Many employers today offer retirement plans to their employees, very commonly set up as a 401k plan. These retirement plans can be an excellent way for investors to build their retirement with help from their employer, but there are many pitfalls to be had if the plan administrator does not understand what to watch out for.
What is a 401k?
A 401k is a tax-advantaged retirement plan that is typically sponsored by an employer. 401k plans are a type of Defined Contribution plan where the plan defines the level of contribution that can be made.
A 401k can be either a traditional or a Roth, tax treatment being the main difference.
Traditional 401k’s allow employee contributions to reduce their income tax burden for the year that the contributions are made, with distributions being taxed later on. In a Roth 401k, employee contributions are made post-tax, but distributions are later tax free.
These plans can be an excellent and easy way to build your retirement, but can be very difficult to navigate with the continually evolving regulations that govern them.
In fact, the vast majority of 401k plans are fundamentally flawed, riddled with conflicts of interest and regulatory issues that can be extremely complex to navigate without the help of a professional fiduciary.
What is a Fiduciary?
A fiduciary is an individual or organization which acts on behalf of another individual or organization to manage investments. A fiduciary has a duty to act in good faith and trust on behalf of their client.
“Being a fiduciary represents the highest legal duty of one party to another, and requires being bound ethically to act in the other’s best interests.”
A fiduciary may be responsible for general well-being, but will typically involve overseeing or managing the assets / investments of another individual or organization. A few examples of professional fiduciaries are money managers, financial advisors, bankers, accountants, executors, board members, and corporate officers, all of which are bound to their fiduciary duty to act in the other’s best interests.
Pick the Right Fiduciary
Investors should be careful when selecting a fiduciary, for not all are qualified to act on behalf of the clients best interests in an investment capacity.
Just like a professor, they may be highly effective and knowledgeable in one area but are lacking in other areas.
By having one’s investments managed (or at least thoroughly reviewed) by a Registered Financial Advisor, many potential conflicts of interest can be identified and / or eliminated.
But why a Registered Financial Advisor?
Financial Advisors are fiduciaries, and as such are held to a much higher and completely different standard of care for their clients than Brokers (who are not fiduciaries) are.
Fiduciaries such as a financial advisor must always act in their clients best interests.
The structure of the relationship between a client and a Fee-Only Financial Advisor is also significantly different than other financial professionals, as advisors lack any incentive to generate excessive commissions (as they take no commission). Also, advisors receive no benefit to peddle proprietary investments as most advisors charge a flat rate management fee based on Assets Under Management (AUM).
Because registered investment advisors have a duty to always act in the best interests of their clients, the incentive structure is built into the relationship to accomplish just this, with the advisors’ incentive (fee based on AUM) tied to the client’s success (growth of investments).
Relationships where the interests of both parties are aligned help to reduce or eliminate conflicts of interests.
Common 401k “Pitfalls”
Common mistakes that uninformed employers or plan administrators can fall victim to include:
Not knowing that a business owner is a fiduciary
Relying on a broker for investment advice
Not knowing your responsibilities as a plan sponsor
Using active management
Relying on Section 404(c) for reduced Liability
Not understanding plan costs, commissions, or fees
Not having an investment policy statement
A recent article describes the two types of fiduciaries that can help employers and plan sponsors / administrators avoid the various pitfalls described above:
“A 3(21) investment adviser is a co-fiduciary role, whereby an adviser provides advice to an employer with respect to funds on a 401(k) investment menu, and the employer retains the discretion to accept or reject the advice.
A 3(38) adviser has the discretion to make fund decisions. The plan sponsor has less liability in this relationship, because they offload fiduciary risk for investments to the adviser; however, employers still carry a fiduciary duty to monitor the adviser.”
When properly managed, 401k plans can be outstanding vehicles for building retirement, but without the management of a professional fiduciary (or at least a thorough review of the plan from time to time by one), there may be conflicts of interest lurking in the plan, eroding the benefit to investors.