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One of the challenges of putting a successful 401K plan together is fund selection. Obviously, picking funds with low expenses should be a priority. But then the question is what asset classes do you choose. Do you have the options available for the sophisticated investor? Do you you keep things simple and use mostly target retirement funds? Or offer both and the run the risk of too many funds confusing participants?

Lessons from previous 401k plan

In our previous 401k plan,  we could pick 12 out of 40 preselected funds. 3 Vanguard funds were available but the rest were all actively-managed funds with expense ratios ranging from 0.50% to 1.75%. (And of course, there was the extra 0.50% asset charge to employees and another 0.50% to the employer.) We picked the best option from each category -- how successful was the lineup? Here is how plan assets were directed:

Money Market                     32% (cash)
Dodge & Cox Stock                16% (large value)
Vanguard Morgan Growth           15% (large growth)
American Funds Capital World G&I  7% (europe/japan value)
AIM Real Estate                   7% (reit)
Vanguard Total Bond               6% (intermediate bonds)
T.Rowe Price Mid Value            5% (mid value)
Bridgeway Aggressive Growth       5% (small growth)
Vanguard Index 500                3% (large blend)
California S&P Small Cap Index    2% (small blend)
John Hancock Lifestyle Growth     1% (moderate growth)

Looking at where the money went, the lineup is disappointing. Obviously, people were confused by the choices leading a whopping 32% in money market. Then there was a solid number of people picking Dodge & Cox and Morgan Growth since those two had decent track records and relatively low expense ratios (0.52% DODGX, 0.39% VMGRX). The rest of the selections ended up being random noise. One participant would choose random ABC fund at 1%+ ER, another would choose XYZ at 1%+ ER.

Of particular interest is how far down Vanguard Index 500 is on the list. We had access to Signal shares at 0.07% ER in this plan which meant people were more attracted to exciting fund names. Growth, aggressive growth, growth+income? Gotta be better than a regular index cuz they grow fast! (Yeah, I'm sure they read through the prospectuses and decide those funds fit their investment strategies better.)

Employee Fiduciary fund lineup

With this past experience in mind, I fleshed out the following criteria:

• Choose index funds not only with low expense rates but with bland names. If you don't have a "ABC Enhanced Credit/Leveraged Aggressive Growth" fund staring in your face, you won't have people mesmerized by the name thinking choosing that fund would let them get away with saving less.
• Offer a menu where picking all funds in equal percentages is a viable plan. (Thanks to The Finance Buff for posting this advice at Boggleheads.)
• A final consideration was to be mindful of what happened in the 70's. The 70's was a terrible era where both stocks and bonds returned -3% real return annually due to high inflation. If you were retired and drawing down your portfolio, some gold and commodities might have kept you off Alpo.

The question still left on the table: use a few broad index funds or many market subset indexes. Part of me wanted to go with just a few funds to reduce performance chasing behavior (although the existence of TSP market timing newsletters say you can never eliminate the possibility). On the other hand, a high percentage of plan dollars belonged to a small number of sophisticated investors -- should I limit their choices in order to force participants to choose specific investment strategies? In the end, I decided on the many fund option with the hope of education working on a small number of employees. The funds I chose were:

Bonds/Fixed Income

Vanguard Prime Money Market
Vanguard Intermediate Bonds
Vanguard Inflation Protected Securities

Domestic Stock

Vanguard Value
Vanguard Growth
Vanguard Small Value
Vanguard Small Growth

International Stock

Vanguard European Stock
Vanguard Pacific Stock
Vanguard Emerging Markets

Other

Vanguard REIT
PIMCO Commodity Real Return D*
American Century Global Gold

Target funds

All Vanguard target funds available on demand

*PIMCO Commodity Real Return D ordinarily costs 1.24% per year. However, 0.25% of this amount is a 12b-1 fee which Employee Fiduciary rebates to us dropping our effective cost to 0.99%. Over time, we will accumulate enough assets to get into Institutional class decreasing costs to 0.74%.

Model Portfolios

Core in the education campaign was the development of model portfolios for employees to choose. I knew as much as I could try to teach people about investment strategies, people would forget everything 2 days later and ask "what funds should I pick?" (And as the plan trustee, I can't answer that question.) So I picked portfolio strategies advocated by various investment/finance authors and fitted them to our fund menu. The portfolios I presented were:

• Harry Browne's Permanent Portfolio
• Larry Swedroe's Concentrated Risk Strategy
• Scott Burn's Couch Potato
• Scott Burn's Margaritaville
• Bill Schultheis' Coffehouse
• David Swenson's Yale U Index
• Equal percentage of all funds
• Equal percentage of all stock and commodity funds

Employee selections

After all the write-ups and presentations, now it came time to see whether my groundwork would be effective in (1) getting employees to participate and (2) avoiding major investment mistakes. Here are the results after a few months of contributions:

Participation

100%

Percentage of Salary Contributions

8%

Model Portfolios Chosen

Coffeehouse   35%
Swenson       20%
Equal         20%
Swedroe       10%
Couch Potato  10%
Custom         5% 

Overall asset percentages

Stock         69%
Bonds         22%
Commodities    9%

Fund percentages

Vanguard Small Value              13% (small value)
Vanguard Value                    13% (large value)
Vanguard Inflation Protected Sec  12% (intermediate tips)
Vanguard Intermediate Treasury    10% (intermediate bonds)
Vanguard REIT                      9% (reit)
Vanguard Emerging Markets          9% (emerging)
Vanguard European Stock            7% (european)
Vanguard Pacific Stock             7% (pacific)
Vanguard Growth                    6% (large growth)
Vanguard Small Growth              5% (small growth)
PIMCO Commodity Real Return D      5% (commodities)
American Century Global Gold       4% (gold)
Vanguard Prime Money Market        1% (cash)

35% of participants picked the Coffeehouse Portfolio so there is some overweighting to Large Value and Small Value. Otherwise, the fund picks look far more balanced than with the previous plan.

While doing background research for this article, I came across Los Angeles Times' Retirement at Risk series. Part 3 of the series on teachers is especially sickening. (Quick summary: teacher unions endorse ripoff annuity pushers in return for cash.) Moral of the story -- picking the right vendor can make a huge difference in the performance of a retirement plan. Of even bigger consequence for employers are the recent lawsuits over 401k expenses. Leaving open the possibility of a lawsuit 20 years in the future claiming unnecessary fees has penalized employees millions is a bad business decision -- never mind the hit owners & management would take as 401K participants.

With costs and fund choices forefront in the equation, my company chose Employee Fiduciary to administer our Safe Harbor 401K.

Costs

As of this post, Employee Fiduciary's cost schedule is:

Type                 Amount             Period    Paid By
-------------------  -----------------  --------  --------
New Plan Setup       $500               One Time  Employer
Existing Plan Setup  $1000              One Time  Employer
Administration Cost  $25/employee       Annual    Employer
                     $1500 minimum
Asset Charge         0% assets < 1M     Annual    Employee
                     0.06% assets > 1M

The 0.06% asset charge is a passthrough fee from MG Trust which is the entity that actually holds plan money. Since, Employee Fiduciary is not in control of this fee, there is risk MG Trust may increase it in the future.

Under our previous 401K plan, the per employee administrative fee was less at $1250/year. However, the employer paid an additional asset fee starting at 0.50% and gradually decreaseing to 0.10% at the 5M total assets. Crunching the simple math, eliminating the employer asset charges pays for the $1000 conversion fee and $750 termination fee in less than a year.

The average fund expense ratio from our previous plan was 0.74%. An additional non-decreasing 0.50% asset charge against employees was added on top. Added together, 1.24% is par for the course when compared to the average 401K plan. However, I'm used to investing directly at Vanguard for 0.25% so that was sore spot with me. Given our current contribution amounts, a 1% reduction in fees could be another million dollars for plan participants after 20 years.

Fund Choices

Employee Fiduciary uses an open architecture for investment choices. This means you can choose almost any mutual fund as long as you meet the fund requirements. From what I can tell, most investor-class fund shares have no minimums for group retirement plans. For example, Vanguard's minimums are usually $3000 for individual investors -- however, I was able to add Vanguard funds to our lineup even though I did not yet have the target dollar amounts for each participant. (I ran into the "almost" with Northern Global Real Estate -- no idea why this plan was not available to us.)

ETFs are also available under Employee Fiduciary's architecture. However, the cost is an annual $500 per ETF offered to manage discrete share issues. Because it is a fixed cost, high plan assets are needed before ETFs become the better choice. Let's use a simple example with Vanguard Large Cap Index:

0.07% Vanguard Large Cap ETF
0.12% Vanguard Large Cap Admiral
0.20% Vanguard Large Cap Investor
Investor class to ETF: 500 / (0.20% - 0.07%) = 384K
Admiral class to ETF:  500 / (0.12% - 0.07%) = 1M

For more exotic asset classes not offered at Vanguard, the spread may be much less. Let's look at International Real Estate for example:

0.48% iShares S&P World ex-US Property Index
1.07% Fidelity International Real Estate
FIREX to WPS: 500 / (1.07% - 0.48%) = 85K

Come by next time to read about choosing a fund lineup.

If you are running a company, sooner or later you will need a retirement plan in order to compete for workers. For a small company, the top three options to look at are: SEP-IRAs, SIMPLE-IRAs and 401Ks. Each has their own unique sets of rules and may be the right choice for you.

SEP-IRA

Typically, SEP-IRAs are recommended for self-employed situations. It is an easy plan to implement with high contribution limits and little administration overhead. If your business is incorporated, you can contribute 25% of wages to a retirement plan. If not incorporated, you can contribute 20% of net profit. In addition, you can sign your company up directly with Vanguard at no additional costs over an individual IRA account. Sounds good, right? There is one slight complication -- the contributions are made in addition to salary by the employer only and must be applied at the same rate to all employees. This makes individual choice very limiting for both company owners and employees. Owners typically will want to shelter as much income as possible but if they put the maximum 25% of their salary away into tax-deferred space, every employee would receive a similar contribution. Likewise, any employee wanting to accelerate their retirement savings would not have the option to do so.

(A Keogh plan looks very similar to a SEP-IRA except for pre-declared contribution percentages and more paperwork since it is a pension plan. With the advent of the SEP-IRA, there should be no reason for a small company to choose a Keogh.)

SIMPLE-IRA

SIMPLE-IRAs are available for companies with 100 employees or less and operate like 401Ks. Employees decide how much of their salary they want to defer and the employer makes matching contributions. Employees must make either 2% matching to all employees whether they participate or not -- or up to 3% elective 3 out of 5 years. Both matching schedules require immediate vesting.

Reasons for choosing this plan -- one page annual filing, low cost of administration. Like with a SEP-IRA, you can open up an account directly with Vanguard at the cost of an annual $25 per fund used per employee. (The fee is paid by the employee until they accumulate $100K in total assets at Vanguard.) As the I in IRA stands for individual, employees have the right to withdraw or rollover any contributions after a 2 year waiting period.

Now for the bad:

• Lower contribution limits compared to SEP-IRAs and 401Ks. For 2007, employee contributions are limited to 10.5K versus a 401K's 15.5K. Catchup contributions for employees over 50 are 2.5K versus a 401K's 5K.
• An employer may not match more than 3%. My guess this is to avoid self-employed from contributing 10.5K + 328% matching to reach the 45K maximum qualified plan limit on ~50K of income.
  
• $25 per fund charge at Vanguard means employees must pick a single target retirement fund to avoid extra fees until they build up a significant amount of money.
  

(There is also a similar plan called the SIMPLE 401K where the only difference seems to be the ability for employees to take loans out against their assets. However, I don't know of any fund company offering this option.)

401K

If you are a hermit who just left your cave, read up about 401K plans at Investopedia. Otherwise, there's no point in going over basics you should know already or can read about on anywhere else. Instead, I'll jump right to employer issues.

Cost -- You will not be able to setup and make the annual ERISA filings yourself. You will have to hire a third party administrator to manage the plan for you. The big boys (Vanguard, Fidelity, T.Rowe Price, etc.) only will deal with you directly if you have enough plan assets or are willing to pay a nice annual fee. This means you must be diligent investigating the fee schedules. Here is a Boggleheads post I wrote a few months back listing about a dozen low-cost 401k options.

Plan Testing -- The IRS frowns on deferring too money for owners and highly paid employees (97K+ for 2007, 102K+ for 2008). Hence, annual contributions must be tested against formulas. If a plan is deemed top heavy, contributions must either be returned (don't file those individual tax returns early) or additional matching must be made on behalf of non-highly paid employees. In a small company where a large percentage of employees could be highly paid, this ends up being a crippling limitation. Luckily, there is a solution called the Safe Harbor 401k. It simply is a regular 401k except with mandatory 100% matching up to the first 3% of salary and another 50% for the next 2% with immediate vesting. Additional matching is possible but where discretionary (ie, depends on profits), it is capped to 4% total on 6% of salary.

The plan my company switched to was a Safe Harbor 401k administered by Employee Fiduciary. My next posts will talk about the plan EF offers and the funds we picked.