There are some professional advisors working in the retirement plan arena that have a rather strong bias against group variable annuity products when being used as funding vehicles for qualified retirement plans such as 401(k)s. I am not personally one of those who feel that they should never be used. I have seen situations where these solutions have been a good fit for the plan sponsor. With that being said, having investment options that are held within an annuity wrapper does not relieve plan sponsors of their responsibility to monitor the investment options that they are making available to their participants.

Additionally, because of how variable annuity products are packaged, it can be difficult to determine if there is a retail mutual fund being used as the underlying investment vehicle or if the insurance company sponsoring the product has retained an outside sub-advisor to manage the assets. In many cases there are recordkeeping and administrative fees that are also layered into the asset-based charges assessed against the plan. These asset based charges are removed prior to the calculation of the unit price of the separate account investment option, making it tough for most plan sponsors to determine the true cost to their participants.

Again, I want to emphasize that I am not inherently against group variable annuity products but do feel that they require an additional level of diligence from the plan sponsor, particularly as the size of the plan grows. I have observed many situations where a group variable annuity product was justifiable and reasonable for a small or startup 401(k) but over time, as the plan assets increased, was no longer the best solution.

During the recent product review I conducted for our prospective client, I was able to identify the underlying retail mutual fund within most of the group annuity separate accounts. For those retail mutual funds where I could identify the specific fund being used, I matched that fund with the least expensive share class for that same fund on an open architecture platform.

I went on to demonstrate that the plan sponsor could have obtained many of the same investment managers, funds, etc. by using a recordkeeping solution that allowed them to go directly to the fund managers outside of that group annuity shell. The savings available for each fund compared was between 0.05% and 0.55%. In most cases the savings on a per fund basis exceeded 0.25%. These small, incremental savings could add up to a meaningful amount over the course of the participants’ years of investing for their retirement.

Keep in mind, I was not attempting to show the client the best or most cost competitive solution in each asset class. I was simply attempting to demonstrate that the client could have obtained the very same investment option less expensively outside of the annuity wrapper. In many cases, further cost savings would have been available to the client when considering other no-load or institutionally priced investment options in the same asset class. Setting aside any considerations with respect to the fiduciary responsibility of a plan sponsor to make certain that the fees being assessed to their participants are reasonable, as a business person, if you can obtain the same service from the same provider 25 to 50% less expensively, why wouldn’t you?

In conclusion, group variable annuity products are not inherently bad choices as 401(k) investment options. However, the plan sponsor should appreciate that these are packaged products built by insurance companies and the underlying investment options are not considered retail mutual funds, but are annuity separate accounts. Consequently, the underlying fees associated with each separate account should be compared to the fees for the same retail investment option. I have seen cases where the separate account was priced less expensively than the publicly traded mutual fund, but this is not normally the case.

To stay up-to-date on prudent practices as a retirement plan sponsor, or to share this information please register for our newsletter by using the registration form located in the sidebar of this blog, or subscribe to our RSS feed. As always, we appreciate your comments, which can be added below. For compliance reasons, comments are monitored and reviewed as soon as possible before posting.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC. Investment advisory services are offered through HBK Sorce Advisory LLC. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPLE. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.

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For example, if a plan has several different large stock growth mutual funds available, how does the average participant determine which large growth fund makes the most sense for them? If a participant selects more than one large growth fund, are they more diversified? The average participant actually has no way of knowing which of the multiple large growth funds available makes the most sense for them to choose, and he or she is very likely less diversified by choosing more than one fund in a given asset class.

One interesting study that examines how investment decision-makers, such as qualified retirement plan participants, are impacted by more choices is, “The Psychological Costs of Ever Increasing Choice: A Fallback to the Sure Bet,” written by Sheena S. Iyengar and Wei Jiang of Columbia University in 2005.  This study drew upon information attained by examining nearly 650 retirement plans with approximately 800,000 participants.

The above referenced Columbia University Study has a number of very interesting observations and conclusions.  One of the most fascinating conclusions drawn from this study was that having a large number of choices from an investment standpoint induced retirement plan participants to refrain from making any choices even when it was costly to do so.

Further, the availability of a significant number of investment choices actually motivated retirement plan participants to choose less risky investment options. The attitude of the typical participant seems to be, “This is not what I do.There are too many choices here. I think I’ll just play it safe.” The selection of less risky investment options, such as money market accounts and stable value funds, may be appropriate for some participants. However, this could be a costly allocation decision for participants with a long time horizon in front of them from an investment standpoint.

One of the most dramatic conclusions made by this particular study was that having too many investment choices actually created a situation where participants were more likely to completely opt out of a pension plan. This tendency to opt out when there are a large number of choices was even proven to be true when there were clear monetary advantages to participate, such as an employer matching contributions.  As options increase, the probability of participation declines.  I personally found this to be an incredible observation.

This recent and rather extensive study provides some compelling observations for plan sponsors to consider when building a fund menu.  Clearly, participants must have a fund menu that enables them to develop an appropriate allocation based on their personal goals, time horizon, and risk tolerance. However, excessive choices actually decrease the likelihood that participants will develop a prudent investment mix.

Another practical administrative challenge for plan sponsors who have a large number of investment choices on their menu is the ongoing need to monitor those investments based on a prudent fiduciary process.  It is reasonable to expect that if you have a significant number of investment choices and have a reasonably high standard for performance of those investment options, that you will need to make rather frequent changes to your investment lineup.  Changing investments on a frequent basis can be costly in a variety of ways including administrative fees associated with changing a fund, the necessity to place the plan into an administrative blackout, and the possible need to communicate the change to retirement plan participants.

In conclusion, having too many choices has proven to actually decrease participation in defined contribution plans such as 401(k)s, even when participants are incented to participate through a matching contribution.  Further, participants that make investment allocation decisions when there are a significant number of choices available are more likely to weight their allocations toward fixed income and cash equivalent investment options. This bias toward less risky investment options when there are a large number of choices occurs even when the end result may not be the most reasonable long-term investment decision for the participants.

A ‘best practice’ for retirement plan sponsors building an investment menu is to first determine which investment categories make the most sense to include in their fund lineup and then select well-managed mutual funds that fit into those asset classes.  These mutual funds can then be monitored carefully, based on a prudent fiduciary standard of care and replaced when necessary.

To stay up-to-date on prudent practices as a retirement plan sponsor, or to share this information, please register for our newsletter by using the registration form located in the sidebar of this blog, or subscribe to our RSS feed. As always, we appreciate your comments, which can be added below. For compliance reasons, comments are monitored and reviewed as soon as possible before posting.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC. Investment advisory services are offered through HBK Sorce Advisory LLC. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPLE. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.

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In his article, Chris reminds his readers that the assessed fees associated with servicing a retirement plan need to be reasonable. Chris also points out the current lack of specific regulations on these fees. That being said, retirement plan sponsors are wise to pay attention to the fees being assessed by fund complexes and other professional service providers to their participants.

My intended audience for this blog is not professional advisors, such as myself, who are obsessed with the pension market and monitoring trends on a weekly basis, but rather company owners who are otherwise busy professionals with limited time to dedicate to company sponsored benefits. Because my readers may not be familiar with the details of ERISA (Employee Retirement Income Security Act) and the fiduciary duties that are required of retirement plan sponsors, I thought it would be useful to provide a real world example of the impact these can have on a participant’s future retirement benefits. Realistically, even small variances in asset-based charges assessed to participant account balances can have a significant impact on a participant’s future benefit.

For example, assume that two participants each contribute $250 per month to the same 401(k) investments. The only difference is the net rate of return available to each respective participant. For this example, investor A earns 8% and investor B earns 7.5% because investor B purchased mutual funds that have higher expense ratios. Based on these assumptions, investor A will have $239,342 at the end of a 25 year period of time.  Investor B, who earned 7.5% over the same 25 year period, will have $220,686. As you can see, paying an additional 0.50% over that 25 year period resulted in investor B ending up with $18,656 less than investor A.

You can take this example an additional step forward by examining the difference in future benefits for these two participants due to the difference in their account balances at retirement. Assume, for example, that they each draw down their respective portfolios over a 20 year period at a 7% rate of return. Investor A could draw almost $150 per month more than investor B. Over this 20 year retirement the total difference in benefit is more than $30,000. For many retirees this is a meaningful number.

If you start to apply this thought process across multiple participant accounts, you can begin to appreciate why it is so important for plan sponsors to pay attention to the underlying expenses assessed against their participants. Clearly, not all investment expenses are bad or imprudent. However, if the same or comparable investment options are available less expensively, then plan sponsors should take action to reduce those costs.

In conclusion, the “401(k) Fee War” is likely to rage on. Unfortunately for plan sponsors, remaining neutral will not be an option. Fees impact participant performance and subsequent retirement benefits. Consequently, plan sponsors need to pay careful attention to the cost associated with providing investments and other services to participants.

To stay up-to-date on prudent practices as a retirement plan sponsor, or to share this information, please register for our newsletter by using the newsletter registration form in the sidebar of this blog, or subscribe to our RSS feed. As always, we appreciate your comments, which can be added below. For compliance reasons, comments are monitored and reviewed as soon as possible before posted.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC. Investment advisory services are offered through HBK Sorce Advisory LLC. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPLE. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.

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A Real Impact on Productivity

If asked, most employers can think of situations in which the financial difficulties of their employees directly and adversely affected workplace productivity. On a personal level, any of us can certainly appreciate the stress that would be created in our own lives in the event of a spouse’s job loss or other reduction of family finances.  Worry over looming debt, mortgage payments, and providing for our children’s needs could easily overtake our thoughts, causing a dramatic drop in the amount of time spent on productive business operations.

Numerous studies conducted within a variety of industries and fields indicate a direct connection between financial duress, work performance and overall productivity of employees. The Personal Finance Employee Education Foundation estimates that at any given time between 15 and 30% of the American workforce is under significant financial stress.

Increased “Presenteeism”

The financial stress suffered by employees is thought to lead to increased “presenteeism”.  Presenteeism refers to time spent during regular work hours dealing with personal matters that are not directly related to the individual’s job. According to April 2009’s Human Resources Magazine, over 53% of employees experiencing financial stress spend time during work hours to attend to their financial issues. This time may be spent dealing with creditors, discussing personal financial situations with colleagues, and worrying about financial matters.  It is not difficult to imagine how employees faced with significant financial challenges and the need to deal with them during the work day will have lower productivity.

Workplace Financial Education

One of the ways that many employers have chosen to address lost productivity from employee financial stress is by incorporating a financial literacy or financial education program as part of their training calendar.  Many employers provide personal development education and training not directly related to their industry because they feel it is the right thing to do for their valued team members.  After examining the studies related to lost workplace productivity due to employee financial stress, employers can also make an excellent business case for enhancing employee financial literacy.

Due, in part, to advances in technology that make communicating with employees much easier, financial literacy training can now take many forms.  Employers who have embraced workplace financial education are making use of tools such as online training programs that employees can attend on their own time, providing books, and other materials on personal finance. They are also offering seminars and workshops on personal financial planning, both on and off company time.

There are other benefits associated with an employee financial literacy program including increased employee morale, more effective use of the benefits that are available to a company’s workforce, and even increased employee health.  In future articles on this subject, we will explore these and other benefits along with the most effective methods employers are using in their financial education programs.

If you work for a company that has a financial education program in place or have responsibility for administering an employer sponsored financial literacy program, we would appreciate the opportunity to hear from you.  Please tell us about your experiences with workplace financial education and its subsequent impact on your organization.  You can find our contact information here on this blog.

Stay Connected With Us

To stay up-to-date on workplace financial education and other employer sponsored benefit matters, or to share this information, please consider registering for our newsletter.  You can find the newsletter registration form in the sidebar of this blog. Another option to stay connected with our updates is by subscribing to our RSS feed. As always, we appreciate your comments, which can be added below. For compliance reasons, comments on this blog must be monitored, however, we will approve and post your comments as soon as administratively possible.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance, LLC. Investment advisory services are offered through HBK Sorce Advisory LLC. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

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Retirement plan fiduciaries not periodically reviewing the cost associated with their qualified retirement plan

It has always been important for retirement plan sponsors to pay close attention to the cost associated with servicing and administering their qualified retirement plans.  Plan sponsors should periodically survey the marketplace to make certain that the fees that the plan is paying for various services are still competitive.  Many times, a plan sponsor will carefully compare fees when the plan is initially established but will not include fees and other plan level costs as part of their ongoing monitoring process.

For example, overall plan assets will typically increase over time due to both participant and employer contributions as well as market performance.  Many times when plan assets increase, so does buying power.  Consequently, there may be options available to reduce the net cost of servicing the plan.

Another reason that plan sponsors should carefully monitor fees and expenses is that in the very near future, thanks to actions taken by legislative bodies and regulators, plan sponsors may be required to publicly disclose all fees paid to all service providers.  With this increased level of transparency across the entire retirement plan space, participants will be in a better position to challenge the fees associated with servicing their employer’s retirement plan.  In many cases, these fees related to servicing a retirement plan have a direct impact on a participant’s returns.

The fees that should be examined by the plan sponsor on a periodic basis include fees associated with the product provider such as the fees for mutual funds included as investment options in the plan, investment advisory fees assessed by an investment consultant associated with the plan, fees charged by the plan’s record-keeping firm as well as retirement plan’s administrative firm and perhaps other service providers such as plan custodians.  Generally, plan sponsors should determine if the fees assessed are reasonable and appropriate.

Retirement plan fiduciaries not being clearly identified and briefed on their responsibility and liability

Another common fiduciary challenge, and perhaps the most frequent issue that I encounter, is plan level fiduciaries not being clearly identified within the sponsoring organization and those same fiduciaries not being fully briefed on both their responsibility and their liability.  Frankly, this particular issue should have been one of the first common fiduciary challenges that I referenced in this series.  If those individuals who are considered fiduciaries in an organization sponsoring a retirement plan are not aware that they are responsible parties, they will be less likely to address some of the other challenges referenced in this series of articles.

Generally complacent attitude relative to retirement plan monitoring and administration

Small business people are exceedingly busy individuals with many demands on both their time and their attention.  Demands on an organization’s leadership have increased significantly in recent years as the pace of business has quickened due to advances in technology.  Further, leaders in all types of organizations including for-profit companies, municipalities and nonprofit organizations are under tremendous stress due to the need to respond to the recent economic downturn.  Consequently, the responsibilities related to employee benefit packages such as qualified retirement plans can easily be pushed to the back burner.

Regrettably, this responsibility and liability associated with servicing a qualified retirement plan is not relieved because plan sponsors are otherwise occupied with the demands of clients, customers, employees and suppliers.  Due to increased transparency requirements imposed by legislators and regulators coupled with increased participant scrutiny of plan investments and expenses, retirement plan administration must be moved up on a decision maker’s priority list.

Conclusion

In this series we have discussed a number of common future challenges faced by sponsors of qualified retirement plans.  Although considering these issues may at first seem overwhelming for an otherwise busy leader in business or nonprofit, having a sound process can make addressing these matters much easier.

For your reference we have built an online quiz that a plan sponsor can take to provide them with a simple assessment of their overall fiduciary monitoring process.  The link to this online questionnaire can be found here and can be taken in about five minutes.  We have also added a sample Investment Policy Statement and sample investment due diligence created based on that investment policy for your review.

To stay up-to-date on prudent practices as a retirement plan fiduciary, or to share this information please consider registering for our newsletter, you can find the newsletter registration form in the sidebar of this blog. Another option to stay connected with our updates would be to subscribe to our RSS feed. As always, we appreciate your comments which can be added below. For compliance reasons, comments on this blog must be monitored however; we will approve and post your comments as soon as administratively possible.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC, investment advisory services are offered through HBK Sorce Advisory LLC and securities are offered through Purshe Kaplan Sterling Investments (PKS), Member FINRA/SIPC. PKS is headquartered at 18 Corporate Woods Blvd., Albany, NY 12211. HBK Sorce Insurance LLC and HBK Sorce Advisory LLC are not affiliated with Purshe Kaplan Sterling Investments. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

In my capacity as a professional advisor who consults regularly with plan sponsors, there are some common challenges with plan administration that I frequently encounter when a new client is referred to me. In this article, I will attempt to outline some of the most common deficiencies and what a plan sponsor can do to address them in the most effective manner.

Not having a prudent process to select and monitor investment options

Plan sponsors have a responsibility to ensure that their employees have a competitive mix of investment options to choose from in a defined contribution plan. In order to make certain that plan sponsors are able to meet this requirement in an efficient manner, it is useful to have a written process outlining how investment options will be chosen and monitored. An excellent tool with which plan sponsors can use to detail this prudent process is an Investments Policy Statement (IPS).

An Investments Policy Statement details how the plan will select and monitor the investment options that are available for participants to choose from. The IPS will typically detail the criteria with which these investment options will be reviewed. A typical selection criterion may include:

• Performance relative to a manager’s peer group over a certain period of time
• Performance relative to an appropriate index
• A fund’s expense ratio relative to it’s peer group
• Various methods of evaluating a funds risk adjusted returns such as Sharpe Ratio or Alpha
• The tenure of the manager or team of managers for the fund
• Style consistency – do the underlying holdings of the fund match the stated investment style of that portfolio?

There are many other criteria that are reasonable and could be used to evaluate a particular investment option. Some criteria that plan sponsors may want to consider included in their evaluation process can be found in another article on this blog – Selecting and Monitoring Mutual Funds. The key is to have a reasonable or prudent process and to follow that process.

Not following your stated process for evaluating investment options

Sometimes plan sponsors will have a reasonable, prudent process outlined for selecting and monitoring investment options. Many times, plan sponsors have even prepared detailed Investment Policy Statements when their retirement plan was established. However, if you’re going to have a written process for evaluating managers, it’s important that you follow the stated process and , are able to document that you’ve done so.

Plan fiduciaries must monitor their plans investment options on a regular and ongoing basis. This can be challenging for plan sponsors simply because of how busy the typical executive in a small or midsized company is. Regrettably, being busy does not eliminate the responsibility.

Not documenting that you have followed your stated process for evaluating money managers

As with many things in business, particularly from a regulatory standpoint, if it’s not written down it didn’t happen. As a plan sponsor, you may at some point be challenged about an investment decision that you made. If that time ever comes, being able to demonstrate in writing, that you have followed a prudent process may be critical.

Unfortunately many times, plans sponsors who have carefully monitored the performance of their plans investment options have no evidence that they have in fact done so. Retirement plan fiduciaries are therefore encouraged to maintain records confirming decisions that they made with respect to plan investment options. Records could include due diligence reports prepared for investment options in the plan or minutes from investment committee meetings.

The key is, being able to prove that you did what you said you were going to do from an investment monitoring standpoint? Are you able to prove that you followed your prudent process?

In part two of this series, we will continue to explore some common fiduciary challenges and how plan sponsors can most easily address them. A sample of an Investment Policy Statement, which we use in our practice, can be found at this link on our Resources page. We have also provided a link to a sample Due Diligence Report that has been designed to coordinate with our sample Investment Policy Statement.

To stay up-to-date on prudent practices as a retirement plan fiduciary, or to share this information please consider registering for our newsletter, you can find the newsletter registration form in the sidebar of this blog.  Another option to stay connected with our updates would be to subscribe to our RSS feed.  As always, we appreciate your comments which can be added below.  For compliance reasons, comments on this blog must be monitored however; we will approve and post your comments as soon as administratively possible.

Disclosure:

Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC, investment advisory services are offered through HBK Sorce Advisory LLC and securities are offered through Purshe Kaplan Sterling Investments (PKS), Member FINRA/SIPC. PKS is headquartered at 18 Corporate Woods Blvd., Albany, NY 12211. HBK Sorce Insurance LLC and HBK Sorce Advisory LLC are not affiliated with Purshe Kaplan Sterling Investments. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.

Depending on your marital status, income, and whether or not you’re an active participant in an employer sponsored retirement plan, the $5,000 contribution may also be tax deductible.  Beginning in 2009, the contribution limit will adjust annually for inflation in $500 increments.

There are many types of IRAs: Traditional IRA, Roth IRA, Education IRA (EDIRA), SEP-IRA, SARSEP-IRA, and SIMPLE-IRA. Traditional IRAs are broken down into Regular, and Rollover IRAs.  The SEP-IRA, SARSEP-IRA and the SIMPLE-IRA are designed for use by small business owners and are beyond the scope of this article.  The Education IRA is now called the Coverdale Education Savings Account and has become somewhat less popular with the recent enhancements made to the 529 College Savings Accounts.  Thus, our focus for this discussion will be on the Traditional IRA and the Roth IRA.

Let’s review the differences between the Traditional IRA and the Roth IRA.  The Roth IRA has essentially turned the Traditional IRA formula completely around.  A Traditional IRA enables taxpayers to make tax-deductible contributions, but all contributions to Roth IRAs are after tax (non-deductible).

In addition, withdrawals are treated differently. With a Traditional IRA, contributions are growing tax-deferred and withdrawals are taxed at ordinary income tax rates With a Roth IRA, investments grow tax-deferred but can be withdrawn after age 59½ tax-free.  However, in order to receive this tax-free treatment on a withdrawal, you also must have held the account for at least five years.

This ability to make contributions that can be withdrawn tax-free is a unique and powerful characteristic of the Roth IRA. The good news is that most taxpayers are eligible to make contributions to a Roth IRA.  The ability to use this tool however, is phased out for Americans in higher income tax brackets.  For example, if you’re single, the $5,000 (or $6,000 if you’re over the age of 50) that you can contribute begins to be phased out starting at $105,000 and is completely phased out at $120,000.  For married filers, the phase out begins at $166,000.  Married couples earning $176,000 or more can no longer contribute to a Roth IRA.  Unlike the Traditional IRA however, contributions can still be made after age 70 ½ as long as you have earned income.

For investors who have existing Traditional IRAs, one consideration is whether or not to convert the Traditional IRA to a Roth IRA.  Conversion from Traditional to Roth is allowed for taxpayers if they and their spouses earn less than $100,000 per year.  The biggest benefit to conversion is that all future earnings grow tax-free.  This certainly sounds attractive, but investors should consider conversion with caution. Currently, all contributions and earnings moved to the Roth IRA from the Traditional IRA are taxable.

This conversion becomes a little more complex when you consider that you cannot use any of the dollars being converted to help pay the tax due without being subject to a 10% early withdrawal penalty if you’re under the age of 59 ½.  Many experts warn that if you do not have other money on hand to pay the taxes due upon conversion, you’re probably better off maintaining the Traditional IRA.

The decision to use either the Traditional IRA or the Roth IRA for new contributions, and the decision whether or not to convert from a Traditional to a Roth are driven in large part by your expected future tax rate.  In the not too distant past, many retirees entered lower tax brackets during retirement.  This is no longer the case for many, particularly as more people are working (at least part-time) during retirement to support the lifestyle to which they had become accustomed during their working years.  Consequently, many taxpayers should take a hard look at conversion and making new contributions to the Roth IRA, again, proceed with great caution.  A consultation with a Financial Advisor and your tax professional is highly recommended.

To conclude, both the Traditional IRA and the Roth IRA are important tools   to consider in the retirement planning process.  Many in fact will establish IRAs a result of a rollover from an employer sponsored plan.  As you consider which tool will work most effectively for you, many factors play into the decision. Those factors include:  your current income tax bracket, estimate for your future tax rates, your marital status, and your ability to pay the tax upon conversion.  For most of you, these decisions are best made with the assistance of a professional advisor experienced in these matters.  Once made, the decisions can be both irrevocable and taxing.

Sources:

1. Income of the Population 55 or Older, 2004, Social Security Administration, Office of Research, Evaluation, and Statistics (May 2006)

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In fact, according to the Investment Company Institute, as of December 2007 there were over 8,000 mutual funds with approximately $9 trillion dollars of invested assets.  In addition, 51 million households (88 million individuals) owned on average $50,000 in mutual funds.  These statistics illustrate the popularity of mutual funds within the investment community, and in particular individual investors.  Thus, it is important that investors adopt appropriate evaluation criteria to navigate through this vast universe of mutual funds in order to decipher which are suitable for use within their investment portfolios.  For many investors, this is somewhat of a daunting task.

So as you travel on your financial path, how do you navigate through these investment vehicles to get to your final destination quickly and with the least amount of wrong turns?  Or, how do you best select a mutual fund managed by an ethical management team that performs consistently well when compared with other funds with the same objective and does so with minimal risk?  The answer is, this selection requires a considerable amount of effort and careful due diligence.  Such a task is not, however, an insurmountable one.

If investors prefer to work with a professional advisor who will recommend specific mutual funds to them, they may consider asking the advisor an important question: “Do you follow a similar selection and monitoring process when choosing which funds you’ll recommend?”  The Foundation for Fiduciary Studies in Sewickly, PA recommends that an investor or trustee examine the following eight specific aspects of fund performance and management when monitoring a manager:

1. Evaluate the fund’s performance relative to its peer group—a group of funds with comparable investment objectives

An investor evaluating a manager on a performance basis relative to that manager’s peer group should attempt to choose managers who consistently perform above the median or top half over a complete market cycle—typically considered to be at least three years.

2. Evaluate the risk that the manager is taking relative to the performance that the fund is providing to its shareholders

The Sharpe Ratio, a popular gauge in the investment community, is used to measure a fund’s risk-adjusted return.  Developed by Stanford University Professor William Sharpe, a 1990 winner of the Nobel Prize in Economic Sciences, the Sharpe Ratio is used to compare the relative performance of managers.  In general, the Sharpe Ratio tells us whether the returns of a portfolio come from smart investment decisions or from a result of excessive risk taking by the money manager.  Because it is a relative measure, there is no such thing as a good or bad Sharpe Ratio.  However, within a given peer group, the manager with the higher Sharpe Ratio is preferable.

3. Consider the product’s inception date

Generally, funds with at least a three-year performance history are preferable.  With fewer than a three-year performance history, it is difficult to develop meaningful comparative measures.

4. Correlate a mutual fund’s performance and stability to a peer group

For example, is the mutual fund’s style of investing consistent over time with the peer group characteristics?  When building portfolios, both investment advisors and individual investors will often make selections based on a model or target allocation.  In order to efficiently maintain that allocation, which some consider to be the most critical element in the investment management process—an investor must be confident that the mutual fund’s style will remain consistent.  Otherwise, they will be taking either more or less portfolio risk than they had originally intended.  For example, it would be important to know if a large, growth-oriented US stock fund were purchasing a disproportionate share of companies based in foreign countries.

In addition, a fund that is not highly correlated with its peer group renders the quantitative measures discussed above less meaningful.  Many of these measures of performance and riskiness are reliant upon appropriate and relevant comparisons.

5. Examine the fund’s total assets under management

Funds with total assets in excess of $75 million are considered preferable.  It is felt that at this level the manager will have the buying power and economies of scale to manage the fund cost effectively.

6. Determine if the underlying securities held by the portfolio are consistent with the stated investment style of the mutual fund

The objective here is to identify funds that have at least 80% of their assets in investments that match the stated investment style of the manager.  For instance, if a large growth US stock fund has 35% of its money in cash, an investor could be inadvertently over-weighted in cash and under-weighted in US stocks.

7. Determine the fund’s expense ratio or fee

All mutual funds have an expense ratio that’s charged against the fund’s assets under management.  This expense ratio is hidden from the investor and may be determined by examining the fund’s prospectus.  The fund’s expense ratio has significant impact on the fund’s performance over time.  For example, a fund with an expense ratio that is .75% (3/4 of one percentage point) higher than another comparable fund–all else being the same–will under perform by that amount each year.  When examining fund expense ratios, investors should look for funds with expense ratios that fall within at least the top 75% of their peer group.

8. Examine the stability of the organization

The first seven measures are very much quantitative benchmarks that are fairly easily measured for comparative purposes.  However, the qualitative benchmark of a mutual fund company’s stability is not as easily measured.  The mutual fund industry regulatory scandal from a few years ago is a prime example of why this qualitative measure is so important.  For example, some fund companies made deals with outside investors that allowed them to “time” their funds, thereby generating profits for themselves and diluting profits of long-term shareholders.

In some cases, fund companies allowed outside investors to place trades after the market closed in order to capitalize on news that would likely impact the next day’s prices of securities held in the fund. In the most egregious examples, in exchange for allowing these trading practices, the fund companies received compensation in the form of assets placed in other investment vehicles run by the fund company.  These violations of fiduciary responsibility on the part of such fund families can only be caught through a systematic process of surveying investment industry news, communications, and regulatory environment.  This is a difficult task for the individual investor.

In conclusion, the quantitative measures involve careful evaluation of a fund from a risk and return standpoint relative to its stated peer group.  The qualitative measure involves a vigilant, periodic review of the stability of the organization managing the mutual fund.  Investors not having the time, expertise or resources to carry out the systematic due diligence process may want to work with a professional advisor.  Investors who work with these advisors should then ensure that the professionals giving them advice are themselves following a comparable process of fund selection and monitoring.

Each of these choices enables employers to make contributions for participants directly to individual retirement accounts or IRAs. Contributions made to either the SEP IRA or the SIMPLE IRA are always fully vested to the participant. Employers establishing either type of plan are relieved of the more onerous compliance and reporting requirements required by traditional qualified retirement plans.

One of the key differences between the SEP-IRA and the SIMPLE IRA has to do with the type of contribution that can be made to the participant accounts. With the SEP IRA the only type of contributions allowed into participant IRA accounts are those made by the employer.  Contributions to the SEP IRA are made on a percentage of compensation basis.  Contributions made to SIMPLE IRAs include both employee salary deferrals and employer contributions. In the case of the SIMPLE IRA, the employer contributions can be made either as a matching contribution based on the employee’s salary deferral or as a percentage of compensation made to all eligible participants.

Again, regardless of which of these two types of plans employers choose, they will avoid the cumbersome reporting and disclosure requirements associated with qualified retirement plans which fall under IRC Section 401(a).   A careful examination of each option will help businesses make intelligent decisions regarding which plan to choose.

The SEP IRA

As previously  noted, contributions to SEP IRAs are employer only. In other words, there is no employee salary deferrals allowed into participant accounts. Currently, an employer can contribute up to 25% of an employee’s compensation annually to a SEP IRA. This percentage limit is not to exceed $49,000. This differs from profit sharing plans in that employers can contribute up to 100% of a participant’s compensation up to $49,000. Unlike profit sharing plans, contributions made to SEP IRAs cannot be weighted toward a particular class of employee or given to certain employees based on age. SEP contributions must be made in a uniform manner based on each employee’s compensation.

The only opportunity to weight SEP IRA contributions towards certain employees is found in the ability to integrate SEP IRA contributions with social security. This social security integration allows employers to contribute more toward employees that make in excess of the social security wage base, which in 2009 will be $106,800. Individuals earning in excess of this amount may end up with a slightly larger employer contribution amount. Beyond this ability to integrate employer contributions with social security, there are no other opportunities to allocate SEP IRA contributions toward more highly compensated or key employees.

As you would expect, contributions made to SEP IRAs on behalf of each respective participant are not currently taxable income to the participant. Furthermore, the earnings on assets held inside of SEP IRAs grows on a tax-deferred basis. Ultimately, as participants make withdrawals from SEP IRA accounts,   those withdrawals are taxed as ordinary income.  As is the case with a traditional IRA, withdrawals made from SEP IRAs prior to age 59 ½ are subject to a 10% penalty in addition to ordinary income taxes.

As with many types of retirement plans, distributions from SEP IRAs can be rolled to a traditional IRA. Again, employees own and control 100% of contributions made to their participant IRA account immediately after the contribution is made. Consequently, due to this immediate vesting, employees can always leave the business and take 100% of their account balance with them.

Similar to a profit sharing plan, contributions made to a SEP IRA on an annual basis by the employer are completely voluntary.  Although the maximum contribution is 25% of an employee’s compensation, there is no minimum contribution required on an annual basis.  Consequently, employees are well advised not to rely completely on the SEP IRA to fund their personal retirement goal.

Another unique feature of the SEP IRA is the fact that it has the longest waiting period of any retirement plan available to a small employer. Employers electing to do so may prevent employees from being eligible to participate in the SEP IRA until they have completed at least three years of service with the employer. Thus, if an employer is in an industry which possesses  a large number of short-term or seasonal employees with significant turnover, a SEP IRA may be more advantageous.

As is the case with most other  retirement plans, employees participating in collective bargaining units and nonresident aliens do not have to be covered under a SEP IRA. Also, employers establishing a SEP IRA after 2001 may be eligible for a business tax credit of up to $500 if the SEP IRA is a startup retirement plan for that business.

The SIMPLE IRA

SIMPLE IRAs are only available to employers with up to 100 employees. Contributions made to SIMPLE IRA’s can also be either employee salary deferrals or some form of employer contribution. The service requirement for participation in the SIMPLE IRA is two years. In each of those two preceding years, employees must have at least $5,000 of earnings. In the current year, participating employees must be expected to earn at least $5,000 of income.

In the year 2009, employees can make contributions of up to $11,500. If the participant is over the age of 50 there is a catch up contribution available that allows employees over the age of 50 to contribute up to an additional $2,500 on a pretax basis into the plan. Unlike the SEP IRA, the $11,500 maximum contribution is not limited by a percentage of the employee’s compensation. Employees can contribute up to 100% of their compensation with an $11,500 maximum contribution limit. Theoretically then, employees earning $11,500 could contribute 100% of that amount to their SIMPLE IRA participant account.

Employers must make contributions to the SIMPLE IRA on behalf of eligible participants in one of two ways. The first is a matching contribution based on the participant’s salary deferral amount. This match is dollar-for-dollar up to the first 3% of the employee’s contribution. Consequently, if employees contribute 3% of their salary to the SIMPLE IRA, the employer must match that amount.  The employer has no obligation to match any employee salary deferral in excess of the 3% maximum. Employers not wishing to make a matching contribution must make a non-elective contribution of 2% of compensation for all eligible employees. This non-elective contribution must be made to employees meeting the two-year service requirement regardless of whether not they contribute any of their personal compensation to the plan. And employers may not make both a matching contribution and a 2% non-elective contribution. They must choose one of the two options.

Similar to 401(k) retirement plans, employee seller deferrals made to SIMPLE IRAs are made on a pretax basis. Employer contributions, both the match and the non-elective contribution, are not currently taxable to the employee. Businesses adopting a new SIMPLE IRA after 2001 are also eligible for the $500.00 business tax credit mentioned in the previous discussion about the SEP IRA. This tax credit was put in place by Congress in 2001 as an incentive for employers to establish new retirement plans.

Like the SEP IRA, contributions made to participant accounts by the employer in the SIMPLE IRA are fully vested to the employee. Consequently, employees can immediately withdraw contributions made to the SIMPLE IRA on their behalf, both seller deferrals and employer contributions. These distributions, like those made from the SEP IRA, are immediately taxable to the employee as ordinary income.  Also, similar to both the SEP IRA and traditional IRA, if these distributions are made prior to age 59 1/2, the participant will be subject to a 10% IRS penalty on the entire amount withdrawn. The penalty for early withdrawal from SIMPLE IRA is potentially even more severe. If participants choose to withdraw their SIMPLE IRA balance during the first two years, they may incur a 25% penalty tax.

From the employee’s standpoint, one obvious advantage of the SIMPLE IRA versus the SEP IRA is the ability to make salary deferrals on a pretax basis.   This may allow employees to develop a systematic savings program on a payroll deduction basis similar to what they would be able to establish if they had a 401(k) retirement plan available to them.

Small business owners should consider a SIMPLE IRA versus a SEP IRA when the amount of self-employed income available to them to contribute to the plan is comparatively small. For example, if an individual owns a small business and works in that business on a part-time basis, an excellent alternative may be the SIMPLE IRA. If the small business owner earns $11,500 per year or less that entire amount could be contributed to the SIMPLE IRA. If however, this small employer had established a SEP IRA, the maximum contribution would only be $2,300.00. This is because the maximum contribution to the SEP IRA would be 25% of the amount earned or $2,300 ($11,500 X 25% = $2,300).

In conclusion, both the SEP IRA and the SIMPLE IRA can be very effective choices for small employers looking to establish a retirement plan that is simple to administer. SEP IRA works best for employers who are able to generate a higher amount of revenue and who wish to contribute at a higher limit.

SIMPLE IRA, on the other hand, works very effectively for employers who may have less revenue and wish to have more of the total contribution to the plan coming from employee’s salary deferrals. SIMPLE IRA is also an excellent choice for people who manage smaller businesses in addition to their other employment.

Because of the complexities in the retirement plan arena, many times it makes sense to consult a financial adviser or tax professional prior to establishing a retirement plan for the small business owner.