that date, that doesn't mean he won't continue to live for another 30 years or so.
5. Ask about ETFs.
Exchange-traded funds operate a lot like regular index mutual funds; the one main difference has to do with how they are priced during market hours. That’s not terribly important when we are talking about a long-term investment goal that is 20, 30, or 40 years off. But what is very important is that ETFs can typically carry the lowest investment expenses. Most 401(k)s don’t offer ETFs, or they are available only through a brokerage window that a plan can offer (often at an extra cost). But that’s in part because plans aren’t pushing for ‘em. Sure, the big plans have the most influence, but I think every entrepreneur who offers a 401(k) plan should be asking the plan provider or third-party consultant about the availability of a low-cost ETF option. At the very least, it puts the provider or consultant on warning that you are now an informed customer who is keeping a sharp eye on costs.
BILL HARRIS | Columnist | CEO, Personal Capital
Bill Harris, CEO of Personal Capital, was formerly CEO of PayPal and also Intuit, the makers of Quicken, QuickBooks and TurboTax. He founded numerous financial technology and security companies, and served on the boards of RSA Security, Macromedia, SuccessFactors, GoDaddy and EarthLink.