Remember being a student, learning theories and processes you use in your work today? Obviously, we can and do learn from teachers and textbooks. But sometimes the best lessons, the ones we are more likely to retain, come from experience.
Ary Rosenbaum, namesake of The Rosenbaum Law Firm, says that his experience has proven invaluable in his ERISA practice today. Ironically, sometimes the lessons he gleaned from an earlier phase of his career were based on mistakes he saw in retirement plans that passed through his purview. Law school, he says, taught him how ERISA plans are supposed to work. Working with plans as an attorney taught him how they actually work. “There is a difference,” he says.
All of this prompted Rosenbaum to pen an article, 401(k) Plan Provisions That Are Bad Ideas, which you can find on his firm’s website. We spoke with Rosenbaum to find out about a few of his favorite “bad ideas.”
Employee Compensation: How often are there mistakes made in retirement plans?
Rosenbaum: I hate to say this, but I doubt there is one 401(k) plan out there that doesn’t have some type of error going on in it. Usually it’s very minor, but I would say that almost all plans have some minor defect. And I would say that even half the plans out there have a major defect. I know that’s startling. It helps out a lot of litigation attorneys; we all have to eat!
EC: It seems that we’re talking about two broad categories, one being “mistakes” that are included intentionally in the plan, like plan provisions that don’t work well in practice, and the other being unintentional errors.
Rosenbaum: Well, there are some plan provisions that are legal, it’s just that they cause more harm than good.
EC: Let’s talk about one item you mention in the article, unlimited plan loans. Is that one of those “more trouble than it’s worth” provisions?
Rosenbaum: I think so. Some people say that plans shouldn’t have loans or any type of partial distributions, because retirement plans are for retirement savings. And we have clients who say that. But that’s an ideal world. The real world is that people need money for one reason or another, and one great alternative is to borrow from your 401(k) plan. You can borrow at a reasonable rate of interest, and you can pay it off through your payroll check. It can be an attractive funding mechanism for people who are hard up for cash, and need a very low-interest alternative to taking out a home equity line of credit or some other lending product.
That being said, there is a flip side to it. I’ve seen plans where people are taking out multiple loans – and we’re not talking about two or three, but seven or eight loans at the same time. The problem with that is dealing with repayments. I worked once with a company that had multiple outstanding loans, and the plan administrator improperly paid off one loan without paying on the other loan. The Internal Revenue Code has a rule that said loans have to be paid at least quarterly, and if there is a quarter that goes by where it isn’t paid on, the loan would go into default. Then it would be a deemed distribution.
Prohibited transactions are basically a transaction between the plan and a party-in-interest, and they are not allowed. But plan loans are considered an exception to the prohibited transaction rules as long as participants can only take out a maximum of $50,000, they have to have at least quarterly repayments, and the loan term is not more than five years unless the loan is for the person’s principal residence. If you have a loan that fails these exceptions, then you have a prohibited transaction.
The quarterly payment was not directed to the correct loan, but no one caught it. There was no deemed distribution and no 1099 was issued to the participant. The plan happened to come up for a random IRS audit, and the IRS agent found it. They socked the plan sponsor with very big penalties for failing to comply. This is just one more headache that plans can avoid by limiting the number of loans, preferably to one.
EC: In the article you mention self-directed investing. It sounds like you don’t care for it.
Rosenbaum: I generally only see it in medical practices and law firms. The biggest mistake I see in connection with self-directed investing in a retirement plan is that if you offer brokerage accounts as an option, you have to offer them to all participants. Employees do have to pay for maintenance and any trades, but it has to be offered to them. The reason it’s a problem is the discrimination tests. You cannot have a plan provision that discriminates in favor of highly compensated employees. If you offer it only to highly compensated employees, then you have a problem that could result in disqualification of the plan. That’s number one.
Number two is, I’ve seen studies that show people who participate in self-directed brokerage accounts do worse [on investment performance] than other employees who simply pick from a fund lineup. And there is liability for the plan sponsor, although I’ve never seen a lawsuit about it. But employers need to understand that, just because you offer a self-directed brokerage account doesn’t mean you are exempt from liability. As a plan sponsor, you are a fiduciary for all of the plan assets, so theoretically you have to look at what is in someone’s individual account. If participants are dabbling in some assets that are going to cause them to lose their entire nest egg, you should be apprised of it because at the end of the day, if you didn’t put in any protection for yourself as a plan sponsor they could theoretically hold you liable and sue you.
The bottom line is that while these plan provisions may be legal, plan sponsors should give a lot of thought to how they will work in actual practice, says Rosenbaum. If you’re concerned about a particular provision in your own plan, he suggests that you seek competent and independent counsel. “Look for an outside ERISA attorney or an outside retirement plan consultant to look at the situation from an independent point of view, rather than going to your TPA’s legal department. Seven out of ten times, they are probably the people who drafted the document to begin with!”