The economic recession has taken a toll on many aspects of business, including defined contribution plans. These plans, including 401(k) and 403(b) plans, took a hit over the last several years. Many employees have scaled back the amount that they have contributed to these plans and some employers suspended their matching programs in order to decrease expenses.
As the economy is bouncing back, so are defined contribution plans. It’s important that you properly manage these plans to make sure you get the most of them and are properly saving for your retirement.
“Employees need to understand that they are responsible for their retirement with a defined contribution plan, because they’re contributing their own money,” says Mike Kozlowski, CPA, director, assurance and business advisory services at GBQ Partners.
Smart Business spoke with Kozlowski about how to properly manage defined contribution plans.
What are some important attributes of defined contribution plans?
Defined contribution plans are becoming the norm, as defined benefit plans are going away. The difference between the two is that a defined benefit plan will actuarially determine what the employee’s benefit will be when they retire. Additionally, the employee may not necessarily have to contribute their own money to the plan.
With a defined contribution plan, the employee has their own account where they’re contributing their own money. The employer may be matching those contributions but is generally not obligated to do so. Whatever your individual account grows to would be your benefit at retirement or when you terminate employment with the company.
What are some key items you should understand about defined contribution plans?
Under defined contribution plans, employees take more responsibility for putting money into the pension plan, and generally are in charge of their own accounts. The employee makes the investment decisions based on the available investments options that the employer has chosen for the plan.
These plans will typically have a third-party administrator who can assist the employee in selecting which funds are best for them depending on their tolerance for risk. Most plans have between 10 and 30 investment options to pick from with varying degrees of risk. This allows an employee to properly diversify their investments and will take some of the risk away from the employer.
How does the employer properly manage a defined contribution plan?
There are three areas that employers need to pay careful attention to. The first is timely remittance of contributions. Amounts are withheld from the employee’s paychecks after each payroll and the company will submit those amounts into the plan. Those funds must be remitted as soon as administratively possible, no later than the 15th business day of the month following the month in which the contributions are withheld.
For example, if payroll occurred on Sept. 15, according to the rule, they would have until the end of the month and then 15 business days following that to get those funds into the plan. However, The Department of Labor is more concerned about ‘as soon as administratively possible.’ Funds should be remitted to the plan within a few days of payroll in order to avoid potential penalties.
The second area is the investment options that are offered in the plan. Proper diversification within your plan is important. The plan should have a good mix of different types of investments. Most plans use mutual funds and offer large cap, small cap and mid cap funds. Within those sectors the plan should have growth and value funds or a mixture of both, which would be a blended fund. Other options are available as well, like international or hedge funds. The plan should have some sort of fixed income or money market fund, so those employees who are risk averse or nervous about the stock market can have a relatively safe investment option.
The third area is plan expenses. Plan expenses are hard to determine, because many fees are hidden. Both the employer and employee need to know what expenses are being paid for within the plan. There is direct compensation, which is usually paid by the employer and includes fees to administer the plan, and there are indirect compensation fees, which are paid from plan assets and will impact the employee’s overall investment returns. These include management fees, sub-transfer agency fees, brokerage commissions and 12b-1 distribution fees. All those fees are being charged one way or another within the plan, and they’re usually hidden, so you don’t necessarily see them coming out of your account. They are basically netted against plan earnings and the employee’s individual account. These fees will vary depending on what share class of mutual fund the plan has invested in. If an employer does not know what fees are being charged they should have a cost audit performed to determine what the fees are and whether they can be reduced.
What are the benefits and risks of defined contribution plans?
The benefit of 401(k) plans is that the employee is saving for retirement. Contributions generally come out pre-tax, so the employee is not getting taxed on the amount that they have put into the plan. Some plans also allow for Roth contributions, which mean the employee is putting post tax dollars into the plan. If certain conditions are met when the Roth amounts are taken out of the plan, those amounts plus the earnings would be tax free.
The risks are similar to any investment risk out there. Over time, these investments should be appreciating in value, but it’s possible that you could incur losses in certain years as was the case in 2008 when many 401(k) plans had losses of 30 percent or more. The market bounced back in 2009 and has performed well so far in 2010.
Mike Kozlowski, CPA, is the director, assurance and business advisory services at GBQ Partners LLC. Reach him at (614) 947-5256 or firstname.lastname@example.org.