Fatal Pitfalls in Small Business 401(k) Plans: Part 2

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Fatal Pitfalls in Small Business 401(k) Plans: Part 2

By Eve Kaplan, CFP®

Last month we kicked off this 3 part series on pitfalls in small business 401(k) plans by discussing 2 common pitfalls: 1) incurring fiduciary liability instead of having the mechanism to shift this to a credible Fiduciary and 2) sky-high hidden fees. Fred and Andrea (well-intentioned owners of “Apex Optical”) thought they were “doing right” by their employees, but they had a 401(k) plan riddled with problems.

Let’s turn to 3 more fatal pitfalls that Fred and Andrea (and many other 401(k) plans at small businesses) suffer from:

1) trusting Wall Street over markets,
2) paltry performance and

3) paralyzed participants

Pitfall #3 -Trusting Wall Street over markets: There are over 20,000 mutual funds floating around. Did Fred and Andrea have the right ones in their 401k plan? This vast array of mutual funds can be broken down into 2 types: a) active and b) passive. The mutual fund world is the opposite of human personalities – in this instance, “active” isn’t necessarily good and “passive” IS good. While active funds try to outperform the stock market rate of return (the return you receive from an index fund), they charge high annual fees and are weighed down by higher trading costs. “Passive” mutual funds, by contrast, lend themselves well to joining together to become a structured portfolio that invests in all stocks in the market. .

A comprehensive study (1975-2006) in 2008 concluded that less than 1% of active mutual funds outperformed the market (other studies are more charitable – but indicate that less than one-quarter of active funds outperform markets).

Fred and Andrea didn’t pay attention to the type of mutual funds in their 401(k) plan – they assumed the company that set up the plan knew best. However, upon investigation, it turned out the mutual funds in their 401(k) plan were expensive “active” funds that robbed them of 1.5% of their investment return per year. Instead of earning 7% to invest in the US S&P 500, they earned  5.5% because their active fund charges 1% management fees and it underperformed the S&P 500 by 0.5%.

Fred and Andrea would have done better with a plan that featured 6 Structured Portfolios that combine index funds to provide a diversified cross-section of asset classes. These give a better opportunity for solid rates of return – far better than Fred and Andrea (and their employees) can assemble by picking active mutual funds themselves (Pitfall #4).

Pitfall #4 – Paltry Performance: Structured Portfolios are professionally managed pre-set portfolios that 401k plan participants select on the basis of “best fit” to their risk tolerance and retirement horizon. How much more do those portfolios return than when employees create their own smorgebord of investments? A Schwab study showed the average annual rate of return for professionally managed portfolios exceeded individual 401(k) plan returns by a whopping 3.4% per year.  That kind of differential can add more than $200,000 to a 401(k) plan balance over the life of a plan..

Pitfall #5 – Paralyzed Participants: Fred and Andrea can’t fully fund their 401k plan because their employee participant rate is lackluster. Some of this inertia was the result of confusion about investment alternatives (the confused mind says “no”). The Apex Optical 401(k) plan has about 15 investment options but employees were picking mutual funds based upon how nice the name sounded. The typical employee spends just 2 minutes selecting his/her portfolio – and then reviews it every couple of years.
Structured Portfolios, by contrast, are low-cost, fully diversified portfolio of 10,000+ securities in over 40 countries and in all market asset classes (bonds, stocks). If Fred and Andrea had a better 401(k) plan with 6 Structured Portfolios, employees could easily pick their preferred portfolio (based upon risk tolerance and/or retirement horizon) and come out far ahead in terms of annual rate of return.

Fred and Andrea learned –the hard way –that the type of investments in their 401(k) plan had a profound effect on the rate of return they could enjoy.

Next month we’ll see what Fred and Andrea decided to do to create a better 401(k) plan for themselves and their employees at Apex Optical.

Copyright © 2010 by Eve Kaplan

Eve Kaplan of Kaplan Financial Advisors, LLC is a Fee-Only (no products sold) Certified Financial Planner in Berkeley heights. She is a Fiduciary Advisor partnered with a Fiduciary Investment Manager offering 401(k) plans to businesses. She can be reached at 908-898-0549 or KaplanFinancialAdvisors.com