Sponsor News - October 2010
The Six Biggest 401(k) Mistakes
Your 401(k) for your retirement is like a screw driver for an assembly. It will help a great deal, but you still have to put in the effort to use the tool properly. 401(k)s bring millions of people in the U.S. many steps closer to a comfortable retirement. But like everything else in life, 401(k)s don't provide absolute retirement security. Here are six mistakes many people are making with their 401(k) plan.
[See 5 Ways to Simplify Retirement Accounts.]Thinking a 401(k) is it. Again and again I hear others justify their outrageous spending as okay because they fund their 401(k)s. Just because you contribute to your 401(k) does not necessarily mean that you are going to have a comfortable retirement. Living below your means is still key and a simple fact that is all too easily forgotten.Relying on auto pilot. Automatic deposits are a great way to save, but it presents problems when we just deploy the set and forget strategy. Even if your plan allows you to automatically rebalance your portfolio, there's a need to change your allocation based on your continually changing needs. For those who don't know how to change allocations by yourself, learn how by asking your colleagues for tips or the plan administrator for an introductory guide.
[See 3 Retirement Worst Case Scenarios To Avoid.]Ignoring alternative investments. Traditional IRAs, Roth IRAs, savings, and investment accounts are all investments that you should have if you want to enjoy your twilight years. Just because 401(k) plans have tax advantages doesn't mean that it's automatically the best place to put your money. The only way to be certain is to do a thorough comparison of the differences between a traditional IRA and a 401(k).Paying high expense ratios. One of the reasons a 401(k) may not be the best place to put your money is that many plans have funds that charge unnecessarily high expense ratios. Just as personal finance 101 taught us, the higher the expenses, the less we keep for ourselves. It's just simple mathematics.
[See 5 Surprising Retirement Truths.]Forgetting that a 401(k) is for retirement. I shouldn't say forget, because most people probably know this. The problem is actually the temptation of that lump sum whenever there's a job change. Too many people will need to rely heavily on their 401(k) to fund their retirement, but then swiftly deplete their account whenever they change jobs, making their nest egg balance a big fat zero. The lure of now is always greater than the future, but 401(k) plans should be set up to allow for a comfortable future. Never forget that.Failing to optimize tax breaks. This is more a missed opportunity than a mistake. Not enough people think about optimizing their entire investment portfolio as a whole. Retirement account assets grow tax free. Consider putting heavily taxed investments in a retirement account and leaving the tax efficient investments in taxable accounts.
401(k) plans are great for everyone who is able to participate. However, having one doesn't mean you are set for life. A comfortable retirement is still your responsibility.
Beware of "Trap" in Restarting Matching Contributions
June 8, 2010
Many employers discontinued matching contributions for 2009 because of the downturn in the economy. Some of these employers are intending to resume matching contributions at some time during 2010 or 2011. However, the employer should be careful to avoid a "trap" that could occur for the plan year in which the matching contributions are restarted.
The potential concern relates to a 401(k) plan or 403(b) plan in which the ACP tests (the nondiscrimination tests relating to matching contributions) are conducted using the "prior year" testing method. Under the prior year testing method, the average matching contribution percentage of highly compensated employees (HCEs) during the plan year being tested is compared to the average matching contribution percentage of the non-highly compensated employees (NHCEs) during the prior plan year. For example, in conducting the ACP tests for the 2010 plan year, the average matching contribution percentage of the HCEs during the year being tested (2010) is compared to the matching contribution percentage for the NHCEs during the prior plan year (2009).
This causes a potential problem if no matching contributions were made for the 2009 plan year and matching contributions were resumed during the 2010 plan year. In that situation, the prior year testing method would not permit any matching contributions to be made on behalf of HCEs for the 2010 plan year.
There is a potential solution. The plan could be amended to use the "current year" testing method to conduct the ACP tests. To make this change for the 2010 plan year, the plan would need to be amended before the end of the 2010 plan year.
It is legally permissible to continue using the prior year testing method for the ADP tests (the nondiscrimination tests for 401(k) contributions) and change to the current year testing method for the ACP tests. However, it may be less confusing to use the current year testing method for both ADP and ACP tests.
If the plan is amended to use the current year testing method, IRS regulations do not permit the employer to amend the plan to resume the prior year testing method for at least five plan years.
Please contact a member of our Employee Benefits Practice Group if you have any questions regarding this Client Alert.
ERISA Fidelity Bonds - What to Think About, What to Look For
By Joe Faucher
The Employee Retirement Income Security Act of 1974 ("ERISA") requires that all persons who "handle" funds of retirement and welfare plans be bonded. The purpose of the bond is to cover losses that a plan incurs as a result of a fraudulent or dishonest act of a "plan official", someone who handles plan funds. The bond is typically required to have limits equal to 10% of the value of the plan's assets, with a maximum of $500,000. There are exceptions to this general rule, including the situation where more than 5% of the plan's assets are "non-qualifying" assets, such as real estate limited partnerships. In that situation, the bond limits must be 100% of the value of the plan's non-qualifying assets.
As a practical matter, most plan sponsors are referred to a surety company (perhaps by a third party administrator or another service provider). The bond company then sends out a relatively simple application and, when it receives answers to the questions on that application, issues a bond. Perhaps more often than not, the plan fiduciaries never read the bond and have no idea what losses the bond covers or whether the persons who caused the loss are covered by the terms of the bond.
Fiduciaries who take such a hands off approach are making a mistake. One of the functions of a fiduciary is to be sure that the plan is properly bonded. If a plan secures a bond on the fiduciary's watch, then sustains a loss that the bond, by its terms, doesn't cover, the fiduciary could be on the hook for the amount that the plan would have received if the fiduciary had obtained a bond that covered all of the persons and losses that it needed to cover. Consequently, plan fiduciaries should not simply take it for granted that a bond will cover everything and everyone that it needs to cover. Since ERISA requires that fiduciaries act prudently in carrying out their duties, one of the things that fiduciaries should put on their "must do" list is implement a process to evaluate the bond.
As part of that evaluation process, fiduciaries should get answers to the following questions:
Who Is "Handling" Plan Funds?
ERISA requires every person who "handles" plan funds to be bonded. A person is considered to be "handling" plan funds if he has the ability to cause a loss to the plan through a fraudulent or dishonest act. For example, any person who has the ability to sign checks on a plan account is "handling" plan funds in doing so (and this may include independent contractors). If a fiduciary has not thought through who may handle the plan,s funds, he may not be in position to determine whether a bond offers the necessary coverage.
Whose Acts Are Covered By The Bond?
Once the fiduciary determines all of the persons who are handling or may handle plan funds, he needs to review the bond itself to determine whether, by its terms, the bond will cover losses caused by all of those persons. In this regard, a good starting point may be to determine whether the bond covers losses caused only by persons specifically identified in a schedule attached to the bond (a so-called "name schedule" bond), or rather, whether the bond covers losses caused by all persons, subject perhaps to certain excluded classes of persons, regardless of whether they are specifically identified on the face of the bond or not. This latter bond is often referred to as a "blanket bond."
Keep in mind that while a blanket bond may cover losses covered by a broader group of people, it is possible that a "name schedule" bond may offer a plan greater protection. (This may occur, for instance, if the name schedule bond provides coverage for losses the plan incurs due to the dishonest acts of two persons identified in the bond acting in concert with each other. Depending on the terms of the bond, in this example, the bond may cover losses up to the bond's limits with respect to the acts of each of the dishonest plan officials.)
Are Other Bonds Available That Provide Greater Coverage?
There is more than one bond company that offers bonds to ERISA-governed plans and not all bond forms are alike. Fiduciaries should consider reviewing multiple bond forms and seeing whether and how they differ with respect to the scope of the coverage they provide.
Are Persons Who Are Not Covered By the Bond Covered By A Separate Bond?
Gaps in coverage may exist under a plan's bond, particularly in the context of a "name schedule" bond. For example, a plan may delegate discretionary investment management to a third party who is not employed by the plan sponsor, but who has control over plan assets. If that person is not identified on the bond's "name schedule," losses he causes may not be covered by the bond. In that case, the plan sponsor has at least two alternatives. First, it can try to get the bond company to cover the investment manager's acts. Second, the plan fiduciaries may inquire of the investment manager whether he has secured or will secure a separate bond that covers him if he causes losses to the plan due to fraud or dishonesty. Fiduciaries are within their rights to ask those persons to secure an appropriate bond to cover their actions with regard to the plan.
New DOL Rules Mean More Disclosures Available to Plan Sponsors in 401k Plans - But What to Do With the Information?
ATLANTA, July 19, 2010 /PRNewswire via COMTEX/ -- The Department of Labor has released final rules regarding ERISA section 408b2. These long-awaited - and now final - rules affect the arrangements between retirement plans and services providers as of July 16, 2010. 401k ProAdvisor, a division of Kring Financial Management, is providing new fiduciary services to assist 401k Plans in evaluating the new information.
Retirement plans and plan fiduciaries will now have new due diligence tools in the form of service provider disclosures. These disclosures will help plan sponsors determine if compensation paid to service providers is reasonable, and to determine the extent of hidden compensation and conflicts of interest.
Compensation is defined to include "both direct and indirect and applies to the service provider, its affiliates or subcontractors." The Department of Labor's newest bulletin on the subject explains that "because certain services and costs are so significant and present such conflicts of interest, information concerning those services and costs must be disclosed without regards to whether services are furnished as part of a bundle or package." Additionally, service providers must disclose if they are acting in the capacity of a fiduciary to the plan.
"As a fiduciary, the plan sponsor is duty-bound to understand, review and monitor the information that will now be required to be disclosed," says William Kring, CERTIFIED FINANCIAL PLANNER(TM) designee and chief compliance officer of Kring Financial Management. Unfortunately, for plan sponsors, evaluating this new information against a standard that compensation be "reasonable" will be difficult.
In instances where the plan sponsor needs outside assistance, ERISA requires that prudent experts are hired. In this role, Kring Financial Management, acting as a fiduciary consultant, offers its 408b2 RulesKIT (TM). The kit and consulting services will take the burden off plan sponsors to evaluate the disclosure information that will be forthcoming. Further, Kring Financial Management will identify fiduciary breaches, conflicts, and highlight areas that need additional fiduciary follow-up based on the disclosures provide from various service providers. If necessary, Kring Financial can negotiate fees across service providers to meet the test of reasonable compensation.
"This is a good day for plan sponsors," says Kring, an ACCREDITED INVESTMENT FIDUCIARY (TM) professional. "With these new rules and proper fiduciary assistance, retirement plans can improve their offerings for the ultimate benefit of plan participants." For more information on the 408b2 RulesKIT or fiduciary consulting services, call 770-333-0113 or visit Kring Financial Management or 401k ProAdvisor.
The Beauty of a Cash Balance Buy-Out Tool
(August 10, 2010)
By Stephen J. Butler
Today many businesses, including accounting firms, have a sobering problem when it comes to older partners.
It can be difficult to negotiate a sale of an owner's interest, and finding a way to pay for it is an even greater challenge.
A unique retirement plan variation can grease the skids of an exit strategy and leave all parties in a win-win situation. This involves the creative use of a special retirement hybrid known as a cash balance plan. In the context of a partnership buy-out, a cash balance plan can be incorporated as an overlay to an existing 401(k) plan and create the opportunity for massive retirement plan contributions for older people in their 60s. By massive, I mean something in the neighborhood of $150,000 per year for many business owners approaching retirement.
The typical dilemma for younger owners of a professional practice stems from their need to come up with after-tax dollars to buy out a retiring partner. This means that a payment of $500,000 will cost $1 million in pre-tax dollars. Then, the dollars are taxed at capital gains rates to the departing partner who, if an original founder of the business, probably has a cost basis of zero. Therefore, the entire amount of the sale proceeds will be taxed at capital gains rates. In simple terms, over half of all the money required at the start of the transaction will be paid in taxes by a combination of the buyer and seller.
The beauty of incorporating a cash balance plan into the mix is that the contributions are a tax- deductible expense for the firm and its remaining younger business owners. For the seller, the deposits are tax-free, or at least tax-deferred, until the retiring seller starts spending the money years later in retirement. Moreover, the money in the plan can be invested and compound on a tax-deferred basis over the years.
In an actual example of a small firm with an owner and a handful of employees, we can start by calculating a yearly "service credit" for each year the firm's owner has worked. In an actual recent case, this turned out to be $25,000 a year for the 25 years this professional had been self-employed, a total of $600,000 becomes the "opening balance." ("Opening balance" is another way of saying that this is what he should have had by now if he had started saving years ago.)
Since he wants to retire in five years, we extend the $25,000 annual service credit out for that length of time compounded at 6 percent per year. We also compound the $600,000 opening balance out for five more years at 6 percent. The total of the two numbers is just under $1 million.
Now, we work backwards to determine how much money has to be contributed over the next five years to accumulate the $1 million lump sum funding level we have just calculated. An annual tax-deductible contribution of $175,000 earning 6 percent for the next five years will do the trick. Fortunately, with the business (at least) in its prime of life, this owner could afford to make those tax-deductible contributions.
Meanwhile, what about other employees in this small firm? Well, the typical turnover at small firms generally means that not many folks have worked long enough to have accumulated much in the way of an "opening balance." This reduces the lump sum to be funded for them. Also, their younger ages as a group allow us to use a much lower service credit. The service credit for the business owner was 12.5 percent of current salary.
The other employees had 2 percent of their current salary service credit, because hypothetically, they had the advantage of about thirty years until retirement. This meant that the business owner contributed about $15,000 for a handful of younger employees as a cost for the right to contribute $175,000 into his own account. A further advantage is that each employee has his or her own specific account. They can actually see their money as opposed to just a vague promise of an "accrued benefit" that may or may not be adequately funded.
The cash balance plan, in this small company environment, offers a tremendous advantage for older business owners or professionals. This example was extreme, to illustrate the point, but this vehicle can be incorporated as an overlay to existing 401(k) plans to "supercharge" the contribution levels and accomplish more for senior owner/employees who find themselves "behind the retirement eight-ball." Employers view their contributions for employees (required of only the lowest-paid half of the non-owner employees) as a good bargain. The thought process says, "I'm just giving to my associates a portion of what I otherwise would have paid in taxes."
This example above is small and simple to illustrate the mechanism. When the tool is used to fund the business interest buyout of a senior partner, younger partners are treating the substantial retirement plan contribution as installment payments for his or her ownership interest.
People selling business interests later in life too often assume the value of their stock amounts to what they have calculated as that final nut to fund their retirement lifestyle, and the sales price in their mind's eye has been "grossed up" to cover what the estimated capital gains tax on the sales proceeds. Either that, or the sellers have some round number in their heads like $1 million. The nicest people in the world can rationalize what's in their self-interest. Buyers, of course, only care about what the business can support financially and remain a going concern. Emotional benchmarks mean little or nothing, and this disparity in priorities can bring negotiations to a standstill.
Judicious use of the cash balance plan, before it gets too late, begins the process of eating the elephant one bite at a time. Practiced over a number of years as part of the sales process, it relieves the pressure of having to come to terms with a single, final, large number.