We’ve been talking a lot about employee benefits recently in our HBS posts, and this week we’re going to focus on the 401(k), which is easily the second-most-popular benefit after health insurance.
While a lot of people think of 401(k)s as solely the province of large companies, the reality is that the IRS allows any company, be it an S Corp, a C Corp, a partnership or even a sole proprietorship, to set up a 401(k), and there are some distinct tax advantages for companies that offer the plans. Each dollar that your employees contribute to the plan reduces your firm’s overall employee taxable income, which should help to lower your tax bill. In addition, there is a provision in the Economic Growth and Tax Relief and Reconciliation Act that allows employers to take a tax credit to offset some of the costs of setting up a qualified 401(k) plan.
While there is no hard-and-fast rule to determine when a small business should launch a 401(k), a good rule of thumb is that once company’s annual payroll reaches about $500,000 a plan probably makes sense. If the time is right for your company, then you’re definitely going to need some help from a professional investment advisor to get started. Fortunately there are a number of firms that specialize in helping small businesses establish 401(k)s, and some of the big boys in the 401(k) world like Vanguard—the low-fee index-fund giant—have special programs geared to entrepreneurs. You may want to speak with several firms to find the one that suits you best. During your due diligence process, you should spend a good deal of time focusing on the two most important characteristics of a 401(k) plan: the fee structure and the choice of investment options.
The fee structure of a 401(k) plan can be pretty complicated, which is one reason why it’s so important to find an advisor that you can trust and who will be straightforward with you about costs. The total cost of a plan can vary tremendously once you account for the various investment management, administrative, and advisor fees. Even a 1% annual difference in fees has a huge impact on the returns that participants will earn on their investments. For example, if you contribute $5,000 annually for 30 years and earn 7% a year with fees of 0.50%, you’ll wind up with $460,000 in retirement savings. But if those fees are 1.50% you’ll have only $382,000, a difference of $78,000. The moral of this story is that fees matter.
One great way to reduce the fees in your 401(k) is to make sure that the plan offers participants the ability to invest in index funds, which attempt to track an overall market average like the S&P 500 rather than trying to outperform it. The fees on index funds are much lower than on actively managed funds. The majority of professional managers that try to beat the market fail anyway, yet they charge much higher fees for their “services”.
You’ll also need to give participants the opportunity to gain exposure to the major asset classes: domestic and international stocks, government and corporate bonds, inflation-protected securities, and a low-risk cash alternative like T-Bills or money-market funds. Resist the temptation to add too many choices as they tend to lead to confusion among participants. And definitely consider adding a target-date fund (TDF), which can greatly simplify the investment process. With TDFs, participants just have to choose an approximate retirement date and the fund automatically invests in an age-appropriate portfolio that decreases in risk as participants approach retirement.
Finally, you might consider having employees automatically in the plan, unless they opt out, instead of requiring them to opt-in. This will help to ensure that the maximum number of people participate, so that all of your hard work and good intentions in setting up a company 401(k) have the maximum effect on everyone.