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A four-step plan to cull 401(k) rolls of the accounts of terminated employees

RIAs can step in and add immediate value to a plan by purging these accounts that drain time, add costs and compromise efficiency

Wednesday, May 28, 2014 – 3:08 AM by Guest Columnist Robert J. Leahy
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Robert Leahy: Anytime you have participant inertia combined with plan sponsor apathy, things are likely to get bogged down.

Brooke’s Note: This article won the 2014 FI360 contest for the best piece written on a matter related to fiduciary care in the financial advisory business. RIABiz helped to judge more than a dozen entries. We felt that the issue of terminated employees clogging up a 401(k) plan has gotten very little attention in the industry. We liked the way Bob Leahy looks at this situation and spells out the precise dangers for plan sponsors who keep terminated employees on the 401(k). But he also offers some suggestions to deal with this matter. I am all ears. I had a 401(k) balance when I left the small newspaper I worked for in Baltimore. That plan is still in place there. I tried to roll it over once to my IRA at my local discount broker and was confronted with questions and assignments to reach people that confused me. Since then I have just let it ride — for 14 years.

In recent years, I’ve noticed a troubling trend in the 401(k) arena: Keeping terminated employees on the rolls of their retirement plans — in some cases for years on end.

New retirement plan clients are bringing on a significant number of terminated participants maintaining an account balance. This makes the conversion process more complicated for those extraneous participants.

It seems like all parties involved — plan sponsors, recordkeepers, and advisors — are aware of the problem, yet no one sees it as a high-priority issue. As a result, the number of terminated employees continues to grow each year. See: How RIAs can rule the 401(k) realm by becoming advocates for plan sponsors — and start by eliminating eight marketplace conflicts.

Growing phenomenon

Exactly how bad is the problem? I haven’t seen any industry data on this question to compare to, so I asked the head of our daily recordkeeping team to conduct a small — and therefore unscientific — survey of plan clients. She found that for plans with fewer than 100 participants, the ratio of terminated participants to active participants was approximately 12%. In plans over 100 participants, the ratio is about 13%, so we are seeing roughly the same percentages regardless of plan size.

It is important to note that these numbers were arrived at after we had already processed the under-$5,000 balances and made at least one attempt to communicate the rollover option to those not eligible for force-outs. For the plans that are coming to us as new clients to our recordkeeping services, I would guess the ratio of terminated participants to active participants is closer to 20%.

This has given me pause as to why this occurs, if it significantly impacts the plan as a whole and, if so, how advisors can help plan sponsors manage this issue. See: 10 essential steps that 401(k) plan sponsors need to take in 2013 to put clients on the right road to retirement.

Back-end inertia

The chief reason for this trend is participant inertia combined with plan sponsor apathy. Anytime these two factors collide things are likely to get bogged down.

Such inertia has traditionally been most evident upfront in the slow enrollment process. As service providers we spend enormous resources to educate both parties that participation in the plan helps everyone. But that same reluctance of some employees to enroll initially just might have an equal but opposite force for employees that move on and leave their vested balance intact.

Much like the eligible employee not contributing to a plan, terminated participants are aware the money is there, but cannot seem to find a compelling reason to take action and roll their balance into a new employer’s 401(k) or IRA. Aside from the occasional awkward contact from a terminated participant, plan sponsors, who are more focused on managing employee benefits for current employees, see it as no big deal to allow these inactive account balances to continue to drift along. See: How RIAs can rule the 401(k) realm by becoming advocates for plan sponsors — and start by eliminating eight marketplace conflicts.

Risks and costs

I believe changes in the regulatory and disclosure rules, along with new ways recordkeepers are pricing their services, should cause plan sponsors to rethink their position and adopt a more aggressive posture in dealing with this issue.

The most obvious reason to minimize the number of terminated participants with a balance is cost. The new 404(a)(5) disclosure delivery requirement, added to an already long list of other mandatory disclosure documents, is a direct expense for all participants that must be paid for by the plan sponsor or plan trust. See: What RIAs must know about hidden, and excessive, fees in serving as fiduciaries to a 401(k) plan.

There is also the time and opportunity cost of tracking former employees, keeping in mind these folks are typically not as proactive as current employees with updating address changes. Then, there is the cost of preparing the IRS form 8955-SSA each year, which requires an updated list of the terminated participants to be filed with the U.S. Social Security Administration. See: Phyllis Borzi tightens the noose on 401(k) providers that flout DOL disclosure, not without critics.

Finally, these terminated participants are included in the total count for the purpose of determining whether a plan meets the plan- audit exemption. This detail is especially significant to a plan that has never been above the threshold of 120 participants and is unaware of the added cost of the independent audit, should they go over the employee count.

That blank look

There is also a risk associated with maintaining a number of terminated balances. Failure to provide any of the mandatory disclosure documents is a breach of your client’s fiduciary duty. An expanding list of terminated participants is undoubtedly increasing the chance that something or someone gets overlooked. You might try asking any one of your plan clients if they sent a copy of the last notice about a fund change to all terminated participants, and pay attention for that look of “I have no idea” expression projected from their face. See: Fidelity Investments wins huge in the 'biggest 401(k) case in decades’ — but bearing battle scars.

Some have argued that encouraging terminated participants to roll out of the plan reduces the total level of plan assets, thus potentially increasing the plan costs. This might have been true in the days of asset-based pricing with breakpoints, but in today’s environment most recordkeepers have established a more flat cost structure based on the number of participant balances, or possibly on average account balance per participant. Neither of these pricing methods will be helped by stagnant participant accounts with low balances.

What can advisors do?

Advisors are in a perfect position to take the lead in developing a process to address this issue.

Advisors who educate plan sponsors on the inherent costs and risks associated with maintaining terminated participant accounts will clearly demonstrate their expertise in understanding the real nuances of this business. Furthermore, once you have a plan sponsor “buy in” to try to reduce this number, you will create a brand new metric that can be measured each year and reinforce your value as a service provider.

I would like to suggest a four-step outline to building such a process:

Step 1: Review with your third-party administrator or bundled provider the rules in the plan document that pertain to participant force-outs

Plan sponsors are allowed to process distributions directly to terminated participants with a vested balance of under $1,000 and process IRA rollovers directly to a custodian when participants have a vested balance between $1,000 and $5,000. See: Schwab shoos $25 billion of client assets out the door as it calls the bluff of employers with lopsided 401(k) contracts.

Do not assume the plan currently allows for both of these options, as some providers do not have a direct IRA rollover solution in place and consequently have left that language out of the document. There is no good reason to exclude both force-out provisions in the plan, so coordinate dialogue between the plan sponsor and plan provider if changes in the document need to take place.

Step 2: Request from your recordkeeper a list of all terminated participants with a balance, preferable in a spreadsheet format

Make sure you make note of how this list was obtained, since you will be going back to them on a regular basis for an updated list. The list should include name, mailing address, and vested balance at a minimum. Upon receiving the list, sort the names in to three groups based on account balance (i.e. less than $1,000 between $1,000 and $5,000, and more than $5,000). See: Why gathering big-time 401(k) assets — and charging regular fees — is well within reach for most experienced RIAs.

Inform them their plan balance will be either be paid in cash (less tax withholding) or rolled to an IRA. Your recordkeeper may be able to assist you with the language to use and the timeline to follow (30-day notice is necessary). If a participant falls into this category and has no current address on file, your recordkeeper can guide you through the “lost participant” process.

Step 4: Compose a letter along with communication materials to send that outlines the advantages of control and investment flexibility with an IRA rollover

This is the most challenging step, because you are dealing with participants that enjoy the same benefits, rights and features as any active participant. They cannot be forced to move their balance out of the plan, and if you try to coerce them by passing along more than reasonable costs to maintain their balance, you may end up a much bigger problem involving discriminatory practices. See: 9 things advisors to 401(k) plans must do to keep clients out of hot water.

You can also explain the ease of a direct rollover to a new custodian, as well as the freedom to roll to another IRA custodian of their choosing. If you are not comfortable with facilitating this step because of a conflict of interest with your fiduciary role, consider outsourcing this task to a non-fiduciary advisor. There are also custodial firms like Schwab Advisor Services and Fidelity Institutional Wealth Services that have created custom marketing materials and a sales desk to address any participant questions.

Final thoughts

Remember, the key is not necessarily in how many ultimately decide to move their plan asset. The key is creating a repeatable process of managing the terminated participant roster, and thereby inserting another layer to your value proposition. See: Selling your value proposition.

Robert J. Leahy, CEBS, AIF is a retirement plans sales consultant with Alliance Benefit Group of Illinois in Chicago. He is responsible for marketing ABG’s suite of plan services, which include plan design consulting, plan administration, and open architecture recordkeeping. He works with hundreds of consultants, advisors and TPAs in the Midwest. A veteran of the financial services industry for 29 years, he began his career as an in independent financial planner in 1985. He is an accredited Investment Fiduciary (AIF).

401(k) Educator

401(k) Educator

May 30, 2014 — 8:06 PM

Wonderful article, Mr. Leahy. I’ve been in the retirement plan industry (educating and enrolling participants) for almost eight years now and it’s refreshing to read such a well written article on a topic that doesn’t get a lot of attention. I even learned a few things in the process. :) Keep articles like this one coming!

the frank adviser

the frank adviser

May 28, 2014 — 6:47 PM

Good article. I have found that the reason most of these people continue to be carried on the roles of 401(k) plans is because of incorrect addresses. With the IRS stopping it’s letter forwarding program in mid-2012, what is the most efficient way of finding/communicating with these participants?

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