Between helping patients and running their businesses, physicians are incredibly hard-working individuals. My own advisor practice is dedicated to helping physicians with small offices create sound financial plans and adopt various ERISA plans, like 401ks and defined benefit plans.
A few years ago, I had an opportunity to present to a group of physicians in a rural area in Kentucky, primarily talking about the importance of saving for retirement and the employee-retention advantage of offering a 401k plan through their office.
When I arrived for the presentation, I found out that they had a 401k plan in place for 11 years and were already contributing with the help of a local advisor. We had a great discussion about financial topics as well as life goals, with a lot of comparisons between life in Kentucky and life in New York City, and how big some of the differences were.
Ultimately, we decided to work on individual financial plans and to ensure sure they were contributing the maximum amount to the established 401k. As a fiduciary advisor, I asked for a copy of their 5500 filing to give to our actuary to make sure the office’s reporting was in regulatory compliance.
To my surprise, they didn’t know what I was referring to; the partners had been contributing without any knowledge of a 5500 filing. After further due diligence and some confusion on their part, I was finally able to inform them that Form 5500 is a required filing for a 401k plan if a business has employees and a value over $250,000.
Their plan could have discontinued if we hadn’t realized and corrected the mistake via the Delinquent Filer Voluntary Correction Program (DFVC).
Mistakes like this are common for sponsors with no financial experience who are administrating a 401k plan. Sponsors are the plan fiduciaries with plan documentation or protocols for following ERISA regulations. In some cases, penalties for errors are severe and irreversible, even if those errors were made in good faith.
Here are some of the most common mistakes when operating 401k plans.
To prevent companies from sidestepping IRS requirements for plans to provide benefits that do not favor higher-earning employees, there are laws that treat groups of entities as one for measuring their compliance.
This disallows employers from holding various entities to gain more tax deductions while avoiding equality in retirement benefits. These laws create control groups and affiliated service groups. A control group is a combination of entities with 80% or more overlapping ownership.
An affiliated service group is a combination of two or more service companies with the same ownership where the entities either provide service to one another or combine to offer services to a customer, which is often seen in the medical, legal, consulting, or accounting fields.
As an example of a group and how it can run afoul of the laws, consider a physician who has an incorporated gastroenterology office that is partnered with a larger medical practice. Should the larger practice want to establish a 401k, they would need to take the gastroenterologist’s office employees into consideration for testing or they would violate the IRA regulations.
Not including all employees who are under the control group or affiliated service group designation is considered a serious violation with significant penalties.
All employer-sponsored plans must have a fiduciary who takes on responsibilities for the plan, such as fund selection, performance monitoring, and meeting to make decisions about the plan’s fees and lineup. These responsibilities take up a great deal of time, and nearly half of plan sponsors are unaware of their duties in this regard, as well as the personal liability they risk should the plan perform poorly.
However, these responsibilities can be outsourced under both capacities defined by ERISA regulations, 3(38) and 3(21).
A 3(38) fiduciary is the more involved of the two, taking on the role of investment manager for the plan and the liability risk that goes along with it. This would mean engaging an advisor who would make and implement investment decisions along with continued management of the plan.
On the other hand, a 3(21) fiduciary is an advisor acting as co-fiduciary with the fiduciary within the business. Under this option, the advisor makes investment recommendations, but the company fiduciary makes final decisions and accepts the liabilities. In either case, it may make sense in the interest of time and financial knowledge to outsource these duties.
Due to recordkeeping errors or an unclear definition of which members of their workforce count as eligible employees, plan sponsors often exclude employees from the decision to make a deferral election.
Plan administrators should be trained on the definition of eligibility for new hires, including regular hours worked or length of employment so they can identify those employees who should be provided this notice, as well as protocols for the future to ensure that corrective contributions aren’t needed later on, which must be made by December 31 of the calendar year in which the error occurred otherwise VCP must be used.
There are clear rules established by the Department of Labor for how employers should treat employee plan deferrals: employers are required to deposit the deferrals into the plan as soon as possible and no later than the 15th business day of the next month. Should the employer fail in this responsibility, there are penalties that could go into effect.
An operational error may be corrected using the IRS Employee Plans Compliance Resolution System to avoid plan disqualification. In the case of a prohibited transaction due to disqualification, the correction should be resolved through the Department of Labor’s Voluntary Fiduciary Correction Program. To avoid these disciplinary results, plan sponsors should try to establish protocols that utilize the earliest dates that deferrals may be deposited.
Lawsuits resulting from 401ks exploded in 2020. Many of these cases were related to disproportionate fees incurred by employees.
At the same time, the higher cost of liability insurance and the lower limit ceiling has some employers needing multiple policies to maintain the level of coverage they had previously.
Plan sponsors should review the details of a plan every few years to make sure that fees are reasonable and as low as possible for participants, utilizing the expertise of fiduciary financial advisors to balance the expense ratio of the plan’s mutual funds, the fees relating to the assets, and advisors’ fees.
An ERISA fidelity bond is basically insurance that protects against losses caused by dishonesty on the part of plan officials in a 401k plan. Apart from Solo 401ks and church or government plans, all plans must have at least 10% of their fund total at the beginning of the year bonded, though they are not required to have more than $500,000.
While there aren’t specific penalties for not having this, a plan may have a higher audit risk and plan fiduciaries will be personally liable for losses that otherwise would have been covered by the bond.
However, as this insurance doesn’t have a high cost, it is a large benefit with a small price for plan sponsors to have a sufficient amount bonded.
A common setup in plans is for employee funds to default into money market funds, which have no return. However, there’s no requirement to use money market funds as the default, and it is in the employees’ interest not to.
By choosing target date funds as the default for employee contributions, the funds will be invested immediately and the employees have the potential for at least some return. Employees can choose to reallocate to different funds at any time should they wish to make a change to suit their own personal goals, so this strategy doesn’t lock the employee into anything they may not want to maintain.
While it may seem like an easy step to skip in plan administration, most 401k plan sponsors are required to file Form 5500, which is the Annual Return/ Report of Employee Benefit Plan. Small businesses in which the employees are only owners/ partners and their spouses are allowed to file the Form 5500-EZ for any year in which plan assets exceed $250,000.
To correct having not made this filing, it’s best to reply to the IRS query with the filing and an explanation. To avoid potential penalties in the future, the filing should be scheduled into plan administration so that the due date isn’t missed.
Overall, 401k plans can be complicated to adopt and to continue to administrate. A newer solution for smaller employers is the 401k PEP option. Pooled Employer Plans, or PEPS, let unrelated employers pool assets and employees, creating a larger overall plan that will grant access to benefits not available to small plans. Regulations on PEPs also allow professionals to handle fiduciary responsibilities, further simplifying establishing a retirement plan due to the lower costs and reduced liability.
Nothing is completely free of liability, but working with professionals with an understanding of 401k regulations, challenges, and how to navigate it all can mitigate risk, whichever 401k option a business chooses.
To reap the benefits of these plans while avoiding common errors and pitfalls, it’s worth it to work with both a reputable TPA service and a financial advisor who can help guide employers toward the decisions best suited to their unique situations.
Syed Nishat, BFA is a partner at Wall Street Alliance Group. He holds a bachelor’s degree in business administration from the University of Nevada Reno. Syed holds the FINRA Series 7, FINRA Series 63, and FINRA Series 66 licenses, along with licenses for life, disability, and long-term care insurance. He also has been awarded the Behavioral Financial Advisor (BFA) designation.