One of my favorite Warren Buffet investing principles is “never invest in a business you cannot understand.” I think the rule of thumb is helpful in mitigating risk. If you’re a small business owner, I recommend you extend this principle to managing your 401(k) plan – never hire a 401(k) provider you cannot understand. What you don’t know about your provider can hurt plan participants and increase your fiduciary liability
To protect the interests of your 401(k) plan participants, you have a fiduciary responsibility to “monitor” your 401(k) provider – basically, ensure their services meet the clerical or fiduciary responsibilities you delegated to them for reasonable fees. It's impossible to meet this monitoring responsibility when you don’t understand your 401(k) provider’s services, investments or fees.
When you can't monitor your 401(k) provider, you can't protect plan participants from harm or yourself from fiduciary liability. This risk is avoidable. Many 401(k) providers provide clarity and transparency, with straightforward administration services, investments, and fees that are easy to monitor. Here’s what to look for to find one of these providers for your company.
401(k) plans are popular today because they offer generous tax benefits to employers and employees. However, to qualify for these benefits, 401(k) plans must complete a myriad of plan administration tasks each year. Ultimately, it’s up to you to ensure each task is completed timely. This responsibility can easily seem overwhelming, but it doesn’t need to be. The key is hiring a 401(k) provider that’s willing and able to do three things - 1) summarize all required tasks, 2) complete the more difficult and time-consuming ones, and 3) provide simple direction for the rest.
Annual 401(k) administration tasks generally fall into one of four categories – nondiscrimination testing, Form 5500 reporting, participant disclosure, and plan document maintenance. These tasks can usually be managed easily using a checklist.
Investment-related fiduciary responsibilities can seem particularly scary to employers. In fact, they can be the easiest to meet. They boil down to picking a menu of “prudent” investments that gives plan participants access to a broad range of financial markets - so they can sufficiently diversify their account. A prudent investment is simply one that meets its investment objective for reasonable fees. These requirements can be easily met with some basic guidance:
- Passively-managed index funds – which are designed to track a market benchmark (e.g., the S&P 500 index) – can make prudent investment selection easy. This is true because comparable index funds (i.e., funds with the same market benchmark) from any of the largest providers – including Vanguard, Blackrock, Schwab, and Fidelity – offer similar returns and low fees. This uniformity makes it easy to avoid underperforming funds with excessive fees that increase your fiduciary liability.
Actively-managed funds are a different story. The returns and fees of comparable funds can differ dramatically – making prudent fund selection much more difficult. If you want them for your plan, I strongly recommend you hire a 3(38) Investment Manager to pick them for you. Unlike a broker or insurance agent, these financial advisors are obligated by law to give you impartial (conflict-free) advice.
- Meeting the diversification requirements of ERISA section 404(c) is the key to offering plan participants access to a broad range of financial markets. These requirements are not difficult to meet. In fact, a simple 3-fund lineup that includes equity (stock), fixed income (bond), and capital preservation (money market or stable value) funds can do the trick.
You have a fiduciary responsibility to pay only reasonable fees for necessary services from your 401(k) plan assets. This responsibility is intended to protect plan participants from unnecessary investment losses due to excessive fees. The problem? Many 401(k) providers charge opaque fees that are hard to total and compare.
401(k) providers can be compensated from three sources today – the plan sponsor, participant accounts or plan investments. 401(k) fees paid by the plan sponsor or participant account deduction are considered “direct compensation,” while fees paid by plan investments are considered “indirect compensation.”
Direct compensation is the most transparent type of 401(k) fee. It must be explicitly reported in 408b-2 and 404a-5 fee disclosures, and quarterly benefit statements. Indirect compensation is a different story. It can be estimated in 408b-2 disclosures, buried in the investment expense ratios of 404a-5 disclosures, and not appear at in benefit statements. The two most common types of indirect compensation are revenue sharing and annuity wrap fees.
I recommend you avoid 401(k) providers paid by indirect compensation. It’s just too hard to keep their fees in check – especially if your 401(k) plan is growing fast.
Protect your 401(k) participants and yourself!
I consider apathy is the #1 source of 401(k) fiduciary liability today. Why? Because I think avoiding fiduciary liability can be easy to do. All you need is a basic understanding of your fiduciary responsibilities and a 401(k) provider with easy-to-understand administration services, investments, and fees.