Guest Article

(Reprinted from The 401(k) Handbook, published by Thompson Publishing Group, Inc.)

Personal 401(k) Plans: Could Some Employees Fall Through the Cracks?

by Martha Priddy Patterson

An intriguing idea for total portability of 401(k) plans - what some call the "personal 401(k) plan" - is appearing in discussions among retirement policy gurus and even the popular press. A personal 401(k) plan would permit each individual to manage his or her own plan, choosing any investment and account manager, as with an IRA. If the individual's current employer offered a matching contribution, that amount would be contributed to the individual's account and immediately vested. The employer would have no authority or responsibility for the choice of investments - and presumably no liability. When the individual changed jobs, he or she would make no changes in the plan other than telling the new employer where to send the employer matching contribution.

The personal plan concept is also sometimes referred to as "open architecture" in 401(k) plans. Open architecture can simply be a plan that offers several different mutual funds, in addition to the mutual funds managed by the plan recordkeeper. The personal 401(k) plan goes far beyond that concept.

The personal 401(k) plan would require several changes in the law to operate as described by its proponents. If these changes could be enacted, the personal 401(k) plan idea might be good for some employees; it might be bad for others. Certainly many current 401(k) plan sponsors might want to seriously consider the idea, depending on the rules that might apply. But even before real study and consideration of the idea can begin, the debate is already being framed as employees against the employers. The personal 401(k) plan is necessary, according to proponents, because it gives the employee, not the employer, the right to choose investments and because the 401(k) fees and expenses paid by employees are too high.

Before the discussion of "personal 401(k) plans" proceeds too much further, let's take look at a few facts about the state of 401(k) plans today and at the personal 401(k) plan's advantages and disadvantages to employers and employees.

Today's 401(k) Plan

The evidence is anecdotal at best that most 401(k) plan participants are dissatisfied with the investment options offered by their plans. On any given day, a participant's satisfaction level may well vary directly with performance of the stock market and not with the availability of sound or diverse investment choices. The average 401(k) plan offers 11 investment options, and nearly 8 percent of plans offer unrestricted investment of employee contributions, according to the 43rd Annual Survey of Profit Sharing and 401(k) Plans, conducted by the Profit Sharing/401(k) Council of America. On the issue of fees, this survey also reports data showing that employers overwhelmingly pay the costs of 401(k) plan administration. Only in the area of investment fees do plans pay more of the fees than employers do, according to the survey.

Would Personal 401(k) Plans Lower Investment Expenses?

Given the enormous economies of scale in 401(k) plans with millions in assets, as well as the plan administrator's fiduciary duty to prudently manage the plan, it is difficult to see how a personal 401(k) plan could cost the individual less in investment fees than would be paid under a current employer plan. In addition to losing economies of scale, all the fees currently paid by the employer in 401(k) plans would now be paid by the individual or from assets in his or her personal 401(k) plan. For example, mutual fund investment fees would be applied to the individual's investment, if mutual funds are part of the plan. If individual stocks are part of the personal plan, trading fees would be associated with the purchase and sale of the stocks.

Finally, as described so far, the personal 401(k) plan would be managed by or with the assistance of a financial advisor, whose fees would likely be considerably higher than those currently paid by an individual 401(k) plan participant. Nevertheless, proponents argue that individuals could negotiate lower fees than those paid by employer-provided plans. This argument seems extremely optimistic considering the pressures of today's investment world.

Potential Advantages for All Employees

The personal 401(k) plan has some clear potential advantages for all employees. First, the personal 401(k) plan would enable employees to avoid gaps in plan contributions between jobs. There would be no waiting periods before joining the new employer's plan because the employee would control the plan. Presumably, the burden would be on the employee to notify a new employer of the amount to be deposited in the personal plan.

Personal 401(k) plans should pose no distribution or rollover issues, because there would be no distributions or rollovers until the employee retired or reached age 59-1/2. Individuals would not lose the tax breaks of a 401(k) plan because of a delayed rollover to an IRA or other employer plan because the money would not leave the personal 401(k) plan on a change of employment. With no distribution, there would be no lump sum to tempt the employee to spend the plan balance when changing jobs.

Potential Disadvantages for Employees

The full responsibility and financial cost of investment and management would fall on the individual in a personal 401(k) plan. Financially sophisticated employees with ample time to monitor their investments and the market might find this responsibility to be a wonderful advantage. It would enable those employees to more easily coordinate their individual savings and non-tax-sheltered savings with their personal 401(k) plan and other employer-provided savings, in addition to offering them total investment independence. Presumably, such individuals would also either be able to select a suitable credentialed, low-cost investment adviser to undertake the day-to-day management of the plan or will have sufficient time to manage their own portfolio. How many such employees exist in the workplace remains an open issue.

Those employees who don't have considerable amounts of free time remaining after working and running a home or whose financial sophistication is not at the graduate school level - presumably most employees - might well find this new responsibility a difficult additional burden. Simply finding a reliable investment adviser is likely to take several hours of interviewing and comparison. Evaluating all the investment options recommended by that adviser would take even more time. In short, many potential plan participants might never get around to setting up their personal 401(k) plans because they believe they do not have the time or the expertise to select such a financial advisor and appropriate investment options.

Advantages and Disadvantages for Employers

Employers currently offering 401(k) plans, if willing to vest any matching contributions immediately, could save considerable amounts in administrative fees and expenses by shifting their employees to personal 401(k) plans. Because the individual would be making all plan decisions, it seems unlikely the employer could be charged with any responsibility for investment results. The employer's only fiduciary duty would be prompt deposit of the employee's chosen deferrals and any matching contributions to the employee's personal 401(k) plan.

For employers making matching contributions with a vesting schedule, the employer would lose the retention incentive of vesting and would experience the increased costs of automatic vesting. Employers could avoid the increased costs of immediate vesting by simply stopping the matching contributions. To mitigate damage to employee relations from the elimination of matching contributions, the employer could present active participants with a one-time additional "seed" amount for each participant's 401(k) plan and explain that the additional independence of investment and portability is a trade-off for the loss of matching contributions.

Who's the Cheerleader, the Coach and the Referee?

Every human resources officer responsible for the 401(k) plan knows the plan sponsor does more than just contribute money to the plan. For many - though not all - employees, the employer must be the cheerleader to make the employee aware of the 401(k) plan and get the employee enrolled in the plan. All too frequently, the plan sponsor must also be a "coach" to help employees understand the importance of getting into the retirement game and the rules regarding investments, the time value of money and other basic financial principles. For all employees, the plan sponsor is the "referee" who has the fiduciary duty to manage the plan with prudence, diligence and diversity of investments. The administrator named by the employer must carefully screen and review investments, fees and any investment advisors hired by the plan.

Who would fill these roles for personal 401(k) plans is an open and troublesome question. Certainly there will be no lack of cheerleaders competing to get most individuals involved in the retirement game. Many of these cheerleaders will also be the coach for the financial education necessary to play the game. Numerous investment firms and advisors currently coach the public on the importance of saving and on the basic principles of financial planning.

These coaches play a valuable and active role in educating the public on the importance of investing and saving for retirement and other life goals. While their basic goal is to sell their products, that profit motive should not detract from the contribution made to the welfare of society by these cheerleaders who emphasize saving rather than consumption.

Unlike the employer, these coaches and cheerleaders are not likely to offer the same disinterested information and advice currently being offered by most plan sponsors. Also, plan sponsors have incentives to contact all employees and urge every employee, especially lower-paid employees, to participate in the plan. Those incentives come both from a need for the plan to pass nondiscrimination tests and from a concern for employees' retirement security. (Regardless of some views, employers who are offering retirement plans are concerned about their employees' futures. Employers who are not concerned do not offer retirement plans.) Individual investment advisors will have little incentive to find low-paid employees and encourage them to set up personal 401(k) plans because servicing such clients will not be economical in the short term, nor perhaps over the long run.

If every 401(k) plan participant is to have a financial advisor, thousands more advisors will be needed. Who will be the referee for these new coaches? The regulatory authorities for such advisors admit that it is already difficult to control unscrupulous financial advisors, not to mention merely incompetent ones.

Some proponents may suggest that plan sponsors' existing ERISA duties and responsibilities simply be extended to personal 401(k) plans. In reality, it would be the rare employer that would continue any type of 401(k) plan that denied the employer the right to control or even review the investments, the investment advisors and administrators of the plan, but left the employer responsible for those administrators, advisors and investments. No board of directors could permit a company's management to incur this risk. Under such an arrangement, employers would simply be required to leave the field.

Martha Priddy Patterson is the director of employee benefits policy analysis with Deloitte & Touche LLP's Human Capital Advisory Services in Washington, D.C. Patterson is the contributing editor of The 401(k) Handbook.

Reprinted with permission from the January 2001 supplement to The 401(k) Handbook, ©Thompson Publishing Group, Inc., 2000. All rights reserved.

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