When we talk about the 401(k) plan, the type of plan most of us usually have in mind is known as participant-directed 401(k) plan. In participant-directed 401(k) plans, all participants get their own personal account and are responsible for managing their own investments. However, the participant-directed 401(k) plan isn't the only type of 401(k) plan available. A common type of plan that was popular back in the '80s—called trustee-directed or a "pooled" 401(k) plan—is staging a comeback, and for some very good reasons. In this article we'll discuss pooled 401(k) plans and explain why a pooled plan might be a better choice for a small practice than a participant-directed 401(k) plan. Before adopting any retirement plan, a thorough analysis must be done to make sure that a retirement plan makes financial sense for your practice.
What is the difference between participant-
directed and trustee-directed (pooled) plans?
In participant-directed plans, every plan participant has his or her own account and is responsible for managing the investments. In participant-directed plans, the plan sponsor has fiduciary responsibility to select plan investments and provide participant education.1 Participant-directed plans require the services of a third-party administrator (TPA), a record-keeper, a custodian and an investment adviser (who is typically an Employee Retirement Income Security Act—or ERISA—fiduciary chosen to assist the plan sponsor in performing its fiduciary duties, thereby limiting plan sponsor's fiduciary liability).2
Pooled plans have a single trust account managed by the plan sponsor (the trustee). All plan contributions are commingled, and are tracked by the TPA. A discount brokerage, such as Vanguard, is typically used as a custodian, and there is no need for a record-keeper. Plan participants do not have individual accounts, and get no say in how their investments are managed. In a pooled plan, prudent investment management is the plan sponsor's primary responsibility. This service is typically provided by an investment adviser who is an ERISA 3(38) fiduciary, also known as an investment manager. As long as the investment adviser is taking full fiduciary responsibility for managing plan investments, the plan sponsor's only duty is to select the investment adviser.3
Why would I want to consider a pooled 401(k) plan?
The three key reasons to consider a pooled 401(k) plan for a small practice are as follows: to limit plan-sponsor fiduciary liability; to reduce the complexity and cost of the plan; and to provide plan participants with top-notch investment management services.
Because of a 2008 U.S. Supreme Court decision, plan sponsors are financially liable for fiduciary breaches such as high investment costs, lack of participant education and participant investment losses. Smaller plans rarely get the benefit of fiduciary advice, so they are exposed to liability due to fiduciary breaches, including fiduciary breaches resulting from the actions of any of the plan service providers. A pooled 401(k) plan can be a great way to reduce your plan-sponsor fiduciary liability. As long as you have an ERISA 3(38) fiduciary taking care of plan investments, your own liability for managing investments is eliminated. Because there are no participant-directed accounts in a pooled plan, you don't need to worry about 408(b)(2) fee disclosures, qualified default investment alternatives (QDIA) selection and disclosures, fee benchmarking or participant education and advice (see Table 1). These are services that a typical participant-directed 401(k) plan has to provide for the benefit of plan participants, and for which the plan sponsor is ultimately responsible.
Participant-directed plans have many moving parts, and the plan sponsor has to both monitor service providers and at the same time rely on the service providers to make sure that everything is done correctly (while still being liable for any mistakes that the service providers make). Pooled plans can help reduce the complexity of the plan's architecture and decrease the plan sponsor's compliance burden, allowing the plan to be set up more quickly and making it much easier to operate and maintain.
Having a plan with a professionally managed investment portfolio can help you and your employees achieve better investment results, especially if you don't want to worry about managing your own investments. In a participant-directed plan, even with the best advice provided to participants, each participant has to still follow through and make the right choices. Having a single managed account eliminates this problem, and all plan participants will benefit from getting their investments professionally managed.
Table 1. Plan sponsor responsibilities for pooled vs. participant-directed plans.
How does the cost of pooled plans compare to the participant-directed 401(k) plans?
Small-practice plans pay some of the highest asset-based fees compared to large-company plans, and since most of the plan assets belong to the practice owner, this can be a significant cost over the long term. Because pooled plans have no record keeper and no asset-based fees, the long-term cost to manage and maintain a pooled plan can be substantially reduced.
A stand-alone TPA can provide plan administration, and a discount brokerage, such as Vanguard, can be used as a custodian. Vanguard has one of the best selections of low-cost index funds available, and that alone will ensure that your investment expenses are low. Investment management in pooled plans can be provided for a flat fee (rather than an asset-based fee), so that compounding will work for you, not against you.4
Would a pooled 401(k) plan work for my practice?
A pooled plan is not an ideal type of plan for larger practices with multiple owners who want to have control over their individual accounts. A small practice with one owner (or with several owners who don't want to manage their individual accounts) may be a good candidate for this type of plan. A pooled plan makes employee choices simpler by limiting their decision to specifying the salary deferral amount, and your employees will be happy that they don't have to deal with investing because few employees know how to effectively manage their investments. A pooled plan is arguably the best and most cost-effective way for a small practice to get the benefit of a professionally managed retirement plan with the highest fiduciary oversight and liability protection possible.
What about using the same portfolio for younger and older employees in a pooled plan?
Several considerations must be taken into account when designing portfolios for pooled plans. Employees will come and go, and some will stay with the practice for the long term. For those employees who leave the practice quickly, the amounts withdrawn from the plan will be relatively small. In time, most of the assets will belong to the owner and long-term employees, so withdrawals will not appreciably affect the portfolio. Because most of the money will be invested for the long term by the practice owner, the type of portfolio most suitable for pooled plans is a globally diversified, balanced portfolio that uses low-cost index stock and bond funds. Such a portfolio can be custom-designed for each practice, depending on practice demographics and turnover statistics.
Why haven't I heard of pooled 401(k) plans before?
Pooled plans have been around for a long time, but fell out of favor in the '90s when plan participants started to demand more control over their individual accounts. Market gains in the '90s created unrealistic expectations that individuals could manage their own portfolios like the pros, but the recent bear markets have shown otherwise. A small number of knowledgeable advisers are still using pooled 401(k) plans for their clients, so pooled plans remain an open secret.
Unfortunately, some advisers who provide investment-management services are using pooled plans as a way to get more assets under management and charge high asset-based fees, so practice owners have to select their plan advisers very carefully. Given the advantages of pooled plans over participant-directed plans, small practices can benefit immensely from what pooled plans have to offer.
Konstantin Litovsky is the founder of Litovsky Asset Management, a wealth management firm that offers flat-fee, comprehensive financial planning and retirement-plan advisory services to doctors and dentists. Litovsky specializes in setting up and managing retirement plans for small practices, including 401(k) and defined benefit/cash balance, and he can be reached at email@example.com.
Nora Bethman, CEBS, QKA, QPA, ERPA, is the president of National Employee Benefit Services Inc., which provides comprehensive plan design and administration (TPA) services for retirement plans, including 401(k), cross-tested profit sharing, cash balance, defined benefit, 403(b), 457, non-qualified, SEP, SIMPLE and ESOP plans. Other key services include compliance review, fee benchmarking, fiduciary training/consulting, voluntary compliance program filing, and IRS/DOL audit assistance..