Archives for October 2013

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What’s Involved in Switching 401(k) Providers?

One topic readers frequently ask about — especially since the Frontline documentary earlier this year — is how to get their employer to switch to a less expensive retirement plan provider. While I’ve shared some thoughts on how to campaign for changes, I’m at a loss with regard to questions about the process itself, having never been involved with it.

Fortunately, Linda Wolohan of Vanguard’s PR team was able to gather and share some information on the matter. (My questions are in bold and italics, and her replies are in normal font.)

When switching to a new 401(k) provider, what does the step-by-step process look like?

Here are the steps at a high level:

The plan sponsor needs to finalize the investment lineup, determining the core lineup (which typically can be index funds or target-date funds) as well as any additional investment options.

Working with Vanguard, the plan sponsor decides on the plan design — what kind of services (i.e., loans, withdrawals) will be offered, restrictions, etc. This may entail changes to the Plan Document, which dictates how the recordkeeping platform is going to be set up from a transactional and workflow perspective.

The focus then moves to ongoing administrative practices.

  • All necessary legal documents to administer the plan and indicate who is authorized to act on the plan are created and executed.
  • Payroll processing is a large component of this. The files that will be transmitted back and forth from the plan sponsor to Vanguard will be programmed and thoroughly tested.
  • Decisions are made on how to best communicate to participants on the upcoming change, their options in the new plan, etc. Communications must also satisfy all regulatory notification requirements.
  • The transfer method for participant assets is determined. Assets can be transferred in-kind or mapped to similar funds. Or sponsors can use what is called the re-enrollment process, which puts all or certain participants into certain default funds to ensure their portfolio is more appropriately diversified. Participants can opt out of all of these choices, of course.

Once the above decisions are made, the plan sponsor’s responsibilities decrease and most of the work is between Vanguard, the prior recordkeeper, and the payroll vendor, if applicable. The prior recordkeeper will provide participant data for Vanguard to review for accuracy and completeness. Vanguard will complete a mock conversion in our test region prior to the actual conversion. This helps ensure there are no surprises or missing data that could prolong the blackout period for the actual live conversion.

During the blackout period, all transactions are restricted at the prior recordkeeper. The assets are transferred on the communicated date. When the assets and final participant records are received by Vanguard, we will reconcile the assets and load the necessary data to lift the blackout and allow participants to access their accounts.

Payroll contributions are then sent directly to Vanguard and the plan will be up and running. At that point the conversion is complete.

How long (in terms of months, rather than hours of work) does the process typically take?

The average conversion takes between 3-6 months depending on client size and complexity. Certain regulatory notification requirements factor into this timeframe. For example, in order to allow for the transfer of the assets, a short blackout period occurs, during which time participants temporarily lose access to their retirement accounts. Plan sponsors/administrators are required to provide written notice — called a Sarbanes Oxley notice — of this to participants. The Sarbanes Oxley notice has to be provided at least 30 days, but not more than 60 days, in advance of the start of the blackout period.

How can I quickly/easily get an estimate of how much money the company (and/or plan participants) will save?

We can’t really give precise estimates because each plan varies in terms of the funds and services it offers, so costs will vary. But [according to] a study from the Investment Company Institute on 401k fees:

“The median defined contribution plan participant is in a plan with an all-in fee of 0.78 percent of assets, based on plans included in the study. Across all participants, the all-in fee ranged from 0.28 percent of assets (the 10th percentile participant) to 1.38 percent of assets (the 90th percentile participant). Larger plans tended to have lower all-in fees.”

[In contrast] with our Retirement Plan Service, the all-in fee for a hypothetical plan with $5 million in assets, 100 participants and an investment lineup of Vanguard index and active funds would be 0.30% of plan assets (actual pricing will depend on a plan’s investment options, demographics, and ancillary services).

Vanguard’s low fund expense ratios are the primary driver of the service’s low all-in costs: Vanguard’s average annual fund expense ratio is 0.19%, compared with the industry average of 1.11%. This cost difference means that investors keep more of what they earn.

Safeguarding Your Asset Allocation

“I think sticking with an allocation is more important than getting the allocation exactly right in the first place.” — financial advisor/writer Allan Roth, at the 2013 Bogleheads reunion/conference.

The average investor underperforms his/her own funds due to jumping back and forth between them at exactly the wrong times. In other words, most people would have better investment performance if they simply crafted an asset allocation, chose some funds to implement that allocation, then stayed put.

Staying put, however, can be difficult. That’s why it’s often worthwhile to take concrete action steps to safeguard your allocation — that is, to improve the likelihood that you will stick with your portfolio as planned.

Making It Easier to Stick With Your Plan

For some people — those with the most fortitude — simply creating a written Investment Policy Statement is sufficient. Once they have an explicit plan in writing, they’re able to stay put.

Some investors (me, for instance) find that using a balanced fund or other all-in-one fund makes it easier to stick with the plan. According to Morningstar research, investors in balanced funds tend to trail the performance of their funds by less than the amount by which investors in other funds tend to trail the performance of their funds. Based on correspondence from readers, I think there are two primary reasons why all-in-one funds make it easier to stick with a given allocation:

  1. Because the portfolio doesn’t require any ongoing maintenance, there are fewer opportunities/temptations to tinker, and
  2. There’s no longer the stress (and temptation to make a change) that comes from seeing one or more funds in the portfolio perform very poorly over an extended period.

For other people, avoiding news about the market is the key to staying the course. This is another strategy that I personally use. I don’t check my portfolio balance more than once a month, and I never check the market’s daily performance. I find that it’s much easier to avoid worrying about a bad day in the market when you don’t even know that it happened.

For some people, the only way to stick with an investment plan is to hire an advisor to manage the portfolio. If you know that you’re somebody who, left to your own devices, would likely mess up the implementation of your investment strategy, hiring a low-fee advisor can make a whole lot of sense.

Finally, the selection of the allocation itself does of course play a big role in your ability to stick with it. Most investors will find that it is better to err on the side of being too conservative rather than too aggressive, given that, for most investors, it is more difficult to stick with the plan in bad markets than in good markets.

Social Security’s Actuarial Neutrality

At the program-wide level, Social Security is set up with the intention of being approximately “actuarially neutral.” That is, the program is indifferent to whether people tend to claim benefits before full retirement age (FRA), at FRA, or after FRA, because, on average, the increase that people receive from claiming later should be approximately offset by the fact that they’ll receive fewer monthly payments.

In the last couple of weeks, I’ve come across two articles making the case that, because Social Security as a program is actuarially neutral, it doesn’t especially matter whether you decide to claim your own benefits earlier or later. To be blunt: This line of thinking is incorrect.

Basing your personal Social Security claiming decision upon Social Security’s program-wide actuarial neutrality is like basing your personal tax planning decisions on the average effective tax rate paid by individuals in the U.S. (rather than on your own personal tax rate). It makes no sense at all.

For an individual person trying to decide whether to claim benefits now or later, there are numerous factors involved, which almost always sway the decision in one direction or the other. That is, there usually is an option that is likely to turn out better than the other options.

Factors to Consider

Factors that should influence the when-to-claim decision for both married and unmarried individuals would include:

  • Do you need the money immediately?
  • Are you in good health? (The longer you expect to live, the more advantageous it is to delay taking benefits.)
  • Do you have a family history of people with unusually long lifespans? (Alternatively, do you have, for example, a family history of people dying at a relatively young age due to heart failure?)
  • What are inflation-adjusted interest rates like at the moment? (The higher they are, the more advantageous it becomes to take benefits early and invest the money.)
  • Are there tax planning reasons to claim benefits early or to hold off on claiming benefits?

Additional factors for married individuals to consider would include:

  • Do you have a higher or lower retirement benefit than your spouse? Having the spouse with the higher benefit hold off on claiming increases the amount the couple receives as long as either spouse is still alive, whereas having the spouse with the lower retirement benefit hold off on claiming only increases the amount the couple will receive as long as both spouses are still alive.*
  • How does your spouse’s age compare to your age? The younger your spouse is compared to you, the more advantageous it is for you to delay claiming your retirement benefit.
  • Is your spouse in good health? And does he/she have a family history of unusually long or short lifespans?
  • Are there strategies available for a few years of “free” spousal benefits, which only work if you claim your retirement benefit at a certain age?

*This is why it is often preferable to have one spouse (the one with the lower earnings record) claim retirement benefits early and one spouse (the one with the higher earnings record) claim retirement benefits late rather than having both spouses claim retirement benefits at or near FRA.

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Topics Covered in the Book:
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Qualifying for Tax Breaks by Controlling Your Adjusted Gross Income

As we discussed a few weeks ago with regard to the Retirement Savings Contribution Credit, if you’re careful to pay attention to the applicable income limits (and how your income compares to those limits), you may be able to adjust your retirement account contributions slightly and in the process either make yourself eligible for the credit or increase the percentage used to calculate the credit.

As a few readers correctly pointed out, similar planning can be used to qualify for other tax breaks as well. (To which I would add that it can also be used to avoid being subject to certain negative tax provisions.)

For example, whether you are eligible for (or subject to) each of the following tax provisions depends (in part) on your adjusted gross income (i.e., your taxable income before subtracting your exemptions and standard or itemized deductions) or your modified adjusted gross income:

Admittedly, given that each of these tax provisions has its own income limit, it’s quite cumbersome to keep them all memorized such that you can always tell whether you’re close to qualifying for any other tax breaks.

For uses like this, tax software can be super helpful. You can simply try modifying your most recent return by bumping up pre-tax contributions of some sort (e.g. 401(k) or HSA contributions) by a few different amounts to see what happens with each change. Do any new tax credits or deductions appear? Or does anything else interesting happen, such as having some of your long-term capital gains or qualified dividends fall into a lower tax range such that they go from being taxed at 15% to not being taxed at all? (The catch, of course, with such experimentation is that tax software for the 2012 tax year will not account for tax provisions that are new in 2013.)

A Point of Caution

When trying to qualify for a given tax break, it’s important to check whether eligibility depends on your adjusted gross income (AGI) or your modified adjusted gross income (MAGI). Your modified adjusted gross income is your adjusted gross income, with a certain deduction (or a few deductions) added back in. But which deductions are added back in when calculating MAGI varies depending on which tax break we’re talking about. In other words, there are several different definitions for modified adjusted gross income.

The reason this is important is that you would not want, for example, to try to qualify for a given tax break by increasing your traditional IRA contributions if the tax break you’re trying to qualify for uses a definition of MAGI in which traditional IRA contributions are added back into AGI.

*Your eligibility for this credit is not actually a function of your AGI. Rather, the amount of the credit is a function of your AGI.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
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  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
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