Pros and Cons of Open Option Investing in a Company Retirement Plan

Transcription

1 Pros and Cons of Open Option Investing in a Company Retirement Plan Understanding Unified Trust s S.A.F.E. Structure for Professional Practices Open option is a term used to describe a design feature in a 401(k)/profit sharing plan whereby participants are allowed essentially unlimited access to the investment provider or solution of their choice. The classic open option plan is a physicians practice where each doctor places his or her plan assets with a favorite broker, mutual fund family, or other collection of investments. There are pros and cons to this approach, but as a practical matter a variety of compliance and performance failures seem to occur disproportionately in these plans compared to more conventional arrangements. Unified Trust evolved the S.A.F.E. structure ( Self Directed Account Fiduciary Environment ) to address these potential flaws as an accommodation we recommend terminating, not keeping, an open option feature. We think open option is not how modern pension trusts are run, and that the best policy for companies is to steer toward a more prudent and effective structure. That said, we understand the reasons behind these structures and are comfortable accommodating them. In essence, we give our advice don t continue with open option but stand ready to assist with the most sensible framework for those who feel the open option structure remains the best choice for them. Advantages of Open Option Allows each participant to work with a personal financial planner or other professional with whom he or she has formed a productive relationship. The broker or advisor can get paid on the pension assets, which can help with the cost of the individual relationship in some cases. Maximum flexibility. Participants who want to use strictly index funds can do so. Those who want to try concentrated stock positions, hedge funds, direct real estate investment, and other alternative strategies are generally free to do so. Those who want portfolios of individual securities managed with the help of a favorite broker can have them. If structured properly, fiduciaries are not responsible for choosing the investments made available at the plan level. This is distinct from individual participant decisions. If structured properly, fiduciaries are not liable for losses suffered by participants as a result of their individual investment choices. Disadvantages of Open Option Sacrifice of purchasing power: even those participants with the largest balances $1 million or more typically pay more in total fees than in a more conventional arrangement. Fees for participants with smaller balances can be dramatically higher. Tendency for discrimination, which is a disqualifying defect. In the classic open option scheme, all the doctors do their own thing but what is done for the participants is completely different, violating the current and effective availability rules under IRC 401(a)(4). In practice, these arrangements never achieve compliance with the conditions which would relieve fiduciaries from liability for investment decisions at both plan and participant level, Copyright 2009 Unified Trust Company, NA, All Rights Reserved Page 1

2 meaning that the plan trustees remain liable. For example, Unified Trust has yet to see an open option arrangement that complies with the list for the notice requirement under DOL Reg. 404c 1. Tendency for unusual assets to creep in, such as hedge funds, direct real estate holdings, options, leveraged accounts, individual securities of bankrupt companies, penny stocks, municipal bonds, and a variety of other asset types that create fiduciary issues. Prohibited transactions are far more common in these arrangements than in traditional arrangements. The participants using the open option feature tend to view the accounts as theirs when they are actually trust assets subject to a complex set of laws and regulations. Administrative and fiduciary errors are therefore common (e.g., improper loans and distributions for which the plan Administrator and Trustee usually the company owners cannot account). Ironically, performance in self directed brokerage is dramatically lower than that in simple diversified portfolios of the plan s mutual fund holdings. See the studies by Charles Schwab and Unified Trust. Performance is an especially significant issue for employees, since they typically have smaller balances and therefore receive less attention from their brokers or advisors. Fiduciary oversight of whatever arrangement is used for the employees who don t self direct tends to be weak. It is common for Unified Trust to find that the investments held on behalf of employees are substantially inferior to those held in the owners accounts, creating a situation few fiduciaries would care to defend. Tendency for employees using open option to be sold investments that are unsuitable for a retirement plan, such as individual variable annuities, B and C share mutual funds, illiquid limited partnerships, etc. The new normal that is emerging for modern plans, the auto 401(k) concept, of which Unified Trust has been a pioneer, is ill suited to the open option environment, with the predictable consequence that employees will retire with less money. Best of Both Worlds? Where sponsors prefer to continue the open option arrangement, we use the S.A.F.E. structure, typically with the following parameters: 1. Core Plan managed by a professional trustee (Unified Trust s role) plus one or more single participant plans (Alternate Plans) for those who choose to continue investing outside the Core. The individual plans have one participant who is sole trustee, creating a form of fiduciary firewall. 2. Steer the business away from open option in future as follows: a. One time grandfathering of open option, after which no new employees will be permitted to use it (including partners, such as new doctors). b. Strong educational effort for employees to ensure the open option feature s availability and impending freezing is understood by all, with the clear message that the Core Plan has been structured for their best interests. Our experience is that it is in no one s interest to have many employees choose open option. Copyright 2009 Unified Trust Company, NA, All Rights Reserved Page 2

3 c. The One way door : participants may move to the Core Plan at any time, but participation in the Alternate Plan is permanently frozen. 3. If possible, we avoid the Alternate Plan structure altogether by opening an in service distribution window that allows participants to roll roughly 30 70% of their current balances to IRAs. The remainder of the money goes to the Core Plan and all new contributions go to the Core. This approach has the advantage of permitting owners to continue self directing a large portion of their balances without imposing the open option structure on their business partners. Summary: Pros and Cons of Open Option Pro Complete investment freedom Direct relationship with chosen advisor Potential volume discount with advisor Potential to limit fiduciary liability if specific conditions are met Con Fees are usually higher Underperformance is common Employees are underserved vs. owners Benchmarking is difficult Fiduciary process tends to be neglected High incidence of hidden discrimination failure (a disqualifying defect) Relatively high incidence of prohibited transactions High incidence of unusual assets, leading to a variety of fiduciary problems High incidence of inappropriate assets such as B and C share funds and certain annuities Higher incidence of outlier participants who experience investment meltdowns Generally poor compliance with steps required for liability relief Ill suited to the widely accepted auto 401(k) concept (the Success Pathway ) Copyright 2009 Unified Trust Company, NA, All Rights Reserved Page 3

4 Real Life Examples of Open Option Problems Most open option plans either experience no problems or unaware that they have any, but the incidence of serious problems, in Unified Trust s experience, is vastly higher in such plans than in a more conservatively managed arrangement. These are examples of problems we or our fellow professionals have personally witnessed (some details changed to protect the parties involved): 58 year old unsophisticated participant experienced 98% loss in her account due to highly aggressive concentrated stock positions chosen by broker Doctor distributed money from his account directly; trustee and administrator unaware Owner took a loan directly from account without following exemption rules Doctor used plan assets to buy land next to his home and kept horses there Lawyer used plan assets to buy land so he could use address for school zoning Owner used plan assets to purchase interest in own firm Owner borrowed plan assets for business cash flow in excess of IRC 72(p) limits Brokers and their fees not listed in 404(c) notice per DOL Reg. 404c 1 Changes in trustees not updated on paperwork Conversion process reveals more than two dozen latent (but minor) defects Commingling of plan assets with tainted IRA assets Doctors wrote personal checks for their annual contributions and sent direct to accounts Lawyer traded stocks on margin, invalidating 404(c) protection Doctor invested 100% of account in a series of single stocks for a huge loss in an up market No transactions in participant s account for two years cash accumulated at 1.5% in up market 7 employees were sold expensive annuities by their doctor/employer s personal broker; underlying annuity funds were available to broker directly at NAV All doctors self direct; no employees do; employees not made aware of option Self direction only permitted for account balances above $250,000; no NHCEs qualify Employee assets invested solely in pooled account with no IPS, poor asset quality Employee assets invested disproportionately in proprietary funds of brokerage firm Employee assets invested disproportionately in B and C share mutual funds Doctor took direct rollover of full balance, including MPP source funds, while still working Doctors invested 100% of plan assets with Bernie Madoff Lawyer invested personal account in hedge fund that held collectibles Owner held municipal bonds in retirement plan account Owner invested account with local insurance agent who went to jail for fraud The age old favorite: doctor invested plan assets in Hilton Head condo and vacationed there Copyright 2009 Unified Trust Company, NA, All Rights Reserved Page 4

5 Summary Open option can theoretically work well but seldom does in our experience. Participants often pay substantially higher fees and tend to underperform, while the plan tends to be prone to a host of fiduciary and compliance failures. Such failures are rarely noticed by authorities, and the legal risk may therefore be nominal, but legal risk is not the point: there is a best way to run a modern pension plan, and that best way simply does not work in an open option plan. Yet many professional practices we work with who have these structures find it undesirable to force a new investing arrangement on their partners, so we created the S.A.F.E. structure as a reasonable compromise. As one 401(k) advisor who works with doctors once said, What Unified Trust says is that if you insist on driving fast, they insist you wear your seatbelts. Copyright 2009 Unified Trust Company, NA, All Rights Reserved Page 5