401(k)s: The Hidden Fees
I'd like to offer a retirement plan for my employees, so I'm investigating a group annuity 401(k) plan. I keep reading about hidden fees in these plans, but the sales literature I've received seems pretty clear. Where are they hidden and how do I find out how much they amount to?
—L.C. Worcester, Mass.
First, congratulations on considering a retirement plan for your employees. The Pension Protection Act of 2006, which went into effect this year, helps private companies provide employees with greater protection for their pensions, and assists those who can to save for retirement through defined contribution plans such as the 401(k). "The act also allows for automatic plan enrollment, which may increase plan participation and may ultimately increase contributions allowable by small business owners and key executives," says Irene Marshall, a CPA and partner at the Philadelphia office of Mitchell & Titus, an accounting firm that specializes in auditing employee benefits.
You're also to be commended for taking the time to investigate various plans. Group annuity 401(k) plans have grown immensely in recent years and they are attractive to many small-business owners because they cost very little to institute and are generally quite simple to administer. About half of the top 50 vendors in the 401(k) field are insurance or insurance-related firms, and they frequently offer annuity products, says Ken Weber, a registered investment adviser with Weber Asset Management, based in Lake Success, N.Y.
Annuities are complicated financial products with contracts that often run 30 to 40 pages. They are difficult for even the most seasoned human resources professional to understand fully, Weber says. "If you're not deeply involved in the 401(k) industry, you'll have trouble following most annuity contracts," he says. Basically, with group annuity 401(k) plans, your employees would be using their retirement funds to purchase shares in an annuity. In a mutual-fund-based 401(k) they invest their retirement dollars in various mutual funds, typically with several fund choices offered that appeal to people with differing levels of risk tolerance.
Potential for Redundancy
Unfortunately, annuity 401(k) plans often wind up being more expensive for participants than other 401(k) plans, experts say. "Dealing with retirement planning as much as I do, it's all too often I see a client's 401(k) statement and notice how poorly it performs in relation to associated indexes and benchmarks," says Todd J. Geller, senior vice-president for investments at Janney Montgomery Scott in Long Island, N.Y.
Annuities can offer tax-deferred growth, which is a plus on its own, but isn't necessary when offered inside a 401(k) plan that is already tax-deferred. Another potential for redundancy is that annuities offer protection of principal and often include options that mimic life insurance, such as "step-up death benefits," Geller says. "This protection can be great if it fits the situation. However many working people already have life insurance policies, which may make this protection redundant and costly."
The average annuity could wind up costing participants 2% to 4% for mortality and expense charges and various riders, he says. On top of those costs, maintenance fees on the underlying investments could run anywhere from 0.5% to 2%. "The overall realized expense to the client could be anywhere from 2.5% to 5%. After you factor in inflation, it's no wonder some participants in these plans feel they aren't getting the most bang for their buck," Geller notes.
Watch for Needless Fees
Weber, who says he is pushing for more regulation of the 401(k) industry in general, warns CPAs to look for red flags when reviewing pension plans for their small-business clients, including "no-load" funds that look attractive but carry higher-than-average expense ratios.
"A significant portion of American workers are burdened with excessive 401(k) fees—fees that will have a major impact on their long-term ability to achieve a successful retirement," he says. "Thousands of employers simply do not know that they and their employees are needlessly paying 1% to 2% more each year directly out of their retirement accounts. In some cases, the amount is close to 3% per year above what are true, necessary costs."
Geller recommends that you have a knowledgeable CPA—preferably one who is familiar with company retirement plans—review any 401(k) plan you are considering before you offer it to your employees. Your best bet is to request information on three or four different types of plans and have your accountant do a side-by-side comparison for you, not only of the cost to implement and administer them, but also of the costs that will accrue to your employees. That's the best way to do the right thing for your company and its legacy.