The headlines about 401(k) plans vaunt the perils of employers offering employees too few investment choices, or too risky ones, or ones with fees that are too high. But none of those are Chris Beck’s problem. Instead, Beck, CFO of BirdDog Solutions, a private-equity-backed logistics provider, is now sifting through a list of the more than 50 investment options that are currently in his company’s plan for about 160 employees with $3 million in assets.
As BirdDog has made three acquisitions in Beck’s two-and-a-half-year tenure, and merged new employees into its 401(k) plan, “we’ve tried to be very accommodating by adding a fund here or there,” says Beck. That courtesy has now yielded a volume of options he considers overwhelming. “We’ve got bright people but they’re not financial types; people kind of shut down when they have to decide if they want to be in the energy fund, or international emerging markets,” or other highly-specific individual investments. As a result, more than half of the plan assets are in the lifestyle and lifecycle funds, effectively prepackaged portfolios that change over time. The task now: “we are going through to find the best of breed in individual funds,” says Beck, who is working with advisers, with plans to drop the rest.
Fast-growing companies are particularly prone to having their 401(k) plans get off track in one way or another, say experts. The combination of fluctuating asset levels, executive overload, and Internal Revenue Service rules that are structured in a way to almost ensure closely held companies will violate them means that CFOs at those companies need to keep an especially close watch on them, at least at a high level. “You’d think I’d be most focused on the finance aspect [of the 401(k) plan], but that’s secondary,” says Gene Lynes, CFO of energy-management consultancy Ecova, which has rapidly grown its plan assets in the past few years to close to $15 million. “Being a good employer, we’re trying to protect people for the future and create high morale”: no easy task these days.
The move toward fewer 401(k) options is one that has gained a lot of fans from companies both small and large in recent years. JP Morgan, for one, recently proposed a winnowing down, or at least an aggregation, of investment options to make things easier for participants. And such screening is a hallmark of plans that are targeted at smaller businesses. At Sharebuilder 401(k) (a division of ING Direct), for example, “our investment committee manages the fund lineup, and takes on the fiduciary responsibility,” giving everyone a fairly slim menu of 16 ETFs or one of five model portfolios, says Stuart Robertson, head of the division, which is aimed at plans with 250 employees or less. While there is still some choice and education involved, “we try to make it hard for participants to get off on the wrong foot,” he says.
That philosophy is extending to other parts of the plans, as well. Vanguard recently announced a new offering aimed at plans with under $20 million in assets, with standardized record-keeping and administration to help keep fees and hassle low. For example, there’s a prototype plan document that plan sponsors are asked to adopt that “has less flexibility than the standard one, but still has everything you need to operate the plan,” says Kathy Fuertes, who leads Vanguard’s new effort.
Testing 1, 2, 3
While the marketplace for smaller 401(k) plans may be getting richer, the new plans are no panacea for the antidiscrimination test violations that take many CFOs by surprise. Such tests include the actual deferral percentage (ADP) test, the actual contribution percentage (ACP), and the top-heavy test. Their aim is to ensure that highly paid executives and owners of the firm aren’t reaping disproportionate benefits relative to rank-and-file employees, so they cap the amount that executives can contribute based on the amount that employees contribute. Violations, even unwitting ones, can wreak havoc on corporate cash flow and executive taxes.
One of the easiest tests to fail is the top-heavy test, which looks at the ratio of the accumulated plan assets of key employees (usually the executive team, and possibly others with ownership) to those of rank-and-file employees, says David Wray, president of Profit Sharing/401(k) Council of America. (He recently blogged about the topic here.) If key employees have more than 60% of the plan’s assets, the plan fails.
Many smaller companies “unsuspectingly walk into the experience” of failing, says Wray, because closely held companies with low employee participation and/or high employee turnover will almost certainly fail within several years. “When you first set up the plan, it’s not top heavy, but it doesn’t take more than four years before it becomes that way,” he says. “And it’s a dagger into the heart of small companies where cash flow is very uncertain.”
The ADP and ACP tests are also easy to fail for rapidly-growing companies, but the problem is not without a solution, notes Joseph S. Adams, an attorney with McDermott, Will & Emery in Chicago. “You can basically buy your way out of the discrimination tests by setting up matching safe harbors,” he says.
There are three options to achieve safe-harbor status, and they largely involve employers committing to match at least 3% of employees’ contributions, vesting the contributions faster, and in some cases, automatically enrolling employees in the plan, says Adams. A profit-sharing contribution is also an option and protects against all violations, but is typically more expensive. A company can elect to change its safe-harbor status from year to year, but cannot change midyear.
Not surprisingly, many companies elected to drop the safe-harbor status in the depth of the recession, when 401(k) matches were one of the few sources of cash left. Both Ecova’s Lynes and BirdDog’s Beck say they have run into problems with these tests based on decisions made before their tenures. “Prior to my arrival, the company went through some tough times and had to pull back, which may be why they didn’t use a safe harbor,” says Lynes. Unfortunately, that resulted in failing one of the tests and executives having to make 401(k) withdrawals, which he says “was a bad scenario,” carrying some severe tax consequences for those who were affected. Now Ecova has increased its level of match and changed the vesting time frame to qualify for a safe harbor, a decision Lynes doesn’t expect to revisit any time soon.
Beck has a similar story. To resolve issues related to a failed test a few years ago, BirdDog set up automatic enrollment and boosted its matches as required for a safe harbor. “It’s better for recruiting and budgeting anyway,” says Beck. Now, “we’ve taken the philosophy that we’re committed to the 401(k) plan, and to the extent we run into a blip we’ll manage it in ways outside the retirement plan.”
All that being said, it’s still worthwhile for CFOs to consider the basic task of negotiating on fees as the assets in the company plan grow. “It’s very important to renegotiate fees every five years,” says Wray. The metric to track is average account balance, rather than total assets, he notes, since that’s where profits come from. “The economies of scale here are just so enormous, and the use of technology [makes a big difference]; you should have a lot of leverage.”