Guest Article

Five Steps To A Great Profit Sharing Plan

By Harlan G. Storey. Mr Stroey, attorney and Certified Financial Planner ™ is President of Cornerstone Capital Advisors, a Registered Investment Advisor, and member of NAPFA, in Green Ohio that provides comprehensive wealth management and financial planning services on a Fee-Only ™ basis. Cornerstone was ranked nationally in the top 75 Wealth Management advisory firms by Bloomberg Wealth Manager magazine for 2001 and 2002. You may reach him at 1-800-448-5319 or at hstorey@ccadvisors.com.

The company profit sharing plan is the backbone of savings for most American workers, with nearly 40 million workers saving for their retirement, college education, and even a new home purchase in their employer-sponsored retirement plan.

With 3 years of downturn in the stock markets still with us, what can you do as a plan sponsor to greatly improve your company's plan, and make it even more attractive to those who depend upon you for this benefit? The following are steps that many employers are taking to make their plans better.

I - Monitor the Performance of Plan Investment Choices

Most company 401k plans with total assets less than $20 million do not have a formal procedure for monitoring the investments of the Plan. Since participants in most profit sharing plans are expected to make their own investment choices, plan sponsors rely on outside vendors to provide the investment menu of mutual funds for the plan. It is assumed that this is enough to provide good investment choices, and protects the plan sponsor from investment fiduciary liability.

The best methods followed by larger plans, those with more than $20 million in assets, are now beginning to be followed by small plan sponsors.

The plan sponsors are consulting with an independent Registered Investment Advisory (RIA) firm to obtain help in monitoring the plan investments. The RIA firm can provide a plan to diversify the investments to allow participants a true asset-allocation portfolio at all levels of risk. Then, the RIA will provide quarterly monitoring of the quality of each investment, comparing them to benchmarks for each type of asset class, and evaluating whether those funds continue to represent the asset class appropriately.

Such a "due diligence" process is recommended by the Center For Fiduciary Studies, at the Katz School of Business located at the University of Pittsburgh. The Center recommends that the fund investments be evaluated at least quarterly. The process used by the Center screens investments based upon 8 different criteria, which are: 1) fund size, (no less than $75 million in assets), 2) fund manager tenure at a minimum of 2 years, 3) assets in the fund must be at least 80% invested in the appropriate broad asset class, 4) each fund must contain investments appropriate to the asset class, and thus not exhibit "style drift", 5) investment performance must be above median for the investments in the fund's peer group over rolling 1, 3 and 5 year periods, 6) the total expenses of the fund must not be in the lowest quartile of its peer group, 7) the standard deviation, a measure of the volatility of the fund's performance must also be above median for the peer group, and 8) the "Sharpe ratio", and "Alpha", both industry measurements of return for the amount of risk assumed, must be above median for the peer group on a rolling 1, 3 and 5 year period.

You might be scratching your head about all of this complication, but this is standard work for the professional money managers in large defined benefit plans. These measures of performance can be done using currently available databases of mutual funds from Morningstar ™ and other service providers to the institutional investment industry.

By using such methods, the plan sponsor will know when it is time to get rid of the "dead wood" investments in the plan. Allowing a poor investment choice to continue after even 1 year not only reduces the performance of the plan, but it exposes the plan sponsor to liability as an investment fiduciary. As an example of this, several of the Oak Associates funds, used by many in Northeast Ohio retirement plans during the bull market, flunked 5 out of 8 due diligence tests as early in the bear market as the 4th quarter of 2000, a full 2 years before the bottom.

II - Get Control Over Plan Costs

Plan sponsors have done little to control the costs of investing in their own company plans because they are not aware of lower-cost alternatives that would deliver the same or better quality to their participants. Improvements in technology, mutual fund investment platforms, and the ability for third party plan consultants to offer many more alternatives have now made this possible.

The RIA or plan consulting firm can put together your plan, or remodel your existing plan, using what has come to be called "open architecture." This means that the consultant can provide the investment platform, recordkeeping, custody, due diligence, participant education, compliance and ongoing co-fiduciary liability all in one package; but with a customized blend of service vendors and investment providers that are custom-tailored to your company's plan and budget.

For example, your plan could use Charles Schwab & Co., Inc. as custodian, American Benefits Group as the record keeper, have mutual fund trading on a Fidelity Investments subsidiary platform, and provide investments hand-picked by the RIA firm from the entire mutual fund marketplace of Schwab, currently some 3,000 funds, including low-cost index and exchange traded funds. The RIA firm will become a co-fiduciary for the investments of the plan, and provide the due diligence monitoring. In addition, the RIA can assist with the drafting of an Investment Policy Statement, and can monitor the work and cost of the other vendors as well. Won't these "extras" push up the costs?

In the writer's experience, typical overall costs to participants can be reduced by .5% to 1.0% annually by using this approach. Consider this example:

• If you were to invest $5,000 a year for 30 years with a 10% annual return,
• that would amount to $863,594 at the end of the 30 years. If during that
• time you experience annual investment management fees of just .25%, that will reduce the ending balance by $40,883. If fees are 1%, as they often are in smaller plans, the benefit reduction is $151,387 (or 21%)---and some plans have costs exceeding 2%!

So, improving costs goes right to the bottom line of your participants' accounts. Another way to help plan participants is for you as plan sponsor to pay directly for all of the plan administration expenses except for the underlying mutual fund management fees. Paying these tax-deductible expenses allows plan assets to grow even faster, in addition to the cost-savings measures that you can take right now.

III - Provide Managed Investment Portfolios

Most plan sponsors cannot afford to hire investment experts to come on-site and educate their employees. And, the vendor of the funds, often a broker or insurance agent, is not qualified to give that advice. The best way to help participants to invest for good results is to have your RIA consultant put together 4 to 5 portfolios of graduated risk from the investment choices of the plan. Unlike the old Lifestyle Funds, that consisted of only large cap stocks and bonds, these portfolios would be true asset allocation models populated with the choices available from the plan menu.

An allocation of 40% stocks and 60% fixed income and Stable Value funds would work well, say, for an employee within 5 years of retirement; the reverse, a 60/40 ratio of stocks to fixed income, would probably serve most employees well during nearly their entire working careers. Of course, employees would still have the freedom to make their own choices. But the success of the model portfolios will enable most participants to do well, and will promote greater confidence in the employees to participate in the plan.

In the 3 year bear market, those who got into trouble with investments had too much in stocks, and too much in just one category: large cap growth stocks. The investment menu of most employers had no small cap funds, REITS, international, and no quality fixed income choices; and participants made many mistakes. A study by Watson Wyatt Worldwide, of 401k retirement plan reveals that managed portfolios like these can on average outperform individual investors in the plans by at least 1.9% per year.

That may not sound like much, but the National Center for Policy Analysis paper, "Reinventing Retirement Income in America," offers this illustration:

"To illustrate what a 1.9 percentage point difference means to an account, if two individuals each contribute $4,000 a year to a 401k account for 30 years, one at an annual return of 10 percent and the other at an annual return of 8.1 percent, each will have contributed $120,000; however, the 10 percent account will grow to about $690,889 while the other grows to about $480,224---a difference of $210,665 or 44 percent!"

These asset allocation portfolios can also provide lower-cost index funds for many of their investment choices, greatly lowering the overall cost to invest. Typically, the 60/40 mix described above costs as much as 1.5% for smaller plans. In a consultant provided plan these costs may drop to the .5-.6% range, a dramatic savings. Again, when employees know that they are getting a good deal, they are more prone to participate. It has been the writer's experience that some will even roll up their "at home" IRA accounts to the plan to lower their overall personal cost of investing and to receive the expert help of an investment expert!

IV - Acquire an Employee Education System

Employees today are better informed about retirement planning and investing than ever before. Most, however, find it difficult to navigate the huge amount of financial planning and investment advice that they read about or watch on television. And, with the results of the bear market for stocks so fresh in our minds, it is clear that they need unbiased advice and help.

Retirement planning advice is readily available today, but until an employee has a one-on-one consultation with someone they can trust, they are unlikely to make major changes in either their savings rate or their portfolio. Yet, research has shown that online calculators for retirement planning are a powerful way to help participants forecast the rate at which they need to save for their own retirement. In addition, if such calculators contain realistic portfolio rates of return for the plan investments actually available to them, employees can see what they need to do: whether to increase the percentage of salary they save, or take more or less risk in their investment allocation, or both.

Experts also recommend regular employee meetings, on a semi-annual or even quarterly basis, to keep them informed of steps that you as plan sponsor are taking to improve the plan. The outside consultant for the plan investments can also be present once or twice a year to discuss changes in the plan investment menu, or to even counsel individual participants.

V - Create and Maintain a Written Investment Policy Statement (IPS)

If there is just one suggestion that you should employ from this article, this is the one. Most small firms don't take this step, and when they do, for most it is provided for them by an outside product vendor. I recommend that you use an expert, independent plan consultant for this important working document.

By putting together a working written document to explain the processes that you as plan sponsor are following, you greatly lower your risk of being blamed by the participants for a poor investment outcome, or for plan costs that are too high.

The IPS should contain, at a minimum, the following:

• Due Diligence Process - the plan should have a written procedure for choosing investments that also functions as the process for ongoing evaluation of the quality of each investment. This process should follow a process similar to the one recommended above. In addition, the "dead wood" investments must actually be replaced by more qualified investment choices, when appropriate.
• Accounting for Risk - the appropriate asset classes to populate the Plan's investment menu should be chosen, and then appropriate mutual funds families or separate account managers should be chosen. If a Stable Value fund or GIC is chosen a method for allowing bids for those services should be documented.
• Accounting for costs - each service that the plan uses, such as record keeping, should be evaluated for cost against other outside vendors. The procedure for Request for Proposal requests should be spelled out.
• Co-Fiduciary Status - to provide the most protection, and the best service, any outside investment consultants (RIA firm, etc.) should sign the IPS and agree to abide by its procedures. This will put the consultant in the role of co-fiduciary as to the investment choices to the plan.
• Choosing to utilize 404 (c) - The Plan should take advantage the provisions of Section 404 (c) of the Internal Revenue Code, if that is not already being done. The importance of this section is beyond the scope of this article, but your RIA or company attorney will be able to guide you in this area.

(Editors note: You can find a sample IPS by clicking here.)

Other items will round out the document, and every person involved in the Plan administration and investments should sign their name to it. As a working document, the IPS should be reviewed at least on an annual basis, or more frequently if there is a change of control in the plan sponsor or a merger or acquisition. In addition, from time to time, different asset classes should be added or dropped when appropriate.

A One-stop Solution: The Multiple Employer Plan

What if your company could simply switch to a retirement plan that already has all of the features you have just read about? A plan that takes care of the mutual fund due diligence, written investment policy, etc. for you? A plan that will automatically search out the lowest-cost providers of recordkeeping, custody, investment management expenses. A plan that would use indexed funds, maintain a professional asset allocation, and, best of all, create model asset allocation portfolios out of these low-cost fund alternatives for your participants at 3-5 different risk levels? What if such a plan could actually lower your annual plan administrative costs?

Better yet, if you could turn over to such a plan your Investment Fiduciary status and the constant liability that comes with it, wouldn't that be wonderful?

Well, such plans do exist. They are called Multiple Employer Plans. An example is one offered by Cornerstone Fiduciary Investment Services called the Great Lakes Profit Sharing Plan & Trust.

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