Empower your 401k plan
With the fluctuations in the stock market over the past decade and the breakdown of consumer confidence in corporate America, there has been an explosion in the demand for alternative investments and greater choice within retirement accounts. A growing number of investors are starting to realize they can invest in real estate and other non-traditional assets using their retirement accounts.
A 401k or defined contribution plan can be a productive way to save for retirement. The 401k plan allows companies to offer additional benefits to their employees by offering them a way to save additional money in a tax-advantaged account. In some 401k plans, the company will even match contributions for their employees, essentially giving them "free money" as an incentive to contribute to the company plan. In 2012, there were an estimated 52 million workers who were active 401k plan participants. In 2013, 401k plans held a total of $4 Trillion in plan assets, compared to $23 Trillion in total retirement account assets. This is a large amount of money being saved for an eventual retirement, however, it only amounts to an average of $77 per person currently saved in 401k plan accounts. This is hardly enough to buy a dinner out with the family. Clearly, people are not saving enough.
One common concern we at Innovative Advisory Group have with many 401k plans is the lack of quality choices available in that plan for its participants (employees). Many 401k plans are stuck in the dark ages of 401k plan history. Mutual funds have long been the asset of choice for most 401k plans. Mutual funds allow investors to get a "diversified" portfolio of the assets in hopes that they will get an expected performance over many years. However, mutual funds are only one possible choice for their company's 401k plan options. 401k plans have come a long way in just the past 10 years. They can offer their employees many choices such as: stocks, bonds, mutual funds, Closed-End funds(CEFs), Exchange Traded Funds (ETFs), stock options, real estate, tax liens, private mortgages, physical gold and silver, private company stock and more. The 401k plan options are primarily limited by the company who offers the plan. While a 401k plan is capable of offering all of these options and more, it is up to the company's plan trustees (a person with fiduciary responsibility at the company who is responsible for the 401k plan: typically someone in HR, owner or principal, CFO, or other finance related person) to decide what investment options it would like to offer to its employees. Since the person in charge of a company's 401k plan investment choices is not typically someone with an investment background, rarely do these 401k plans offer a wide selection of investment options outside a selective group of mutual funds. Frequently brokers or financial advisors are the people proposing an investment selection to the plan trustees. While there is nothing wrong with offering mutual funds as a choice in the 401k plan, it is only a small sliver of the investment universe.
What is a self-directed 401k plan?
A self-directed 401k plan is a plan which is capable of having virtually an unlimited number of investment choices within the plan. The self-directed 401k plan allows the plan participant (employee) to choose what to invest in with their retirement money. This is a significant benefit for people who want to invest in assets which they are most familiar. For example, if a real estate investor has a 401k plan invested in mutual funds, and he wants to invest in real estate, which he most likely would be an expert in, then he could use money from his 401k plan to invest in real estate on a tax-advantaged basis. Peter Lynch was famous for saying , " Invest in what you know." Well, if a real estate investor knows real estate, then why should he try to invest in technology companies which he is not as familiar with. A self-directed 401k plan provides a freedom of choice to the employees.
Why are mutual funds the most commonly used investment choice within 401k plans?
Mutual funds are generally a suitable choice for many 401k plans, however, there are a few reasons many financial advisors and plan trustees chose mutual funds over the many other investment choices.
- They just don't know- most financial advisors and 401k plan trustees are not aware that they can offer investments other then mutual funds. There is a growing need for the investing public to be educated on the additional investing options available to them within 401k plans. The lack of understanding of all the potential choices which could be offered in the 401k plan is a large factor of why mutual funds are most commonly offered in a 401k plan.
- Easy to manage and easy to understand- Mutual funds are the most widely understood investment type, so it is easier to offer a mutual fund than another type of investment, which not all employees may fully understand. Additionally, there are suitability requirements which make mutual funds an easy choice.
- Herding Behavior- If everyone is doing it, then it must be ok. The human psychology is such that people feel safe in herds. I'm sure it goes back to the days of cavemen when you tried not to be eaten by a tiger by traveling in herds or groups. People feel safer acting like others, so they don't stand out. Since most 401k plans offer mutual funds as the primary investment choice, it is easy to follow the crowd.
- Easy to hide fees and costs- Many mutual fund share classes are set up specifically for 401k plans. These share classes have a fee structure which allows flexible choices for the plan trustees. It allows the plan trustees to either pay for the 401k plan costs out of the company's cash flow, or pass some or all of the plan costs onto the employees. Until recently, employees were mostly unaware of this cost which was passed along to them. Since 2012, when the Department of Labor published a new regulation requiring fee transparency, it has been required that plan fees are disclosed to the plan participants as well as what the fees are used for.
- Lack of knowledge- Most people are not savvy with their investments. Anecdotal evidence has suggested this for years, but now a 2014 Dalbar study proves it. The company plan trustees do have a fiduciary responsibility to their employees, so they need to find a simple solution. Mutual funds have been around long enough to make them feel comfortable, even if the funds themselves happen to be expensive, poor performers, and/or not actually suitable for the employees. This is a serious problem for plan trustees who do not have a strong investment background or knowledgeable financial advisor to assist them.
- Self-interest - Let's face it, while brokers or financial advisors may be professionals, they have to earn a living. It is much easier for a broker to earn money from hidden fees than to fully disclose the fees to the plan trustees or plan participants. In the past, there was nothing wrong with this behavior (other than ethically) since the fees were not required to be disclosed. Therefore it was easy to wrap the costs into a bundled plan and present it as a package. Since 2012 this changed where 401k plans are required to disclose fees and what they are used for to the plan participants. "Bundled 401k plans" are a very common way for brokers or financial advisors to solicit a new 401k plan or changes to an existing one.
Do you have mutual funds in your 401k plan, but want more personal investment choices. What should you do?
The first question is what options do you want? If you don't know what options are available to you, we have provided a few which you might want to consider ( If you want a more detailed list of options to choose from Contact Us).
- Different investment choices- Your current 401k plan may have a poor selection of mutual funds with high fees, poor performance, and poor diversification. The answer may just be to request that the company choose a better selection of fund choices. Many plan trustees want feedback from their employees, so asking is the best first step to take.
- More investment choices- Your current 401k plan may only offer 10-25 mutual fund choices. This is very common. However, you may want to broaden your choices to include thousands of mutual funds. This option is frequently available, but the company may require that you sign a release of liability. The company may also have to make changes to the plan itself to accommodate this option.
- Different investment types- Mutual funds are not the only investment available in 401k plans. There is a growing trend to add investment types which are similar to mutual funds without the high fees associated with owning the fund. One investment type is what is called an Exchange Traded Fund or ETF. ETFs act just like mutual funds in that they are a basket of stocks or bonds, except that they can be bought or sold throughout the day and typically have lower fees associated with them. Many fee-conscious investors prefer ETFs to mutual funds. Separately managed accounts, or SMAs are another similar type of investment to mutual funds. The one major difference is that a SMA owns the actual stocks which you should be able to see in your account. The fees can have a wide range and may be higher or lower than mutual funds.
- Self-directed 401k account- Self-directed 401k accounts are a very flexible option for employees. This allows the employee to invest in any asset which the custodian is capable of providing access to as long as it is approved by the company plan. This can include stocks, bonds mutual funds, ETFs, Closed-end funds(CEFs), options, or other investments. This is a favorite option for many savvy investors.
- Alternative investments- Alternative Investments are typically referred to as investments which are not securities. Examples of alternative investments are: real estate, tax liens, private mortgages, equipment leasing, physical gold and silver, stock in a private company or franchise, horses, livestock, farmland, private equity and more. Employees who want to maximize their investment selection with choices that they feel most comfortable with might want to consider offering alternative investments in their 401k plan. This choice is typically not well suited for fortune 500 companies, but rather professional service groups such as attorneys, accountants, doctors, dentists, real estate agents or brokers, consultants, or financial advisors. Anyone can offer this choice to their employees, but it would require a specialist who fully understands how the investments fit into the plan to do it properly. If you want to learn more, please feel free to Contact Us.
If you are a plan participant, (employee who is participating in the 401k plan) then you should speak to your 401k plan trustee who works at your company. If you don't know who this is, then it would be best to call someone in the HR department who is your point of contact for the 401k plan. When you speak to this person, ask if they are considering making a change to the 401k plan. Most companies want to hear from their employees about the 401k plan. Remember, the 401k plan is an employee benefit. It is there to benefit you as the employee, so ask if they are willing to make a change to the plan to add more choices. Many companies are looking for employee feedback and are willing to make changes to make the employees happy.
If you are a plan trustee, (the person responsible for the 401k plan in a fiduciary capacity) then the choice is mostly up to you. You can make the decision as to what investment choices are available to the employees. While this choice is not an easy one to make as the plan trustee, it is worth exploring your options as to what is available to you. You can contact us if you want to explore what your options are to enhance your 401k plan. We can also work with you directly or with your existing pension consultant, or investment advisor to implement changes to your current 401k plan.
What investment options are available if you want to self-direct your 401k plan?
There is no limit to what investment options are available inside a self-directed 401k plan, withstanding a few prohibited investments. According to the Internal Revenue Code (IRC) retirement accounts cannot be invested in life insurance contracts, a S-corp, or collectibles. These are considered prohibited investments. Excluding these prohibited investments, the plan participant can invest in anything that is allowed in the plan documents. Here are some examples of what some people consider investments for their 401k plan:
- Real Estate
- Tax Liens
- Private Mortgages
- Air Space rights
- Mineral rights
- Precious metals (gold and silver)
- Private businesses or Franchises (LLCs or C-corps)
- Private Equity or Venture Capital
- Medical Equipment leasing
- Payday Loans or Title Loans
Your creativity is virtually your only limitation.
Do you have to use the investments that your company offers in your 401k plan?
Yes. You do have to use the company's investment options. If you are not the plan trustee, then you have very little control over these options. A 401k plan is set up to provide a level of control over 401k plan participant accounts. While the participant can invest any way they want within the allowed investments, they are restricted to those options. It is worthwhile having a conversation with the plan trustee about what you would like as a plan option. Many trustees are interested in making their employees happy and will consider adding more options is requested.
How can you self-direct your 401k?
The first step is to find out if you can self-direct your 401k plan. If you are an employee, then you need to speak with your plan trustee to find out if you have the option of self-directing your 401k plan account. If it is not allowed in the 401k plan documents, then you should request that the option should be offered in the plan. This choice is up to the plan trustee, and you may not have any control over this. If you are self-employed you can set up a solo 401k (soloK) and chose what investments you want in your plan. If you are a plan trustee then you have the choice as to whether you want to offer additional self-directed options or alternative assets in your plan. This will require that you work with a specialist since most plan providers don't have a comprehensive understanding of all the self-directed options especially alternative investments.
How can your company offer additional choices to your employees?
If you are a plan trustee for the company 401k plan, then you have a lot of control over what you choose to offer to the plan participants. There are some suitability requirements which you must follow, but overall there is a lot of flexibility in the plan choices which can provide the employees a high-quality self-directed 401k option.
In addition to a self directed 401k plan, you can also consider a secret retirement plan that your advisors have never told you about. This retirement plan is called a defined benefit plan.
How can you use your 401k or IRA to start a business?
A 401k plan can potentially be used to invest in a new business, although the method of doing this is complicated. It also requires that the person works with a professional who fully understands the details of making this investment properly in order to prevent creating a prohibited transaction. Contact Us to find out more.
What is a bundled vs. unbundled 401k plan?
It is important to understand how a 401k plan works and what components are involved. There are multiple pieces of the 401k plan which most people are not aware of. There is the Custodian, which holds or provides custody for the investments. The investments are held at this firm. Next, is the Third-party administrator or TPA. The TPA is the firm that helps prepare the 401k plan tax returns and accounts for the plan account balances. Then there is the Recordkeeper. The recordkeeper provides the platform which allows the plan participants to manage their investments. They also maintain the participant records, trades, loans, and distributions. Frequently, the recordkeeper and the custodian are one and the same, but not always. Lastly, there is the Financial advisor. The financial advisor's job is to help select the investment choices available within the plan and monitor those choices for any changes that need to be made. Some advisors are even capable of transferring most of the fiduciary liability from the plan trustee over to the financial advisor. This can be a significant benefit for plan trustees who are uncomfortable with taking on personal liability for the plan. It is possible to have other components or professionals involved in the plan, but these are the most common ones.
A Bundled 401k plan is a plan which attempts to bundle most or all of these services in one package for one price. This is one of the more common methods of constructing a 401k plan. However, it is not necessarily the best or most appropriate way. Bundled 401k plans are common because they are easier to understand for plan trustees and it is easier to bundle the plan fees as well. However, the plan trustee may not get exactly what they want from a plan by bundling it.
An unbundled 401k plan is a plan which separates out each of these pieces into separate decisions which need to be made. While this may require more work on the plan trustee's part, it is easier to get exactly what they want in a plan and potentially lower plan expenses as well. Contact Us if you want to know which option works best for your company.
How can Innovative Advisory Group help you with your self-directed 401k plan?
IAG has a unique and extensive understanding of the legal and financial considerations involved in a Self-Directed 401k. We work with our clients to give them as much or as little help as they need, from proper Self-Directed 401k setup to helping them evaluate one or more investment choices to fit their specific needs and avoid common pitfalls. As long as the IRS, DoL and ERISA rules and regulations are adhered to, the imagination becomes the only limitation to an investment portfolio. If you want to learn more about how we can help you with your self-directed IRA, Contact us.
Are you a 401k plan provider or trustee:
Whether you personally have a 401k plan, or you are a plan trustee, plan provider, or plan sponsor, we may be able to help you expand your investment options. Our 401k retirement plan group can help companies add additional benefits to their plan. We offer a unique solution for 401k or group retirement plans. In light of recent economic conditions, more participants and plan sponsors are looking to add alternative investments to their plan choices. We can offer a solution to those requests. Please Contact us to get additional information about this service.
All statistical data on this page is from the Investment Company Institute (www.ici.org)