Ted's Table

Technical Terms Fiduciary Employee Retirement Income Security Act (ERISA)

TB: I have been doing a lot of thinking about this issue lately. With the approach of the 20th anniversary of the first 401(k), I have been considering how to make these plans better for both participants and employers. The major issue for 401(k) participants today is investing, because account balances have become the most important asset many employees have.

The fiduciary standards for retirement plans were established when the Employee Retirement Income Security Act (ERISA) was passed during 1974. Employers are required by ERISA to act solely in the best interest of participants. The primary retirement program when ERISA was enacted was employer-funded, defined-benefit pension plans. Determining what is in the best interest of participants is feasible for such plans because the investment risk (and rewards) are borne by the employer.

This standard is impossible for employers to satisfy with 401(k) plans because employees bear the entire investment risk, and what is in the best interest of employees is determined by many individual factors that are beyond the knowledge level of the employer. I am convinced the best alternative for both employers and employees is for employers to remove themselves from the role of investment gatekeeper. Giving participants the same investment flexibility that they have with other vehicles (IRA and personal investments) is, in my opinion, in the best interest of participants. However, giving employees unlimited choice and control is a frightening prospect for those who have trouble selecting from 10 to 12 funds. I expect 401(k) to change over the long run so that employees will eventually have the same investment flexibility with their 401(k) money that they do with their other investments, but with support from an independent investment advisor to help them select their investments.

You ask a number of specific questions about what the employer must do to satisfy its fiduciary responsibility. The writers of ERISA did not foresee the movement to a plan that would be funded primarily by employee contributions and where investment decisions would be made by the participants. As a result, ERISA doesn't contain answers to your questions. I will answer your specific questions by assuming that your goal is to reduce your company's liability exposure to the lowest possible level.

If this is your company's goal, you should establish investment options that cover the risk spectrum, and then select "funds" which consistently meet or beat the appropriate benchmarks for the applicable class of investment. The best way is to retain an independent advisor to write an investment policy for each fund and to help you select funds that fit each category. The advisor should also monitor performance by providing a quarterly report. This review should measure performance against the benchmark and should track the manager's decisions to see whether there has been style drift. I believe this is the process that will put you in the best possible position, but it will make sense only in a multimanager structure because your advisor will need this flexibility to find quality funds in each investment category.

I should also note that performance reviews are of value only if appropriate benchmarks have been established for measuring performance for each investment class. For example, the S&P 500 Index is not an appropriate benchmark for a small-cap fund. Investment return must also be evaluated on a risk-adjusted basis. Did the manager take more or less risk than the benchmark to achieve the return? I recommend meeting with your advisor annually to discuss each manager's results.

TB: First you need to consider the risk-related return against the benchmark rather than just pure return. You should not be happy if the manager met the benchmark but took substantially higher risks to get there. On the other side, a manager who produces a return 1 percent below the benchmark but took an appropriate amount of risk should not be put on notice.

Next, your evaluation should look at the manager's ranking for the class of investment rather than just the risk-related return. A manager's performance usually is measured by ranking the performance against a peer group by quartiles. Generally, managers who place in the top two quartiles are not replaced. Managers who fall into the third and fourth quartile are candidates to be put on notice and/or replaced.

Lastly, you need to decide what are appropriate time periods for each of these actions. A manager who drops into the bottom quartile for a year should be put on notice. A two-to-three year period of lower quartile performance is a long enough period to justify replacement. You should also carefully monitor the investment decisions of a manager who is put on notice because the added pressure to perform may result in style drift and/or added risk. I also strongly recommend using an independent consultant to measure a manager's performance against that of his or her peers because you cannot count on the managers to properly rate their own performance.

TB: Yes, employer contributions to a 401(k) are tax-deductible, but the employer still bears the major cost for these contributions. Similar to your pretax contributions, the tax break covers only part of the cost. For example, if your effective tax rate is 28 percent and you contribute $1,000, your tax bite is reduced by $280 but the other $720 comes out of your pocket. You have to give up $720 that you could use for other purposes to make a $1,000 contribution to the plan.

The same math applies to the employer contribution. If the employer doesn't have any taxable profits, the employer doesn't gain any tax break by contributing to the plan. Any employer contribution is paid fully by the employer in this instance. The tax break is 25 percent of the cost if the employer's effective tax rate is 25 percent. In that instance, the government picks up 25 percent of the cost via the tax deduction and the employer pays 75 percent.

TB: The law was written by Congress to tie the amount that HCEs may contribute directly to the average percentage of pay that the other employees contribute. The law includes a definition of those who are included in the "highly compensated employee" group. Employees who earn more than $85,000 this year or are 5 percent owners are included in this group, unless there are a lot of high-paid employees and the employer decided to include only the highest-paid 20 percent of employees.

Related Reading How to Turn Your Retirement Money into an Income Stream Who Should Educate Us about Retirement Saving?

Contributions for the HCEs are restricted because the government wants to limit the tax break that these employees receive relative to the other employees. They don't want the HCEs to be able to contribute 10 percent of their pay if the non-HCEs are contributing an average of only 2 percent of pay. In such an instance, the major tax revenue loss would benefit the higher-paid employees without doing much to help lower-paid employees.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every week. With over 30 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored two books, Helping Employees Achieve Retirement Income Security and Escaping the Coming Retirement Crisis, and is President of the 401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and comments have appeared in numerous publications, including The New York Times and The Wall Street Journal.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Ted's Table

Technical Terms Fiduciary Employee Retirement Income Security Act (ERISA)

TB: I have been doing a lot of thinking about this issue lately. With the approach of the 20th anniversary of the first 401(k), I have been considering how to make these plans better for both participants and employers. The major issue for 401(k) participants today is investing, because account balances have become the most important asset many employees have.

The fiduciary standards for retirement plans were established when the Employee Retirement Income Security Act (ERISA) was passed during 1974. Employers are required by ERISA to act solely in the best interest of participants. The primary retirement program when ERISA was enacted was employer-funded, defined-benefit pension plans. Determining what is in the best interest of participants is feasible for such plans because the investment risk (and rewards) are borne by the employer.

This standard is impossible for employers to satisfy with 401(k) plans because employees bear the entire investment risk, and what is in the best interest of employees is determined by many individual factors that are beyond the knowledge level of the employer. I am convinced the best alternative for both employers and employees is for employers to remove themselves from the role of investment gatekeeper. Giving participants the same investment flexibility that they have with other vehicles (IRA and personal investments) is, in my opinion, in the best interest of participants. However, giving employees unlimited choice and control is a frightening prospect for those who have trouble selecting from 10 to 12 funds. I expect 401(k) to change over the long run so that employees will eventually have the same investment flexibility with their 401(k) money that they do with their other investments, but with support from an independent investment advisor to help them select their investments.

You ask a number of specific questions about what the employer must do to satisfy its fiduciary responsibility. The writers of ERISA did not foresee the movement to a plan that would be funded primarily by employee contributions and where investment decisions would be made by the participants. As a result, ERISA doesn't contain answers to your questions. I will answer your specific questions by assuming that your goal is to reduce your company's liability exposure to the lowest possible level.

If this is your company's goal, you should establish investment options that cover the risk spectrum, and then select "funds" which consistently meet or beat the appropriate benchmarks for the applicable class of investment. The best way is to retain an independent advisor to write an investment policy for each fund and to help you select funds that fit each category. The advisor should also monitor performance by providing a quarterly report. This review should measure performance against the benchmark and should track the manager's decisions to see whether there has been style drift. I believe this is the process that will put you in the best possible position, but it will make sense only in a multimanager structure because your advisor will need this flexibility to find quality funds in each investment category.

I should also note that performance reviews are of value only if appropriate benchmarks have been established for measuring performance for each investment class. For example, the S&P 500 Index is not an appropriate benchmark for a small-cap fund. Investment return must also be evaluated on a risk-adjusted basis. Did the manager take more or less risk than the benchmark to achieve the return? I recommend meeting with your advisor annually to discuss each manager's results.

TB: First you need to consider the risk-related return against the benchmark rather than just pure return. You should not be happy if the manager met the benchmark but took substantially higher risks to get there. On the other side, a manager who produces a return 1 percent below the benchmark but took an appropriate amount of risk should not be put on notice.

Next, your evaluation should look at the manager's ranking for the class of investment rather than just the risk-related return. A manager's performance usually is measured by ranking the performance against a peer group by quartiles. Generally, managers who place in the top two quartiles are not replaced. Managers who fall into the third and fourth quartile are candidates to be put on notice and/or replaced.

Lastly, you need to decide what are appropriate time periods for each of these actions. A manager who drops into the bottom quartile for a year should be put on notice. A two-to-three year period of lower quartile performance is a long enough period to justify replacement. You should also carefully monitor the investment decisions of a manager who is put on notice because the added pressure to perform may result in style drift and/or added risk. I also strongly recommend using an independent consultant to measure a manager's performance against that of his or her peers because you cannot count on the managers to properly rate their own performance.

TB: Yes, employer contributions to a 401(k) are tax-deductible, but the employer still bears the major cost for these contributions. Similar to your pretax contributions, the tax break covers only part of the cost. For example, if your effective tax rate is 28 percent and you contribute $1,000, your tax bite is reduced by $280 but the other $720 comes out of your pocket. You have to give up $720 that you could use for other purposes to make a $1,000 contribution to the plan.

The same math applies to the employer contribution. If the employer doesn't have any taxable profits, the employer doesn't gain any tax break by contributing to the plan. Any employer contribution is paid fully by the employer in this instance. The tax break is 25 percent of the cost if the employer's effective tax rate is 25 percent. In that instance, the government picks up 25 percent of the cost via the tax deduction and the employer pays 75 percent.

TB: The law was written by Congress to tie the amount that HCEs may contribute directly to the average percentage of pay that the other employees contribute. The law includes a definition of those who are included in the "highly compensated employee" group. Employees who earn more than $85,000 this year or are 5 percent owners are included in this group, unless there are a lot of high-paid employees and the employer decided to include only the highest-paid 20 percent of employees.

Related Reading How to Turn Your Retirement Money into an Income Stream Who Should Educate Us about Retirement Saving?

Contributions for the HCEs are restricted because the government wants to limit the tax break that these employees receive relative to the other employees. They don't want the HCEs to be able to contribute 10 percent of their pay if the non-HCEs are contributing an average of only 2 percent of pay. In such an instance, the major tax revenue loss would benefit the higher-paid employees without doing much to help lower-paid employees.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every week. With over 30 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored two books, Helping Employees Achieve Retirement Income Security and Escaping the Coming Retirement Crisis, and is President of the 401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and comments have appeared in numerous publications, including The New York Times and The Wall Street Journal.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.