Is it Time for a 401(k) Plan (or a Different One)?

At a recent Chief Executive Boards International meeting, a member brought up the idea of introducing a
401(k) plan into her company. Several members had some experience with 401(k) plans, and another member said he had priced them several years ago, and found both the setup and maintenance fees to be prohibitive. If you've declined to adopt a 401(k) for cost reasons, it's time to take another look.

Turns out, a lot of things have changed in the competitive landscape of 401(k) providers. The most important is that they have figured out that small and mid-sized companies are where the job growth is. And where the 401(k) prospects are. As a result, they have automated and streamlined their 401(k) offerings, reducing their costs and, more importantly, reducing their prices.

American Funds, for one, has targeted this market, and will set up a small 401(k) plan for under $2,000 and refer you to a Third Party Administrator (TPA) for fees in the range of $1,500 per year, depending on the number of participants. Like everything, these fees are surprisingly negotiable. Particularly if you have some rollover funds, such as SIMPLE IRAs.

American Funds products are sold through independent financial advisors. See: http://www.americanfunds.com/about/adviser.htm?r=t
The primary differentiator and the one thing to look for and ask repeatedly about is FEES. These are hidden inside the investment funds themselves, and not at all obvious unless you're looking for them. I know of a small company that was surprised to learn that the annuity-style product they'd put in place several years ago had an 8% back-end load (declining over 8 years) on with drawls. Wow! Beyond that, the internal fees in the average fund in the plan was above the competitive range by a full 1% annually. They actually chose to move to another provider and keep the old plan alive while the 8-year declining loads play out.

Smaller 401(k) plans are a bit more expensive than an open-market IRA, for example. Look for Class C shares, which have slightly higher annual costs, but no front-end or back-end loads. A haircut on the front end or the back end is something you don't want to be trying to explain to your employees.

A second thing to know about 401(k)s is the testing rules by which Highly Compensated Employees (HCEs) (those who make over $105,000 in 2008 or own more than 5% of the company) are free to "max out" their 401(k) contributions -- currently $15,500 + $5,000 catch-up if over 50.

If you choose not to go the safe harbor route, the maximum contribution of the HCEs is limited to 2% above the average contribution of non-HCEs. In the case of an S-Corp, that's based on actual salary + bonus paid through the payroll system -- not including your S-Corp net profit. Unless you offer some kind of matching (and perhaps even if you do) , non-HCE participation is likely to be low, and you'll be limited to a few percent of salary as your own maximum participation (The $5,000 catch-up is not subject to these tests).

Safe Harbor elections WAIVE that comparison testing and allow HCEs to contribute to the max dollar limits. Safe Harbor plans are required to contribute to employee accounts in one of two ways:

• You can make non-elective contributions to all eligible employees, regardless of if the employees participate in the company 401k plan. The required non-elective contribution is 3% of salary -- the equivalent of a 3% across-the-board raise. or
  
• You can make matching contributions, based on actual employee salary deferral amounts, and include only those who elect to be active 401k participants.

Additionally, the rate of matching contributions being made to highly compensated employees cannot exceed that being made to non-highly compensated employees (probably not a good idea, anyway).

Finally, it's important to note that existing plans with significant rollover assets are very interesting to the big guys -- Fidelity, Vanguard, TRowe Price, etc. They're more competitive, and have even lower fees. If you haven't looked at internal fees in your plan lately, it would be a good time to do so. In today's more competitive environment, you might be able to roll over into a plan with better fund performance, due to fees alone.