036: How Does a 401k Plan Work?
Nov 23, 2020
Business owners have a lot of choices when it comes to providing employee benefits, and one of the biggest benefits available is the 401(k). However, many employers don’t know how they work, what their liability is, or how to protect themselves.
If you’ve had a job with benefits, you’ve likely had a 401(k), but implementing one as an employer is another story entirely. Today, we’re walking through everything that you need to know as an employer about how 401(k) plans work, how to implement them, and why it’s so important to have an advisor who’s focused on them in order to help both you and your employees benefit.
Here are just a handful of the things that we'll discuss:
- How a 401(k) advisor can help business owners make sense of planning and implementation.
- The many different individuals and government organizations involved in 401(k) implementation and administration.
- Why 401(k)s are not one size fits all plans – and how people accidentally put themselves at risk when dealing with 401(k)s.
- Why mistakes with 401(k)s can be very expensive – and how to best avoid them.
- “You have to find someone that you like, trust, and want to do business with.” – Ed Siddell
LeAnne Siddell: It’s The Retirement Trainer with Ed Siddell, a podcast about finding ways to help you become financially fit for your future no matter what shape you’re in now. Business owners have a lot of choices when it comes to benefits for their employees. And one of the biggest benefits is the 401k.
So, how do employers wade through the confusion of how they work, the cost, most importantly, understanding the liability and how to protect themselves? This is LeAnne Siddell and here to help us wade through all of these questions that we have and give us some guidance and put us in the best financial shape possible, The Retirement Trainer, Ed Siddell. Hello, Ed.
Ed Siddell: Hey, LeAnne. Sounds like it’s a little crazy. Putting together a retirement plan, there’s a lot of cooks in the kitchen.
LeAnne Siddell: Yeah, there is. And so, the 401k being that there is so much to wade through, let’s try and simplify this as much as possible to help employers know, what’s especially important for these employers to know?
Ed Siddell: It’s confusing. Let’s just call this the 401k basics, okay, because normally, when we talk about a subject like this, we try to do it from a 30,000-foot level, we’re really going to have to drop down and do it from like, a 10,000-foot level because there’s a lot of details that we can’t leave out, even when we’re just talking about the basics.
LeAnne Siddell: Well, I think that’s probably the one thing that I wanted to touch on before you got started was just to say, all of us have been involved in a 401k if you’ve been in the working world and we see it from the employee perspective, but boy, oh, boy, you have no idea what the employer is telling me about their side.
Ed Siddell: You and I, I mean, we see it from all three, as the advisor, as an employer and a participant. So, the first step for an employer and we’re talking about someone who’s an employer who’s not offered a plan before, but thinking about it, is to really try and figure out why you’re offering it. Is it so, as the owner of the business, you can put more money away? Is it a benefit for the employees and help them with their retirement is a combination of both? And what we’re seeing right now, living in crazy town with COVID and everything else, I mean, as we’re going through our quarterly meetings and even our year-end meetings with all the plan sponsors, the employers, we’re reevaluating why they’re doing it.
So that’s an ongoing question, just to make sure that the benefit that they’re providing still suits their needs. And one of those is, do we offer a match? And how does the match work? And is it safe harbor? Is it profit sharing? And we’re not going to get into that. That’s a whole topic for another day, but these are the questions and that’s why it’s so important to have a good team and have a good advisor that really focuses on 401k. And I’m not talking about an advisor that has one or two or five or 10 plans, I’m talking about, that’s their focus or a big part of their practice for their firm because it’s complicated. And so, if you’re working with someone that specializes in this area, they can kind of help you navigate the turbulent waters, if you will, and make sure that it’s smooth sailing. Well, that was very corny, but yeah.
LeAnne Siddell: No, but you don’t know what you don’t know. And sometimes, having somebody there that has already navigated the waters makes it a lot more smooth and you have somebody to fight your battles for you and that advisor. So, how do employers know what to choose?
Ed Siddell: Well, all right. So, again, working with an advisor, it’s the discovery process. So, we just met with another company who wants to put in a 401k plan for next year. And it’s the discovery process, why do you want to offer it? Is it for a benefit just for the employees? Do you want to offer a match? The owners of the business, do they want to contribute? Is it for them to maximize their contributions? We’re not going to get into that in a whole lot of detail, but basically speaking, if you’re under the age of 50, the full contribution, you can do both a traditional and a Roth and a 401k up to 19,500 for 2020 and 2021. And if you’re 50 and older, it’s an extra $6500. So, you’re looking at $26,000 that you can actually put into a Roth or a traditional 401k plan if you’re trying to get the deduction before any match or anything else. Okay. So, why do you want to offer it? I mean, that’s the big thing.
And then, once you figure that out, you get a census which is all the employee data and you put together what we call a feasibility study. And that feasibility study, as a business owner, as we are, I mean, it’s all about cash flow. And so, you need to go into an offering a benefit eyes wide open and know what the costs are. And so, often, it’s so cloak and dagger, most people don’t understand what all the fees are. And I’m not just talking about the third-party administrator fees, the setup costs, I’m talking about the employee costs. And so, that feasibility study kind of puts everything together, so per pay period, per quarter, on an annual basis estimated what those costs could be on an average for your industry, as well as what the maximum costs are, so that you can prepare for it.
LeAnne Siddell: Got it. Now, all those lining up the questions to get answered is probably some… So, let’s talk about the parties involved.
Ed Siddell: There’s a list, and there is. So, the first one which is the most important is the employer. So, the employer, once they decide to have a plan in place that they’re sponsoring that plan and so, they are actually called the plan sponsor. So that’s the first one. The second one is the trustee and that is also typically the employer as well. And then, you have the person that administers the plan for the employer and that can be either the owner of the business or sometimes, it’s the HR or CFO or controller or just someone in the office who’s the go-to person, that catch all, that does everything. And that’s important. That’s such a big job. And we’ll talk about liability here in a minute.
LeAnne Siddell: That’s what I was just going to move in that direction is to say, da-da-dan, who gets that title?
Ed Siddell: Well, yeah, and so, then, you have the record keeper. The record keeper is I equated to a bookkeeper. So, they’re the ones that make sure when the money comes out of your check as a participant, that it goes into your account. And that’s really, really important. And then, the next party is called the TPA or third-party administrator. Now, a lot of times, the record keeper and the third-party administrator, it’s the same company, but they can also be separate. And I equate the TPA or third-party administrator as like the CPA.
So, they reconcile the bookkeeping every pay period, every month. They file the tax returns, which are called the 5500s with Uncle Sam, the IRS, who’s also a party, we’ll talk about that here in a second and the Department of Labor. And they make sure that all the notices are sent out to the employer and then, it’s the employer’s responsibility to get those notices to all the employees and disclosures and fees, etc.
Then, you have the custodian, so everyone forgets about the custodian, but they’re extremely important because that’s where the money is held. And when we’re talking about 401k’s, it’s a protected asset, so that money is held in trust. And so, for your 401k, when everyone, each individual participant, those accounts cannot be rated as part of ERISA, Employee Retirement Income Security Act of 1974, which we’ll get into. So, the custodian is really important.
And then, you have the advisor, which we’ve already touched on a couple more times, we’ll probably touch on it a little bit more, but their whole job is to be the fiduciary to take the brunt and act. If they do their job right, they do all the heavy lifting. They kind of act as the quarterback for us and for those who do this for a living, as far as the 401k’s. They are the quarterback. On an annual basis, we do the RFPs or the request for proposals from, not just the current TPA, but everyone else to make sure that we’re getting the lowest fees possible for our clients, the people that we’re helping, as well as meeting with the participants and everything else.
LeAnne Siddell: I was just going to say, the education of the employees, what they’ve got.
Ed Siddell: In developing those relationships and helping people understand why it’s so important to fund your own retirement. And then, you have the two sets of three initials…
LeAnne Siddell: That you already kind of touched on there.
Ed Siddell: The IRS and the Department of Labor. And they have separate roles, but they’re conjoined. And it’s really important and it is to protect all parties involved, just to make sure the money is going where it’s supposed to go, that the matching is going where it’s supposed to go, there is no overcharging of fees by any one party involved. And so, those two provide a series of checks and balances along with everyone else.
LeAnne Siddell: Well, I always say I like to compare 401k’s to mortgages and how they’ve morphed and how it changed over the years. They used to be, you just sign on the dotted line of this two-sheet piece of paper and then, all of a sudden you got a disclosure that’s added and another layer. And I think that’s the same way with 401k, you’re seeing all these layers that have been brought into it. But again, it’s because generally, there is something that has gone unsaid or undone and they needed to bring a layer in.
Ed Siddell: Yeah, generally speaking, the EGTRRA, the PPA 2006, all these different laws that have come into play have really benefited for the most part, the participant and added protections to the employer to make sure that they’re not being taken advantage of. And so, it is a coordinated effort. And that’s why having someone to manage the team is so very, very important because it’s really easy to get into the weeds, but it doesn’t have to be. In our industry, the financial services, it’s a completely different language, it’s a foreign language. Now, think of the 401k and the retirement planning space, it’s a different dialect of that language.
LeAnne Siddell: Well, that’s why I liked the fact that you broke down all the different names involved and who they were because essentially, you start talking TPA, you start talking record keeper and people are confused. They just don’t understand.
Ed Siddell: It’s overwhelming.
LeAnne Siddell: Yeah, it is.
Ed Siddell: I mean, it really is.
LeAnne Siddell: So, again, sounds like it’s a little over the top, but moving forward.
Ed Siddell: Well, all right. So, once you decide to have a plan or you have it reviewed and I encourage, even our own clients, those employers that we’re working with, which is why we do the RFP. Every year for every client is, you want to have your plan reviewed and you should be getting that review for your investments and everything on a quarterly basis. And then, once a year, have a full-done review. It’s really not an audit because it’s not certified, but that’s basically what it is. Just to make sure that you know what happened this past year and what it’s going to look like next year, again, for cash flow.
Doing that feasibility study is what we talked about. And the question that you really have to ask yourself because it’s amazing doing this for so many years, we still come across employers, where they are their own fiduciary and they just don’t understand the liability. And as we go through, we’re meeting with them and we’re helping them out and breaking it down, they’ve done a great job, but again, that’s not their job, their job is to do what their business for.
LeAnne Siddell: That’s not what they specialize and that is a task.
Ed Siddell: Yeah, absolutely. And I always look at it as, if the advisor does the job the right way, they should pay for themselves. And that’s really what it comes down to. Typically, a lot of times, the fee should be a little bit lower than helps cover the cost and in the time savings. I mean, just think about the hourly wage that you’re losing when you’re having to spend as an employer all that time on that plan.
LeAnne Siddell: Well, that’s why I’m going to back you up and I’m going to say the first step is, because there are a couple things that you mentioned in there, but I want to start the first step that once they make the decision to have a plan, what is the first step?
Ed Siddell: Well, to do the feasibility study. Well, the first step is to hire a good advisor. That’s number one. So, you got to build your team. So, you got to find someone that you like, you trust, and you want to do business with. That was actually given to me by a very dear friend of mine who’s since passed, but those were words of wisdom that I heard 15 years ago and have continued to live by. And that’s really what it comes down to.
So, build, start with your team. And then, once you kind of have that person, that go-to person, the person quarterbacking your whole plan, then you do the feasibility study, which is to figure out, okay, what is my cash flow? How much is this going to cost me? Does this make sense? What are the other options and just touching on it, then you have non-qualified deferred compensation, where risk doesn’t come in and you have all these other things that you can do. So, that’s why we’re doing this at a 10,000-foot level just on the 401k basics.
LeAnne Siddell: Well, again, I feel like this was one of the big things that I had to really… the word fiduciary is thrown around so much, people hear it all the time, people say, “Are you a fiduciary?” What does that mean? But again, I’d prefer you to give that big picture, what is a fiduciary?
Ed Siddell: All right. So, fiduciary, legally speaking, so it’s a legal definition. My definition of fiduciary is to do what’s in the best interest of the person that they’re serving, whether they make a penny on it or not. So, that’s the general. Now, under the Department of Labor and the fiduciary role that keeps changing, depending on who’s in the White House and heading up the SEC, but in the world of ERISA which is the Employee Retirement Income Security Act of 1974 and all retirement plans, pension plan for federal employees, which are TSPs, Thrift Savings Plan, a fiduciary is anyone who exercises discretionary authority or control over plan assets, and here’s the kicker, or anyone who provides investment advice directly or indirectly for compensation or who has authority to do so, so the plan administrator.
And this is why when we meet with the employers and I say, “Are you the plan administrator?” And everyone looks at me like, “What?” What does that mean? So, who typically handles it? Oh, yeah, that’s not me. That’s so and so.
LeAnne Siddell: But I don’t even think the person that actually does the tasks of the plan administrator knows that they have the title of plan administrator at times.
Ed Siddell: You’re right. And that’s the whole thing. And so, understanding that because just by doing the act and having control over the plan, they’re now a fiduciary. And so, they are professionally and personally held liable for things that they do and/or don’t do or say. And that’s why hiring that person, going back, you want to make sure that you have that advisor that… Education, when we have that first meeting, it’s a group meeting, that’s why we call it education on enrollment. And it’s not just for the participants, it’s for the staff who’s running the plan, whether it be the owners or the bookkeeper or the CFO or whoever it is.
LeAnne Siddell: And using us as an example, when we schedule these and we do them, you schedule time individually with the employees and then, you schedule time with the staff, it’s not something where you’re doing this mass, everybody fits in the same.
Ed Siddell: One size fits all.
LeAnne Siddell: It’s not, it’s individual.
Ed Siddell: Yeah, a lot of times you’re putting a square peg into a round hole or vice versa and that’s the job. So, a quick list of those that have authority directly or indirectly, it’s the plan sponsor who is the employer, the trustee who is typically the employer, the plan administrator who is either the employer or an employee. And here’s the big one, that we still see a lot of, anyone who’s on the investment Committee who’s making those decisions as to what that lineup is going to be for the plan. What they don’t realize is they’re putting themselves at risk, that’s the craziest thing is to have an investment committee because, I get the premise, hey, we want to decide and we’re going to bring someone in from each job class from the owner to the administrative pool to HR to the line all the way down to the bottom. And so, you have a rep from every one on there and it’s not fair. They don’t understand what they’re doing to themselves.
LeAnne Siddell: At risk.
Ed Siddell: Yeah. So, the remedy is, there’s a couple different types of fiduciaries and we’ll get into what these are, but I want to say first, so it’s not new, so you have a 316 and that’s usually the owner of the business, the plan administrator. You have the 321 which is non-discretionary investment advisor and then, you have a 338 which has the control. And what a good advisor does as they’re going through that discovery period is finding out what they’re wanting to do and make sure that you’re putting those protections in place to protect the people that you’re helping. I mean, that’s really what the goal is.
LeAnne Siddell: And I do think a financial advisor on a plan serves many different parts of the puzzle in both protecting the employer and protecting the employee, giving counsel and advice. There’s a lot that’s involved there, but what I want everybody to understand is right now, they don’t have to. Correct?
Ed Siddell: Well, yeah, because, as we’re going through this, I’m sure people are like, “Oh, my gosh, I’ll never have a 401k plan,” or “Oh, my gosh, I can’t believe we have one and I didn’t even understand it.” That’s not the purpose of this. So, I equate it to, let’s just say that you want to build a house, you’ve never built one before. And so, now, all of a sudden, you’re going to build one, you have no experience, you don’t have a construction management degree. Number one, unless you have all the cash, a bank is not going to give you money because you don’t have the experience.
And chances are, if you’re in that situation, you kind of know what you want, but you also know that you’d be crazy to try and build a house on your own without any kind of experience. Think of it, it’s the same thing. You’re going to want to hire an expert, you’re going to want to hire that contractor that’s going to ask you, all right, how many bedrooms? How many bathrooms? In my case, do you want a five-car garage? I would love to. So, I don’t have to work on the cars out in the snow. I mean, all those things and so, then you start off with the blueprint. That’s the feasibility study.
And so, then once you know what you’re building, then that blueprint, you’re going to be able to base on the blueprints, determine what the cost of that build is going to be. And then, that general contractor, their job is not to say, “Here you go, you’re off on your own.” Their job is to say, “All right, if you’re okay with this, let’s go ahead and get started and we’re going to start with a foundation first,” because you don’t want to start building the roof, you got to have the good foundation which is the custodian third-party administrator, the bookkeeper, and so they’re going to go out and interview to make sure that they’re getting the best prices possible for you to fit within your budget and to hit your goals.
LeAnne Siddell: That was the one thing I was going to say. It’s also knowing somebody who knows what it should cost, who knows what a fair price is because, again, everybody charges differently from the custodians to the TPAs, they all charge differently,
Ed Siddell: And making sure that you’re getting value. It’s not always about the cheapest price, but if it’s a starter plan, you also want to make sure you’re not paying the same cost, as to 50/50 person, company, or 150 person company with that minimum fee, that just doesn’t make any sense. And that contractor, they’re going to do what they’re doing because they also want to make sure that they’re taking on the liability of the build, they’re taking on the liability of making sure that you’re protected. If anything were to happen, it falls on them. It’s the same thing with hiring a good advisor. Their whole job is to protect the homeowner or the employer.
LeAnne Siddell: And I’m only going to use myself as an example, I have had to learn a lot of things, in some ways by accident or by making mistakes and I don’t recommend that for anybody, but essentially, something like this is one of those big items that you don’t want to learn by mistake on a 401k plan.
Ed Siddell: Yeah, a mistake can be expensive,
LeAnne Siddell: It can be very expensive.
Ed Siddell: So, the takeaways, I guess, would be, because we can go on forever, but I think people would be like, “Oh my gosh,” but really, the number one takeaway is to hire good contractor, hire a good advisor that’s going to protect you, that’s going to do the heavy lifting, that understands, and that’s the bulk of their practice. So, like I said, not someone who’s got a couple plans, but that has a lot of plans and a lot of experience.
LeAnne Siddell: That’s where that’s going. When you say a lot of plans, it’s because they’ve dealt with a lot of different issues along the way.
Ed Siddell: Yeah, and it’s ever changing. And so, then the next thing is part of that protection is to make sure that they understand whatever that team that you’re putting together, the levels of fiduciary responsibility and to help remove that liability from you. So, we offer through the companies that we partner with, the 316, and we have a couple of clients that love that because they do nothing. The 316, that’s when a company comes in and acts as if they’re the employer and they take care of all the notices, the filings, and set up, that’s who we contact for the education enrollment meetings.
Now, obviously, the employer is kept abreast, but it’s one layer of fiduciary protection. And especially, as a plan administrator, as an employee, you’re kind of taking these things off the books and it’s much cheaper than paying someone an hourly rate as a part-time job, typically. Then, the next one is the fiduciary consultant, that is a non-discretionary consultant. Typically, that is someone who’s not making the decisions but kind of help advise an investment committee or if an employer is like, I’m going to make all the decisions which is crazy because now, they have all the fiduciary responsibility.
But the 321, their job, as part of it, is to meet with all the employees on a one-on-one basis and help them with their investments and as part of their overall retirement planning. Then, you have the 338, so that is the investment manager, that their job, and we act as this, too, is to pick the investments, the fun lineup and remove that responsibility from the employer, the investment committee, and as well as swapping those funds out. So, we do that throughout the year, not just on a quarterly basis. Now, especially this year, we’ve swapped out more funds with all the craziness going on and lack of performance and fees and because our ultimate goal, if we do it the right way, we want to exceed the Department of Labor standards. We want the majority of our funds not just in the top 50% but in the top 25 percentile over the one-year, three-year, five-year term.
And as part of the fiduciary responsibilities, then you want to make sure that you have a written, we call it an IPS, which is an investment policy statement that dictates and is another layer of protection for the employer that says, look, if this happens, then this is how we pick our investment selection, this is how many times we’re going to meet with the employees and educate them. And that whole thing, that’s what that investment policy statement is and have it documented as well as what that review process. Then, you’re going to want to constantly have your plan reviewed and monitored and get those reports on a quarterly basis because, again, you can’t completely remove yourself as a fiduciary when you’re sponsoring a plan, but if you put in all these layers, you got to get through all those first before they get to you.
And then, that’s the number one key and this is part of the agreement. Before we work with any employer, we say, “Look, you have to agree to meet with us throughout the year because otherwise…
LeAnne Siddell: We can’t do our job.
Ed Siddell: We can’t do our job.
LeAnne Siddell: And this seems to be a common theme for you and all that you do are all that you give counsel, but the plan is so important. So, again, we’re talking about a plan here, but whether it be 401k, whether it be your personal, there’s always a step that makes…
Ed Siddell: It’s a process. Everything’s a process, yep, step by step.
LeAnne Siddell: All right, Ed. So, how can business owners and other people learn more and make sure that their 401k or pension plan is the right fit for them?
Ed Siddell: They can call us right here at the office. We’re right here in Dublin, Ohio at (614) 526-4118 or send us an email. They can even send it directly to me at email@example.com and look, there’s no cost, there’s no obligation. We’ll actually meet and do an RFP and do a feasibility study and see if we can help you out.
LeAnne Siddell: Or you can reach us by going to our website at www.egsifinancial.com. Give us a call at the office, again, (614) 526-4118. Thanks, Ed.
Ed Siddell: Thanks, LeAnne.