Corporate retirement plans have been, historically, either defined benefit (DB) or defined contribution (DC) plans. With a DB plan, the employer is “guaranteeing” a life-long retirement benefit to the employee at the time of retirement. That benefit is usually a function of the years worked at the company and the salary earned over a previous time period. Annual contributions are made into the DB by the employer to ensure that the plan will be able to pay benefits over the retiree’s life expectancy.
With a DC plan, the employer is guaranteeing only a certain “contribution” amount for the employee’s retirement. The actual benefit or amount received by the employee at retirement will be based on the amount to which the plan account has grown over the years until retirement. One can readily see that the shift to DCs (and it has been pronounced) from DBs places the investment burden on the employee and away from the employer. That shift in investment responsibility has been a primary driver of the elimination of DBs (pension plans) in favor of DCs (401(k), 403(b), etc.).
Since 401(k)s now require employee management, it behooves us to look at some of the factors affecting the final amount in the 401(k) that generates the income stream in retirement. Some of these factors include the following:
- Sign Up- Participation in the plan is usually voluntary and requires the employee to take action to participate. Most plans offer an “employer match” whereby the employer matches the employee’s contribution (i.e. the employee contributes 3% of his/her salary and the employer matches that 3% contribution). Every employee should at least contribute the maximum the employer will match; if not, the employee is leaving “money on the table.”
- Asset Allocation- The employee is responsible for investment selection in the 401(k) plan. How the money is invested (stocks, bonds, etc.) and in what percent is an employee choice. Again, this investment selection is critical for the long term benefit in the account.
- Plan Expenses- Most individuals are familiar with the preceding two items; they may not be as familiar with plan costs. Plan costs basically include the following:
- Investment Management Expenses- These are the expenses charged by the individual mutual fund managers for investments in mutual funds allowed as investment options in the plan. It is the fund’s “expense ratio” and the pro-rated amount is deducted daily from the fund.
- Administration Fees- These fees cover the costs associated with operating the plan: accounting, legal, record keeping, trustee services, etc.
- Individual Fees- These fees cover charges associated with account owner actions (such as taking a loan against the 401(k)).
Who pays the fees associated with a 401(k)? It depends. The employer may pay a portion or all of the fees; however, the employer may shift some of the costs to the employee. For example: A common share class of mutual fund offered in retirement plans is the “R” class. However, that R share comes in several “flavors:” R1, R2, R3, etc. One popular mutual found in many 401(k)s—a four star, gold Morningstar rating—has seven separate share classes for the same fund. The difference in the R class is the expense ratio charged. Of the seven different classes, the highest expense ratio is 1.55%; the lowest expense ratio is 0.05%. The higher the expense ratio in the plan’s R class, the greater the proportion of plan expense shifted from the plan sponsor (the company) to the employee. Plan expenses are a significant concern. There is now a lawsuit working its way through the legal system to the Supreme Court; it was filed by an employee against his employer for excessive 401(k) fees (Glenn Tibble v. Edison International). There may be significant changes in plan expense structure as a result.
There are multiple items to consider toward maximizing your retirement plan results. Investments in retirement plans should be integrated with investments held outside retirement plans; this integration provides for a more diversified total portfolio.
We at Paragon Financial Advisors are happy to help our clients evaluate their company retirement plan options and their potential consequences. Please call us anytime to see if our services are a good fit with your needs. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.