How to Offer a Low Cost 401(K) Plan

Any employer wishing to provide a solid benefits package to its employees is likely to offer a 401(k) plan. However, just because an employer offers a plan does not necessarily mean that this vehicle is the best mechanism for an employee to save for their retirement. Especially for smaller employers, the "all in" cost of a 401k plan may amount to more than 2% of plan assets. Thus, an employer should pay close attention to all of the costs of their plan to assure that they are providing a great benefit to their employees.

According to a study by Deloitte and the Investment Company Institute1, over 74% of a plan's all in" cost is attributable to investment expense. Thus, ensuring that your plans offers investment options with low expense ratios is the best way to ensure that you're offering a low cost 401(k) plan.

1) Include index funds - Because index funds only track a certain market index rather than attempt to outperform it like actively managed mutual funds, their operating costs are much lower. According Morningstar, index funds are 0.51% cheaper than actively managed funds.2 Furthermore, over time; many index funds have proven to outperform their actively managed counterparts.

2) Include ETFs - Like index mutual funds, ETFs are a basket of securities that attempt to replicate a market index. While we are beginning to see some actively managed ETFs surface recently, for the most part, ETFs are passively managed funds. Like index funds, their primary benefits are their low cost and market like performance. Morningstar reports that the average expense ratio for a passively managed ETF is only.56%.3 However be sure to consider the commissions that will be charged for the purchase and sales of ETFs. Yet, even when factoring in these commissions, including ETFs in a plan's lineup if likely to reduce the overall cost of a plan.

3) Avoid funds with revenue sharing - Revenue sharing is when mutual fund companies pay either a broker dealer or recordkeeper a payment for the distribution of their funds or servicing of accounts using their funds. Revenue sharing payments can come in the form of 12(b)(1) fees, sub-transfer agency (Sub TAs), or shareholder servicing fees. Any of these types of payments increase the overall management fee of the fund itself. Unless your 401(k) provider uses all revenue sharing payments to offset plan expenses, you can lower your overall plan cost by sticking to funds that don't include these payments.

4) Avoid variable annuities - Many insurance providers "wrap" an added expense on top of a mutual fund. To the average investor, it appears as if they are invested directly in the mutual fund. However, their returns will not match that of the mutual fund due to these added expenses, which can sometimes amount to more than 1%.

In addition to the above suggestions about the investment lineup, the following are some additional ways that an employer can assure they are offering a Low Cost 401k plan:

Force Out Terminated Participants with Low Balances If your plan document allows you to force out terminated participants with balances less than $5,000, you should be diligent in doing so, especially if your recordkeeper or TPA is charging a per participant fee. Additionally, if your plan is around 100 participants, by distributing balances of these participants, you may lower your total participant count whereby you will not have to incur the added expense of performing an annual audit.

Join a Multiple Employer Plan (MEP) A MEP allows many unrelated entities to become a part of the same 401(k) plan. If you are a small employer, it is possible that joining a MEP could be a cheaper option for you than a standalone plan whereby you may be subject to minimum fees because of a low participant count or asset size. Additionally, a MEP may allow you access to cheaper investment options because of the collective size of the plan.

Because every dollar of fees paid by the participants reduces their retirement nest egg, it's important that consideration be given to every possible way to lower plan costs. These suggestions should help get you started in your quest to offer a great low cost 401k plan to your employees.

1 Defined Contribution 401(k) Fee Study (2009). Deloitte and Investment Company Institute. 2 U.S. News and World Report, "Why Investors Are Flocking to Index Funds", March 16, 2010. 3 How ETFs Have Reshaped Investing. The Wall Street Journal, April 18, 2011.

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Simple 401(K) Asset Allocation Options

Studies have shown that the more investment options available in a 401(k), the lower the participation percentage. This is because most employees lack the desire or knowledge to carefully select their investment options. One way an advisor can mitigate this issue is by offering an asset allocation option that provides a participant exposure to stocks, bonds, and cash through a single fund. Two of the most common types of asset allocation funds in 401(k) plans are target date funds and customized 401(k) portfolios, i.e. "managed models".

Target Date Funds Target Date Retirement funds are becoming an increasingly popular investment option in 401(k) plans. If your recordkeeper offers an open architecture 401(k), then you will have the benefit of choosing among target date offerings from multiple fund families. All target date funds follow a "glide path" which is essentially the percentage of assets allocated to stocks, bonds, and cash. Most mutual fund families offer these funds in 5-year increments, although some may only offer 10-year increments. As the target date approaches retirement, the funds get more conservative, lowering their allocation to equities and increasing their allocation to bonds and/or cash.

Many investors are unaware that there are really two separate types of target dates funds; "through retirement" funds are designed as an investment that is supposed to be held in one's retirement years. As such, these funds typically have an equity allocation of 50-60% around age 65, decreasing to 20% thirty years after retirement. The concept of these funds is that one's retirement could last many years, so they need to maintain a fair amount of equity exposure to make one's retirement balance last. Vanguard is an example of a fund family that offers "through retirement" target date funds.

The other type of target retirement date funds are known as "to retirement" funds. As the name implies, the goal of these funds is to get one to retirement, at which point the primary goal becomes generating income while minimizing risk. J.P. Morgan's offering is an example of a target retirement fund that can be classified as a "to retirement" fund; its equity allocation at age 65 is only 33%.

"Managed Models

Whereas target retirement date funds are almost exclusively comprised of funds from a single fund family, managed models can include funds from multiple fund families. Some recordkeeping systems will limit the models to include only funds available in the plans' core lineup. However, other open architecture 401(k) platforms may allow funds outside of the core lineup. Managed models are a great way to include EFFs in 401k plans. While many ETFs are appropriate when used in models to reduce volatility while increasing returns, they may not be appropriate as standalone investment options.

Managed models are extremely flexible and can be established as either age based or risk based products. Since there isn't a published glide path that needs to be followed, an advisor can employ either a tactical or strategic allocation approach. This allows a tactical advisor to take advantage of market opportunities by changing the risk level of the portfolio. For the advisor using a strategic asset allocation, a managed model can be automatically rebalanced quarterly, semi-annually, or annually.

In summary, for the majority of participants, it is a good idea to leave asset allocation in the hands of a professional. Rather than attempting to decide how much money to allocate to the major asset classes and ultimately to funds within those asset classes, selecting an asset allocation fund such as a target date fund or a managed model is a great way for participants to receive proper exposure to both equity and bond markets.

401K Investment Advice   How Do I Choose the Best Retirement Investment?   Provident Fund Withdrawal - Duties of the Regional PF Commissioner   Rules and Regulations For a Self-Directed IRA   The Rules of a 401k Rollover   Borrowing Money From Your 401k