Mac Williams founded a firm that provides military arms-control verification systems, so he knows a thing or two about detection. It turns out he needed those skills when he decided to set up a retirement plan for his employees.
“I thought I knew a lot about 401(k)s going in, but for someone who’s not in the financial-services business, it’s a real struggle,” he says. “As we say in the military, `It’s way above my pay grade.’ “
Fortunately, the former naval officer is a quick learner. One insurance company made it seem as though it would administer the 401(k) plan for free. But Williams figured out that the recordkeeping costs were actually embedded in the plan’s mutual funds, and that the plan’s total cost was almost triple that of others he was reviewing.
An unusual tale? No way. Small-company owners often find that buying a 401(k) can be a lot like buying a used car: Without a big benefits and legal department to turn to, the company, and the employees, can get taken for a ride.
But the good news for small companies, and the 33 million people who work for them, is that it’s never been easier and cheaper to set up a 401(k)–if you know what to look for.
With a tight labor market, companies such as BAI Inc., Williams’ firm in Alexandria, Va., want to use the 401(k) as a recruiting tool. “I have to attract good people, so I need to offer them a good retirement plan,” Williams says. He hopes to expand to 30 employees by the end of the year from his current 10; to do that he will need to entice talented professionals accustomed to good benefits packages.
To get the ball rolling, Williams contacted a variety of 401(k) providers. There were plenty to choose from. Only a few years ago, plan providers turned up their noses at the small-fry employer, because the big money was in the big companies. Today, 96 percent of companies with more than 5,000 employees now have 401(k)s, according to Spectrem Group, a consulting firm in San Francisco. Meanwhile, 87 percent of companies with fewer than 100 employees don’t have such plans, Spectrem says.
Not surprisingly, most major mutual-fund companies, securities brokerages, banks and insurers now target small companies. The growth potential is huge. Charles Schwab, Vanguard Group and T. Rowe Price Associates say their small-company business has exploded in the past year. And Fidelity Investments, which expects the number of 401(k) plans it manages for small businesses to double this year to 2,000, has a unit with 700 employees just to service small-business clients.
With no shortage of companies interested in signing him as a client, Williams quickly bogged down in the confusion over administrative costs. Suspecting that there is no such thing as a free lunch, he figured out that the plans that appeared to be “free” tucked the administrative costs into the investment expenses charged to the plan’s mutual funds, which is a common practice. “Most 401(k) plans for small businesses are set up to transfer the administrative cost to the employees,” he says.
But, he realized, this can be a painful cost. One insurer with “low” administrative costs provided mutual funds with annual expenses of 2 percent of assets or more, plus surrender charges that started at 7 percent of assets and lasted as long as seven years. Had Williams chosen that provider’s plan, employees who occasionally switched funds would have lost big chunks of their savings, and the high expenses would have undermined investment performance for both those who did and didn’t move around.
He also found that not every provider was clear about investment expenses. One company claimed its index-based stock fund, for example, had “below average” expenses. But the salesman was comparing it with the average expense for a fund run by a stock picker, a costlier variety. In reality, the index fund, with its 1 percent-of-assets annual expense, was triple the cost of many similar index portfolios.
“I got so much misinformation it just made me angry,” he says.
In the end, Williams decided that T. Rowe Price’s plan, which at first looked relatively pricey, was actually cheaper overall. The startup cost was $1,300, and the annual administrative expense is $3,300. (Various providers charge $2,500 to $3,500 a year.) This pays for everything: record keeping, Labor Department filings, compliance testing, quarterly statements and employee communications. Employees get Internet access, 24-hour toll-free phone service, daily mutual-fund valuations, loan provisions–pretty much what they would get at a large company.
One drawback for small companies is that small-plan providers usually keep their costs low by offering a small menu of funds rather than a total smorgasbord. Williams, for example, was limited in his fund selection to a dozen investment vehicles. But he figures the assets will grow quickly, especially as new employees roll 401(k) money into the plan from other plans.
Small businesses that can’t afford to pay the annual administrative costs can shift this expense to employees. But that doesn’t mean they should accept expensive investments (which will undermine the performance of the owners’ savings as well). For help in rooting out all the charges, the Labor Department recently released a 401(k) fee-disclosure form, available on the Web site of the Investment Company Institute, a mutual-fund trade group in Washington (www.ici.org).
Small employers are also finding that some 401(k) providers are eager to help them maneuver through a thicket of Internal Revenue Service rules involving what financial contributions, if any, a company must make to a plan on behalf of employees.
Many small-business owners fear they must make large contributions. But if a large enough percentage of eligible employees contribute, then the IRS considers the plan to be an employee benefit, and no matching contributions by the employer are required.
However, if only the owner and a few key employees participate–and, thus, 60 percent or more of the plan’s assets are in their accounts–the plan is considered to be a tax shelter, or, in technical terms, “top heavy.” If this happens, the company is required to contribute 3 percent of pay for all employees.
The rules also stipulate that unless a certain percentage of the lower- and middle-paid employees participate, then the higher-paid workers can put in only, say, $7,000 to $9,000, instead of the maximum annual contribution of $10,000 that the law permits.
The cost of a matching contribution isn’t as high as an employer might think, because turnover among employees means that not everyone will collect the match; most plans have vesting periods of three to five years. An employer also can decide to provide part of a salary increase in the form of a company match. So, instead of a 4 percent salary increase, the employee gets a 2 percent increase and a 2 percent matching 401(k) contribution.
A new twist that went into effect this year is that companies can be exempt from the discrimination rules that can lead to restraints on the contributions of the highest-paid workers as long as they do one of the following: Provide all employees a 3 percent matching contribution or offer to provide a dollar-for-dollar match on the first 3 percent-of-pay contribution by an employee, and 50 cents on the dollar for the next 2 percent contributed.
