Check the fine print in picking a 401 plan - k - advice for small-business owners - Small Business Financial Adviser

Nation's Business, May, 1996 by Randy Myers

It all looked so easy at the beginning. One vendor would manage the money invested in the 401(k) plan at Continental Industries Group Inc., and another would oversee the plans administration. All that would be left; to be done by the firms controller, Rhoda Cuthill, would be a bit of minor paperwork as she and her 12 fellow employees began to amass their retirement nest eggs.

Alas, instituting a 401(k) plan for Continental, a New York City-based international trader of industrial chemicals, has proved anything but easy for Cuthill.

Several younger employees don't want to participate in the three-year-old plan because it levies a sales charge of 5 percent on any assets withdrawn within five years of the contribution. (Assets withdrawn between five and 10 years afar a contribution are subject to a sales charge that gradually declines from 5 percent.) That would hurt them if they wanted to withdraw money for, say, a down payment on a house.

With modest participation by lower-earning workers, Continental discovered in 1995 that for the previous year its plan was top-heavy (skewed in favor of higher-wage employees, which is against Internal Revenue Service regulations).

To correct the imbalance, Continental's owners were obliged to make additional contributions to the plan on behalf of all employees, even those who weren't participating, prior to filing the plan's Form 5500 with the IRS for 1994.

Now the owners aren't making contributions to their own accounts in the plan, fearful that it could become top-heavy again. Cuthill, meanwhile, is doing calculations on her own throughout the year to monitor the plan's status, something she thought--before the top-heavy mix-up--that she could rely on the plan administrator to do.

"Unless you're really a 401(k) expert and know exactly where to look for the information, putting in one of these plans is not an easy process," Cuthill concludes.

Sorting It All Out

Fortunately, there is help. Many vendors, from mutual-fund and insurance companies to brokerage firms, now offer turnkey 401(k) services that include plan design and documentation, record keeping and administration, investment management, and employee communication and education.

For a company with only a handful of employees, these plans often cost the employer as little as $1,000 to set up and $2,500 a year to maintain. Even as companies grow, costs are seldom prohibitive.

Pension Dynamics Corp., a pension-administration firm in Lafayette, Calif., recently compared the annual costs of operating 12 different 401(k) plans from 11 different vendors. Each plan had a hypothetical $1 million in assets and 50 participating employees; the average cost was found to be $18,912.

The benefits of such plans can be significant. Employees, including the company's owners, can contribute up to $9,500 of their pre-tax salary to a 401(k) plan (to a maximum 20 percent of their gross salary, including any matching contributions made by their employer), then watch their earnings compound with taxes deferred until withdrawal.

An employee who salts away $5,000 a year in a 401(k) account earning 10 percent a year would have $606,160 after 30 years, even after paying taxes upon withdrawal at a 33 percent rate. In comparison, an employee who made an identical contribution to a taxable account earning 10 percent would end up with $319,960- or about $286,000 less--at the end of 30 years.

What's more, employers can make matching contributions to their employees' 401(k) accounts if they like, a feature that many employees find attractive. But even if the employer chooses not to make a matching contribution, a 401(k) plan can help it retain valued workers.

Facing The Challenge

As Cuthill's experience indicates, though, finding the right plan can be a challenge.

"The average plan sponsor [employer] finds himself sitting down at a table with a stack of three-ring binders describing all these different offers," says Stephen J. Butler, president of Pension Dynamics and author of The Decision-Maker's Guide to 401(k) Plans. "While these offers are clear about what costs to the plan sponsor are going to be, they're not clear about what the cost to participants is going to be."

In some plans, virtually all charges are billed to the plan sponsor. In many others, individual plan participants bear some of the plans costs. Those costs may be in the form of charges for loans or withdrawals from theft account, sales fees (loads) levied on mutual funds offered through the plans, or investment-management fees.

"Where this is a big problem in the small-company environment is where the business owners and key managers may have in their accounts half the assets in the plan," says Butler. "If they've chosen a plan with high internal [participant] fees, they've just relegated themselves to a plan that they're effectively paying for out of their own accounts, with money that otherwise would have been compounding tex-free. It's the worst possible resource for paying fees."

Where Can You Turn?