401k Plan Eligibility Best Practices

On the surface, 401k plan eligibility seems simple enough.  However, there are several rules and factors that trip many plan sponsors up in this area.  One of the most common compliance failures can be on the first day an employee becomes eligible for the plan, and this amplified if your plan has relaxed eligibility requirements and your company is on a hiring binge.

The first step is to have a full understanding of your plan’s eligibility requirements and the data that’s involved.  If your plan has an hours requirement, who will be tracking hours?  Will it be your payroll provider?  What systems do they have in place to notify you of when someone becomes eligible for the plan?

Thankfully, our platform tracks hours that we receive in payroll data each payroll cycle.  However, it’s crucial that we receive hours for all employees – not just those participating in the plan.  A lot of employers assume that their payroll vendor or their 401k plan provider is tracking eligibility, when in fact, they’re not because they’re not receiving the data or because the payroll vendor’s system isn’t capable of tracking plan eligibility.

Either way, it’s very important to make sure that one of your vendors has this covered.  The best experience is for your 401k plan provider to manage this by receiving payroll data for all employees.  It allows your provider to do their job, which is managing the plan.  It also allows your 401k plan provider to handle delivering the required notices and disclosures that an employee must receive before participating in the plan.  This is something your payroll provider probably isn’t set up to handle.

Plus, it’s best for your 401k provider to work with your employees on enrolling in the plan through their workflow channels.  At ERISA, we have an email campaign that gets automatically triggered to your employees when our system calculates an eligibility date that’s approaching soon.  This email campaign provides your employees with reasons they should save for retirement and instructions for signing up in the plan.

Let’s say that hours of service won’t work for your company because it’s too difficult to track that data.  Your plan can be set up to only require employees work for your company for a certain period of time before becoming eligible for the plan.  This is known as an “Elapsed Time” method that works great for small businesses or companies with a lot of salary employees.  This is by far the easiest eligibility method to manage for your HR team and your 401k plan provider, and it’s actually ERISA’s default plan option.

Hours of service for eligibility is best-suited for companies with high turnover in their hourly employee group or for companies that utilize seasonal workers and interns.

The key things to remember when dealing with your plan’s eligibility are…

  1. understand your plan’s provisions
  2. determine if they make sense for your business
  3. establish clear responsibilities for this with your service providers

Have more questions?  Contact us and we’ll be glad to help!

The Department of Labor’s RFI

The U.S. Department of Labor recently released a Request for Information (RFI) regarding its Fiduciary Rule. According to the Department, this RFI “seeks public input that could form the basis of new exemptions or changes/revisions to the rule and PTEs.” They are further asking advice on whether or not the original January 1, 2018 applicability date should be postponed, and in the event of delayed applicability, they have also asked for an estimated “time expected to be required” for viable, long-term solutions to the new fiduciary guidelines.

The RFI listed “clean shares” as one of the best, long-term solutions “to the problem of mitigating conflicts of interest with respect to mutual funds.” However, funds will need more time to develop clean shares than is allowed by the Jan. 1, 2018 deadline for full compliance, hence the need for a new estimated compliance timeline.

The Department also listed fee-based annuities as a viable option for Fiduciary Rule compliance. In light of these innovative solutions, the Department would further like to know if “it would be appropriate to adopt an additional more streamlined exemption or other rule change for advisers committed to taking new approaches like those [listed above].”

In addition to these general commentaries on the transition period thus far, the DOL also listed over a dozen questions, including:

  • “Would a delay in the January 1, 2018 applicability date of the provisions…reduce burdens on financial service providers and… [allow] more efficient implementation…What costs and benefits would be associated with such a delay?”
      • “What has the regulated community done to comply…? Are there market innovations that the Department should be aware of beyond those discussed herein that should be considered in making changes to the Rule?”
      • Questions relating to the cost and efficiency of clean shares, including “How long is it anticipated to take for mutual fund providers to develop clean shares and for distributing Financial Institutions to offer them…?”
      • Question 9 seeks information of other streamlined approaches to the Fiduciary Rule outside of clean shares, T-shares, and fee-based annuities
      • “Are there ways in which the Principal Transactions Exemption could be revised or expanded to better serve investor interests and provide market flexibility? If so, how?”
      • “…To what extent would the ongoing availability of PTE 84-24 for specified annuity products, such as fixed indexed annuities, give these products a competitive advantage vis-a-vis other products covered only by the BIC Exemption, such as mutual fund shares?”
  • “To the extent changes would be helpful, what are the changes and what are the issues best addressed by changes to the Rule or by providing additional relief through a prohibited transaction exemption?”

Responses to these questions are due soon; responses regarding a delay of the January 1, 2108 date must be submitted on or before 15 days after the RFI is officially published in the Federal Register. All other responses must be submitted on or before 30 days after the RFI’s release in the Federal Register.

Hardship Withdrawals from 401(k) and 403(b) Plans

On February 23, 2017, the Internal Revenue Service released its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans. And on March 7, 2017 they released a similar memorandum regarding section 403(b) plans. These two statements outlined the requirements for safe harbor hardships in an effort to better inform the public about which events allow a plan participant to qualify for such a distribution. They also outlined steps to follow for determining whether or not a participant is eligible for a hardship distribution. Under these regulations, section 403(b) plans are subject to the same rules as the 401(k) guidelines outlined below.

The IRS gives two main steps when determining whether or not a distribution request meets the “immediate and heavy” financial need requirement:

Step 1:

  • Determine whether the employer or third-party administrator, prior to making a distribution, obtains: (a) source documents (such as estimates, contracts, bills and statements from third parties); or (b) a summary (in paper, electronic format, or telephone records) of the information contained in source documents.
    • If a summary of information on source documents is used, determine whether the employer or third-party administrator provides the employee notifications required on Attachment I prior to making a hardship distribution.

Step 2:

  • If the employer or third-party administrator obtains source documents under Step 1(i)(a), review the documents to determine if they substantiate the hardship distribution.
  • If the employer or third-party administrator obtains a summary of information on source documents under Step 1(i)(b), review the summary to determine whether it contains the relevant items listed on Attachment I.
  • If the notification provided to employees in Step 1(ii) or the information reviewed in Step 2(ii) is incomplete or inconsistent on its face, you may ask for source documents from the employer or third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need.
  • If the summary of information reviewed in Step 2(ii) is complete and consistent but you find employees who have received more than 2 hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions and with managerial approval, you may ask for source documents from the employer or third-party administrator to substantiate the distributions. Examples of an adequate explanation include follow-up medical or funeral expenses or tuition on a quarterly school calendar.
  • If a third-party administrator obtains a summary of information contained in source documents under Step 1(i)(b), determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.

In an article, entitled Do’s and Don’ts of Hardship Distributions, the IRS gives further advice regarding what to do and what not to do when determining hardship eligibility. They first suggest reviewing the terms of hardship distribution outlined in the plan document, including:

  • Whether or not the plan allows for hardship distributions
  • The procedures the employee must follow to make the distribution request
  • The plan’s definition of what qualifies as a hardship
  • Any limits to the amount/type of funds eligible for hardship distribution


After taking all necessary precautions to make sure the plan allows for the type of withdrawal being requested, the employee must then make sure the distribution is on account of an “immediate and heavy financial need” as defined under § 1.401(k)-1(d)(3)(iii)(B) of the Income Tax Regulations. The distribution will be considered in compliance with these regulations if it is for one or more of the following:

  • Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
      • Costs directly related to the purchase of a principal residence;
      • Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
      • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
      • Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan; or
      • Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under section 165,

and the employee has provided written representation that the need cannot be adequately addressed from other sources such as:

  • Through reimbursement or compensation by insurance or otherwise;
      • By liquidating the employee’s assets;
      • By ceasing elective deferrals or employee contributions under the plan; or
      • By other distributions or nontaxable loans from plans maintained by the employer or by another employer, or by borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need,

or if a need can’t be relieved by one of the actions listed above without increasing the amount of need. For example, a plan loan can’t reasonably relieve the need for funds to purchase a principal residence if the loan would disqualify the employee from obtaining other necessary financing.


Once it has been determined that the plan allows for hardship distributions, and the sources available for distribution have been determined, the following steps should be taken to begin the distribution process:

  • Obtain a statement/verification of the employee’s hardship as required by the plan document’s terms
      • Determine that the exact nature of the employee’s hardship qualifies for a distribution under the plan
      • Document (following plan’s guidelines) that the employee has exhausted all other options outside of the hardship distribution
      • Document the employee’s lack of other resources (spousal/minor children’s assets) if applicable
      • Make sure the distribution amount does not exceed amount required to satisfy the employee’s immediate financial need (may be adjusted to account for any taxes or penalties at time of distribution)
      • Make sure the amount of distribution does not exceed any limits under the plan, and consists only of eligible amounts
      • Let the employee know if receival of the distribution will suspend them from making contributions to the plan for at least six months

If your plan is not properly making hardship distributions, go here to correct any mistakes: https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-hardship-distributions-were-not-made-properly


The IRS also released a list of responses to some FAQs regarding hardship withdrawals, such as:

  • What is the maximum amount of elective contributions that can be distributed as a hardship distribution from a 401(k) plan?
      • Cannot be more than the amount of the employee’s total elective contributions, including designated Roth contributions, as of the date of distribution reduced by the amount of previous distributions of elective contributions
      • Generally does not include earnings, qualified non-elective contributions, or qualified matching contributions unless the plan specifically allows for certain grandfathered amounts to be included
      • If provided by the plan, other amounts such as regular matching contributions and discretionary profit-sharing contributions can also be distributed in times of hardship
    • What are the consequences of taking a hardship distribution of elective contributions from a 401(k) plan?
      • Hardship distributions are eligible to be included in gross income (unless they consist of designated Roth contributions) and may be subject to additional taxes on early distributions of elective contributions
      • Unlike loans, hardship distributions are not repaid to the plan, so they will result in a permanent reduction in the employee’s account balance under the plan
      • A hardship distribution cannot be rolled over into an IRA or other qualified plan (§ 402(c)(4))
      • Hardship distributions may be subject to the 10% early distribution tax on distributions made prior to reaching age 59 ½
    • Are hardship distributions allowed from an IRA?
      • There is generally no limit when an IRA owner may take a distribution from his/her IRA, but there may be unfavorable tax consequences including an additional tax on early distributions
      • Certain distributions from an IRA that are used for expenses similar to those that may be eligible for hardship distributions from a retirement plan are exempt from the additional tax on early distributions
      • Any distribution from an IRA for higher education expenses or to finance a first-time home purchase is exempt from the early distribution tax (§ 72(t)(2)(E),(F))

In its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans, the IRS also gave a more detailed outline of the types of documentation required for each hardship distribution:

  • Notifications the Employer/Administrator must provide to the employee:
        • Notification that the distribution is taxable, and additional taxes could apply
        • The distribution amount cannot be more than the amount required to solve the “immediate and heavy financial need”
        • Earnings on elective contributions from QNEC or QMAC accounts are not eligible for hardship distribution
        • The recipient must preserve all source documents and make them available at any time, upon request, to the employer or administrator
      • General information required for a hardship request:
        • Participant name
        • Total cost of the event causing hardship
        • Amount of distribution being requested
        • Certification (provided by participant) that all information provided is true and accurate
        • Specific information required on deemed hardships
      • Medical care:
        • Name of individual who incurred the medical expenses
        • Above’s relationship to the participant
        • The purpose of medical care provided
        • Name and address of service provider
        • Total cost of medical expenses not covered by insurance
      • Purchase of principal residence:
        • Will this be the participant’s principal residence?
        • Residence address
        • Purchase price
        • Types of costs/expenses covered by withdrawal (down-payment, closing costs, and/or title fees)
        • Name and address of lender
        • Purchase/sale agreement date
        • Date of closing
      • Educational payments:
        • Name of individual on whose behalf the payments are being made
        • Above individual’s relationship to the participant
        • Name and address of educational institution
        • Categories of payments involved
        • Period covered by the educational payments (beginning and end dates of up to 12 months)
      • Foreclosure/eviction from principal residence:
        • Is this the participant’s principal residence?
        • Residence address
        • Is this a foreclosure or eviction?
        • Name and address of party that issued foreclosure/eviction notice
        • Date of foreclosure/eviction notice
        • Payment due date in order to avoid foreclosure/eviction
      • Funeral and burial expenses:
        • Name of deceased
        • Relationship to participant
        • Date of death
        • Name and address of service provider (funeral home, cemetery, etc.)
      • Damage repairs to principal residence:
        • Is this the principal residence of the participant?
        • Address of residence that sustained damage
        • Description of cause of damage, including date of the casualty loss
        • Describe repairs required, including date(s) of repair (whether still in progress or already completed)


Lastly, in their 401(k) Plan Fix-It Guide: Hardship distributions weren’t made properly article, the IRS also gave some helpful pointers in determining whether or not a company’s hardship distribution program is being abused or poorly managed. The first warning sign is that too many hardship requests are being made by one group or division; the second is that requests for distributions from multiple employees appear identical, because each situation should have its own individual circumstances; the third and last warning that they offer is to beware of instances where only the highly compensated employees have hardship distributions, because this may be a sign that the rank-and-file employees have not been properly notified of the availability of hardship distributions under their plan.








Nevada’s New Fiduciary Standard

As discussed in a previous article, the Department of Labor’s Fiduciary rule, which went in to effect on June 9, could have its final applicability date pushed back beyond January 1, 2018 to allow firms more time to come up with more cost-efficient, long-term solutions. However, despite the urgings of some to delay the final applicability date, certain states are beginning to take measures to implement new regulations that will bring the guidelines of the transition period more in line with those of the full-applicability period. Heading this movement is Nevada, who, on March 20, introduced Senate Bill 383, which was signed in to law on June 2 and is set to take effect on July 1.

This bill will revise the Nevada Securities Act, and will grant the Nevada securities administrator greater authority in defining the fiduciary duty by defining certain acts as violations or exclusions from the duty. Furthermore, under this law, investors will now have the right to sue financial planners for any “economic loss and all costs of litigation and attorney’s fees” that may result from a financial planner neglecting to act as a fiduciary, or by violating the Nevada law in any way by “recommending the investment or service. ” This bill not only broadens the definition of a fiduciary, but also gives a set definition of a financial planner as someone who: “for compensation advises others upon the investment of money or upon provision for income to be needed in the future, or who holds himself or herself out as qualified to perform either of these functions.”

Nevada is making great strides in fortifying its financial law, as well as in its compliance with the DOL’s new Fiduciary Rule. Although there are still some groups that are demanding delayed full-implementation of the law, there are several other states, including New York and California, that are moving closer in the direction of Nevada and would like to receive full implementation sooner rather than later.

For further information on this law, go to: http://scholarfp.blogspot.com/2017/06/most-nevada-financial-planners-become.html

A Look at The New Fiduciary Rule’s First Month

The Department of Labor’s Fiduciary Rule went in to effect less than a month ago, and already new concerns surrounding it are arising. The first of these is the struggle of the SEC and DOL to come to an agreement on the technical definition of a “fiduciary.” For the law to go in full effect on its set January 1, 2018 applicability date, these organizations must come to a mutual decision on the definition of fiduciary and standard of care sometime before December 31. Coming to this agreement before the set date is turning out to be increasingly impossible. It is the opinion of Fred Reish of Drinker Biddle that “the DOL will extend the transition period, perhaps for as much as a year. That would allow time for the two agencies to work together in a thoughtful manner and at a reasonable pace.”[1] In the meantime, all the transition period regulations of the Fiduciary Rule will remain in place.

Although the full standards set by the regulation will not be in place until January 1, 2018 at the earliest, there are still some important things to remember in the meantime. Primarily, among these is a message to employers; even if you have entrusted your plan oversight to an insurance provider, payroll company, or other TPA, you could still be held liable by the DOL for any non-fiduciary actions. This is because some record-keepers and TPAs have claimed that they are not Fiduciaries, and that for a company’s plan to satisfy the Fiduciary Rule, plan owners must obtain a third-party fiduciary service provider to stay compliant with the new law. Doing so will simply add another layer of unnecessary fees. So, as a plan owner, it is important to understand the exact role your TPA is playing in the management of your plan, and to make sure that you are not being charged excessive fees. But, primarily, you should make sure that your TPA is, in fact, also acting as your plan fiduciary so that you will not personally be held liable by the DOL for not complying with the new fiduciary standard.

Although some groups (such as record-keepers and other TPAs) are trying avoiding the new fiduciary responsibility, other previously non-fiduciary employees could now be considered a fiduciary under the DOL’s new regulations. Largest among these are fund managers, who will now be considered fiduciaries with respect to activities that occur before an investment takes place due to the communications required for that investment to be made. Since these communications, in some circumstances, can rise to the level of a “recommendation” under the final DOL regulation, the fund manager will be considered a fiduciary in certain scenarios, and should act as such to prevent liability. To help fund managers avoid said liability, as well as help guide them in showing their good faith compliance with the final regulation, Winstead recently released an article laying out some helpful steps in plan compliance:

  • “Revise private placement memorandums and subscription documents to incorporate statements disclaiming the provision of investment advice to benefit plan investors;
  • Adopt universal policies regarding permissible marketing and promotional activities; and
  • Require written representations of independent fiduciaries to satisfy regulatory exemption.”[2]


[1] Reish, Fred. Interesting Angles on the DOL’s Fiduciary Rule #52. http://fredreish.com/interesting-angles-on-the-dols-fiduciary-rule-52/

[2] With the tip of a hat, a fund manager can be an ERISA fiduciary. http://www.winstead.com/Knowledge-Events/News-Alerts/228406/With-the-Tip-of-a-Hat-a-Fund-Manager-Can-Be-an-ERISA-Fiduciary

The New Fiduciary Rule’s Important Take Aways

On April 7, 2017, just three days before the original set applicability date, the Department of Labor announced they will be postponing the applicability dates originally stated in the Fiduciary Rule from April 10, 2017 to June 9, 2017, and certain provisions in the exemptions will be further delayed until January 1, 2018.

Under this new rule, any individual who offers investment advice for a fee or any other form of compensation (whether it be direct or indirect) will be considered a fiduciary. They are therefore required to act only in the best interest of the recipient of their advice, with no regard to their own interests. In other words, almost any insurance or investment recommendation to a plan, participant, or IRA will now be a fiduciary act, and is therefore required to work in the best financial interests of a plan and its participants.

As wonderful as this sounds, it will prove to be a big transition for many firms. This is why the Department has allowed for a transition period lasting from June 9, 2017 – January 1, 2018. During this time fiduciaries must simply comply with the Impartial Conduct Standards (ICS) defined by the DOL (outlined below):

The standards specifically require advisers and financial institutions to:

  • Give advice that is in the “best interest” of the retirement investor. This best interest standard has two chief components: prudence and loyalty:
    • Under the prudence standard, the advice must meet a professional standard of care as specified in the text of the exemption;
    • Under the loyalty standard, the advice must be based on the interests of the customer, rather than the competing financial interest of the adviser or firm;
  • Charge no more than reasonable compensation
  • Make no misleading statements about investment transactions, compensation, and conflicts of interest. [1]

The applicability of all other 2016 amendments will be delayed until January 1, 2018.

As for the implementation of the Rule during the transition, rather than imposing strict penalties and citing violations, the Department has chosen to take the stance of an assistant. According to the Department, they will not pursue claims against any fiduciary who is “working diligently and in good faith to comply with the fiduciary duty rule and exemptions.” They have also asked the IRS to not apply the §4975 or related reporting obligations to any transaction or agreement where the Labor Department’s temporary enforcement would apply. That said, if the fiduciary fails to make these diligent and good-faith efforts to comply with the Rule, then he/she will lose the benefit of the temporary non-enforcement policy.

Even though the Rule will be put in to action in a week, there is still some potential for further changes to be added during the transition period. According to the Department, the “review of the Fiduciary Rule and exemptions is ongoing…[and] based on the results of the examination…additional changes will be proposed.” In an effort to see what further changes might be necessary, a Request for Information (RFI) will soon be released to ask for public input on ideas for possible new exemptions or regulatory changes.

There is evidence to suggest that the results of the RFI could prompt the Department to not only make further changes to the rule, but also further delay the final implementation date of January 1, 2018. Now, you may be wondering why such a delay would be necessary; well, according to recent market developments, some of the most promising responses to the Fiduciary Rule (such as “clean shares”[2]) are likely to take more time to implement than originally thought when the Department set the January 1, 2018 date for full compliance. So, by allowing additional time firms have the opportunity to create compliance mechanisms that are less costly and more effective than the measures they might resort to if given less time. In other words, the Department wants to give firms enough time to create well-though-out and long-term solutions that will be better for plans and their participants in the long run.

Regardless of what the rule eventually morphs into, the key takeaway for trustees and plan sponsors is this: the Department has established a framework that, in principal, grants further protections if they hire investment fiduciaries. Compared to the suitability standard that dominated the marketplace prior to the DOL’s fiduciary rule, plan sponsors can now, in effect, delegate investment fiduciary duties to their investment advisor. However, the regulations are very clear that fiduciary duties can only be delegated to other fiduciaries. Non-fiduciary service providers who sell only “suitable” investments are not fiduciaries, and therefore cannot be expected to represent the best interest of the plan’s participants or trustees.

For further reading on this subject, check out:

Impartial Conduct Standard: More Than Meets the Eye – NAPA Net: http://www.napa-net.org/news/managing-a-practice/regulatory-compliance/impartial-conduct-standard-more-than-meets-the-eye/

Steering Clear of Fiduciary Enforcement Troubles – NAPA Net: http://www.napa-net.org/news/managing-a-practice/regulatory-compliance/steering-clear-of-fiduciary-enforcement-troubles/

Conflict of Interest FAQs (Transition Period) – U.S. Department of Labor: https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2

Fiduciary Rule to Go Live June 9, 2017: http://www.truckerhuss.com/2017/05/fiduciary-rule-to-go-live-june-9-2017/

The Department of Labor Confirms June 9th as the Effective Date of the Fiduciary Rule: What Employers Need to Know Now: http://www.dickinson-wright.com/news-alerts/effective-date-of-the-fiduciary-rule

[1] U.S. Department of Labor. Conflicts of Interest FAQs (Transition Period). May 2017. Accessed May 30, 2017.

[2] “Under this approach, the clean shares sold by the broker would not include any form of distribution-related payment to the broker. Instead, the financial institution could set its own commission levels uniformly across the different mutual funds that advisers may recommend, substantially insulating advisers from conflicts of interest among different mutual funds.”  – DOL Conflicts of Interest FAQs (Transition Period)

Defining a Standard of Care

In the context of retirement readiness, how do we identify the circumstances under which reasonable caution and prudence must be exercised?

The standard of care stems from the 1837 case of Vaughan v Menlove. This case established that the standard of care is dependent on the circumstances, and upon whether the individual proceeded with reasonable caution as a prudent person would have exercised under the circumstances.

Employees fortunate enough to work for a company that offered a defined benefit plan didn’t have to worry about contributions or investment decisions. The entire process was managed by the employer and their advisers. The employer defined the benefit, provided the necessary funding and was responsible for overseeing the management of the plan’s investments. Investment performance below the expected return meant higher contributions for the employer.

The plan sponsor bore the responsibility to establish a prudent process to benchmark investment performance, minimize investment related cost, or be straddled with the burden of higher contributions. This model worked extremely well for employees but the employer faced challenges balancing benefits and employee’s need for higher current compensation.

The introduction of 401(k) plans in 1980 provided employers with an alternative to defined benefit plans. The funding obligation and investment management responsibilities were shifted to the employee. Unfortunately for participants, there hasn’t been adequate guidance on what their contributions should be. Worse, in many cases their investment choices have been limited to high-cost, low-performance options. This epic failure of the 401(k) industry over the past 36 years has left many employees inadequately prepared for retirement.

The Yin and Yang of Benchmarking Fees—and Contributions

Retirement readiness is conditioned on two linked, fundamental factors: contributions and investment performance. Employers who offered defined benefit plans understood this concept and established prudent processes to address each factor. The key features of defined benefit plans can provide a framework for establishing prudent processes and checkpoints for 401(k) plan sponsors.

First and foremost, the employer should help define the contribution for the employee. A flexible compensation solution that allows the employee to define their desired retirement benefit simplifies the process of identifying long-term funding needed to achieve retirement readiness.

Employees who start saving later in their career may have a higher funding goal than those who started earlier. Individualizing the target for each employee, based on their own facts and circumstances, establishes a prudent process and a high standard of care.

Plan sponsors understand that both subpar investment performance and high investment costs erodes retirement readiness, and increases the employee’s funding obligation. By establishing a fee benchmarking process, plan sponsors have discharged their fiduciary responsibilities. That method has proven to be an effective method for curbing high investment costs. But benchmarking fees, alone, ignores the impact of contributions.

Benchmarking employee outcomes, rather than just investment fees, measures the effectiveness of all aspects of the retirement plan, including contributions. A focus on outcomes also ensures that plan sponsors have taken reasonable caution, and exercised prudence in establishing a path to retirement readiness. In the end, benchmarking outcomes serves both employees and plan sponsors in a way that is superior to a focus on fees only.

Employee Investment Outcomes and the New Fiduciary Standard

When Section 401(k) became a permanent provision of the Internal Revenue Code in 1980, a seismic shift occurred in American workers’ preparation for retirement. The responsibility for contribution and investment decisions shifted from employers to employees.

Before 1980, companies that offered a retirement plan were required to fund them. That meant that the employer alone bore the contribution and investment responsibilities.

In those defined benefit plans, if the investment returns were less than expected, then the employer’s funding obligation increased, to offset the shortfall on investment returns. The employer was tasked with achieving sustainable investment outcomes to support their employees throughout their retirement years.

With the introduction of 401(k) plans, contributions became the responsibility of the employee. Moreover, they have had to decide an adequate savings rate and become investment savvy.

Employee-directed Retirement Investment Falls Short

Employees have, overall, not been up to these tasks. This shift to a 401(k) retirement world thus ushered in an era in which employees were inadequately prepared to face the tasks at hand.

Early on, participants had no guidance on the how much they should be saving for retirement or how those funds should be invested.

The Department of Labor has created numerous regulations over the past 36 years to ensure employees have the information and resources needed to make informed and educated decisions about their retirement savings.

Not surprisingly, insurance companies and financial services firms jumped into the void of information, and developed slide rules, websites, online calculators, glide path funds, target date funds, custom QDIAs, and a plethora of other tools and products to serve the fledging 401(k) investor.

The outcome of these endeavors has been disappointing, to say the least.  With the first generation of 401(k) participants approaching retirement, the reality of inadequate preparation of is beginning to set in.

Retirement Unpreparedness Meets New Fiduciary Duties

The average account balance for the typical participant lies far below the threshold needed for a sustainable retirement income. The education, tools, and resources provided by employers, their advisors, and the industry have left many ill-prepared for retirement. This void is being addressed by longer working careers, government intervention, and an opportunistic legal system. [is this common knowledge in the industry? If not, spell out what are you referring to here re the legal system]

Public school systems have been sued over failed outcomes by their students, but the courts have been reluctant to rule in favor of the parents and students in such cases. The potential liability would not be in the best interest of school systems and the public good.

While a standard of care is mandated by law and periodic achievement test can demonstrate some level of proficiency in the public education system, it is doubtful the 401(k) industry will be afforded the same latitude.

Against this background, we have the passage of the new fiduciary rule for investment advisors. It elevates the standard of care investment advisors must use to the highest level. No longer should the products and services simply be suitable; they must also be in the best interest of plan participants.

“In the best interest of plan participants” implies a quantifiable outcome. To protect themselves, and help their employees make wiser investment and saving decisions, employers would be well served to quantify the progress participants are making toward retirement.

Education alone is not enough. Tools and resources alone are not enough.

The new fiduciary rule is only the beginning of accountability standards employers and service providers can expect in the future. Plan sponsors need to ensure that they have appropriate, quantifiable measures in place, so they can demonstrate that participants have a path to achieving retirement readiness.

Defining and achieving sustainable outcomes mitigates the employer’s liability while improving productivity and employee morale.

The New Fiduciary Rule—Advisors Who Only Educate Might Put Plans at Risk

At a recent 401(k) summit in Nashville, I was surprised to hear the number of advisors who said they are considering offering only education to participants, so they do not have to comply with the new fiduciary rule.

As many now know, under the new fiduciary rule announced by the Department of Labor, anyone who provides investment advice and receives a fee will be subjected to the more stringent, fiduciary standard of care. The fiduciary standard of care requires that all decisions and actions that affect a participant’s account balance be in the best interest of the plan’s participants.

In contrast, education activities will continue to operate under an exemption to the new rule.  But advisors who merely educate participants about investment choices and strategies are potentially missing the mark on preparing participants for retirement.

Plan Sponsors Could Inadvertently Breach Fiduciary Duty

As the plan sponsor, you are the gatekeeper of the plan’s assets. It is your responsibility to select, monitor, and hold accountable any and all service providers who are paid from plan assets. Simply allowing the advisor now to be considered an “educator,” without a basis for measuring results, is potentially a fiduciary breach for which the fiduciary can be held personally liable.

Advisors are reluctant to take on the personal liability of acting as a fiduciary. Providing only education, rather than advice, may be an out for them. But it may not be the same out for plan sponsors.

The plan’s act of selecting an educator could be a fiduciary act, which requires diligence and care. True, participant education is not considered advice under the rule. But if the education is funded from plan assets, the best practice is to determine what’s in the best interest of plan participants.

Tools for Assessing Educator Effectiveness

Identifying the expected or desired outcome from any endeavor establishes a basis for evaluating the progress toward the stated goal. Education is no different.

A decision matrix could be instrumental in providing an organized structure and procedural process to determine an expected outcome. Such a matrix might evaluate:

  • What’s the purpose of participant education, and what is the desired outcome?
  • What problem is it intended to solve?
  • What scoring method will be used to define a successful outcome?
  • How many providers will be evaluated before finalizing the selection?

A starting point for plan sponsors is to conduct a survey of all eligible participants to see if they feel they are on track for retirement. A number of organizations publish national results each year, so benchmarking your participants to a national study can identify potential areas for improvement.

National surveys may be somewhat qualitative. For a quantitative approach, instead calculate the current average replacement ratio of all participants. Other key information to gather includes identifying a baseline of how the participants feel toward retirement readiness, and a quantifiable replacement ratio. From there, plans can build out a decision matrix to determine the effectiveness of current and future endeavors.

The desired outcome is not just a higher participation rate, but rather a greater sense of retirement security and higher average income replacement ratio.

Fiduciary Basics – Helping 401(k) Plan Sponsors Understand Fiduciary Status

A fiduciary is defined as a legal or ethical relationship or trust between two or more parties. Typically, a fiduciary prudently takes care of money for another person. How does this relate to 401(k) plans?

When a company decides to sponsor a 401(k) plan they must establish a trust account to hold the contributions to the plan. Commonly, the owner or an executive of the plan sponsor will be designated as the trustee, or in some cases there may be multiple trustees. The trustee is charged with oversight of the assets held in trust for the benefit of the participants and beneficiaries.

As a fiduciary, the two most important duties of the trustee is to invest the assets of the plan and monitor expenses. In today’s 401(k) environment, the most common approach to investing plan assets is to offer the participants a menu of funds so they can create their own asset allocation. Some plans also offer a brokerage account window. In a brokerage account, participants have complete access to all traded securities in the marketplace. However, when a trustee selects a lineup of funds they are limiting the investment choices of the participants. This limited access exposes the fiduciary to significant liability, and they are then held to a prudent expert rule. They must use prudence when selecting the funds to include in the lineup. Performance is not the only variable to consider. In fact, the courts have placed more emphasis on the fees related to the selected options instead of performance. While there hasn’t been legislation, at least not yet, to mandate index funds be included in a trustee selected fund lineup, the U.S. Department of Labor has strongly suggested inclusion so participants have access to lower cost options.

To my knowledge, there has not been a single successful lawsuit brought against a fiduciary for selecting only the lowest cost index funds available for a given plan. Lawyers have tested the courts for fee cases and won. As more attorneys seek new streams of revenue, expect to see more litigation over excessive 401(k) fees. If you are a trustee or have the authority to make decisions over the disposition of plan assets, or the selection of service providers, then you are probably a fiduciary. More than likely your service providers are NOT a fiduciary, so you need to make careful informed decisions. Objective, expert advice is invaluable, and it never hurts to have a documented second opinion.

by Richard Phillips AIF, ERPA, CPC, QPA, QKA