For years, there has been debate on how much and where companies were investing their employees money as part of their 401(k) plans and whether it was the best process. If an employer was going to use at least a part of its employees earnings as investments, it stands to reason those employees would want to be sure it’s a solid investment.
Now, new regulations have been put in place that places a bigger responsibility on employers to make their investments more transparent. It’s all comes down to communication and within the next week, employees should begin seeing the results of those efforts. The goal is to drive the fees down while also – ideally – increasing the returns. And it’s about to become very detailed as companies around the nation move forward with the new guidelines.
The IRS defines a 401(k):
A 401(k) plan is a type of tax-qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pretax basis. Generally, these deferred wages (commonly referred to as elective contributions) are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 (PDF) since they were not included in the taxable wages on your Form W-2 (PDF). However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.
A look at history reveals a slow transition in terms of who shouldered the responsibility of employee retirement. In the 70s, things really began to change. Employers were slowly opting out of covering their employees and that often resulted in an employee not being able to retire as soon as he’d hoped simply because the days of a guaranteed pension were dwindling down. Enter the rise in popularity of the classic 4019(k). Soon, employers would shift their own way of thinking and began contributing to employees’ retirement funds once again – but in a fairer division of who invests what. The biggest reason millions chose this plan was because of the plentiful tax advantages. Taxpayer/employees never had to pay gains on the money until they retired and then began using the money.
In the past decade or so, new concerns have popped up, specifically, the willingness of an employer to bring in a third party, usually some type of broker, to handle the elective contributions. That meant a this broker or overseer stood to rake in handsome fees for their services. Worse, the participating employees often never knew of this outside party.
The problems with the current employment 401(k) programs are many, though the new transparency rules are sure to make it a more fluid process.
Currently, small investors often find these programs, as they are now, a heavy burden. They’re more expensive and they’re unfair. A pizza delivery guy pays three percent a year in retirement fees based on his specific income bracket. But so do the nation’s wealthiest. Proportionally, the pizza guy will feel it while the nation’s wealthiest will hardly give it a second thought. It’s realistic that a middle class household with two working adults could spend more than $155,000 over their lifetime in fees associated with their retirement.
There’s also an absence of other lower cost offerings; employees don’t have a choice in how the money’s invested.
Another interesting fact is 71% of folks have no idea that they’re even paying 401(k) fees.
Now, though, these new rules will level the playing field and put the employer and employee on equal footing. Employers must now ensure those disclosures are sent out immediately while they must also disclose these fees to employees in a yearly letter, and within each quarterly performance statement those employees receive for their holdings in your 401(k).
Another important change is the requirement that employers begin considering replacing the more expensive funds with those that are similar, though with lower expense ratios – and by “expense ratios”, it means lower fees that the funds charge. Further, price shopping requires a comparison of same fund types. There can no longer be comparisons of, say, foreign bonds to U.S. government bonds.
The rules also require a move from actively managed to passively managed funds. With an actively managed mutual fund, money managers try to outsmart the market by buying and selling winning investments. The problem is that very few succeed (the market beats 72% of professional investors).
Ultimately, the goal is to provide an easier to understand investment process so that employees aren’t overwhelmed and that they can understand exactly what’s going on with their money. Lowering the fees makes it a better process for those employees and the transparency is something that’s long overdue.