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By Konstantin Litovsky, Guest Writer
Medical practice retirement plans typically have more assets than the plans of other non-medical businesses with a similar number of participants. And with most of the assets held by the partners/owners, it should come as no surprise that one of the biggest reasons why medical practice plan sponsors decide to make changes to their plan is high assets under management (AUM) fees and higher-than-necessary expense ratios for the plan investment options.
While minimizing cost is important, there are several other key considerations that plan sponsors should know about. Management of larger medical and dental plans (with two-plus owners) can be challenging due to the following factors:
Challenges of Medical and Dental Retirement Plans
Here are some things to know about when it comes to medical and dental retirement plans.
Compliance Issues
Lack of awareness by the owners/partners of the plan sponsor’s fiduciary responsibility under ERISA, as well as having a plan that does not comply with several key ERISA and IRS/DOL provisions—including 404(c) and ‘benefits, rights, and features’—which can result in higher than necessary liability for the plan sponsor. There is a whole range of requirements under ERISA that are often ignored due to either a lack of knowledge or a prior setup that did not anticipate future changes in the practice and its demographics. Most common issues for medical practice plans include plans that only have self-directed brokerage accounts (SDBAs) for all participants (which causes a significant increase in plan administration complexity) and paying higher-than-necessary expense ratios for plan investments and/or high AUM service provider fees.
Dedicated HR Support
A lack of dedicated HR support to interface with the Third-Party Administrator (TPA) and record-keeper. The owners must do all the legwork, and because of a lack of good advice, the owners can make costly mistakes or miss mistakes made by the plan administrator and/or the record-keeper. Even when there is HR support, owner-run plans may have several key owners dictating the policy for the whole plan, often resulting in a subpar arrangement for the rest of the owners.
Demographics
There is typically a big gap between the owners and key employees, who are more knowledgeable about investing, and non-highly compensated (NHCE) staff, who are a lot less knowledgeable. Partner-only plans are quite different from plans with NHCE staff, as all participants are highly compensated employees (HCE). This difference alone can have a big impact on plan design.
Complex Plan Design
This could involve a profit-sharing component and/or a cash balance plan. This makes plans more difficult to administer, requiring top-notch service providers that are experts in combined 401(k) and cash balance plan administration. In the right situation, a cash balance plan and extra profit sharing (up to the maximum allowed) can provide the owners with a large tax deduction and the ability to catch up on retirement savings.
Unnecessary Creativity
Unnecessary creativity and/or lack of knowledge by the owners (or service providers/advisers) sometimes leads to complex (and ERISA non-compliant) solutions that can result in fiduciary breaches by the plan sponsor. This typically involves self-directed brokerage accounts as well as Controlled Group and Affiliated Service Group (ASG) situations that are common with medical practices.
Lack of High-Quality Fiduciary Advice
This leads to a lack of knowledge about different options, such as how to go about decreasing the cost of running the plan and making sure that the plan is ERISA-compliant. Working with an independent fiduciary can help the group make prudent decisions that take into account the interests of all the partners and the NHCE staff. After all, the plan sponsor is supposed to be acting in the best interest of all plan participants, not just the owners.
In this post, we will examine the types of issues that group practice retirement plans may encounter and show how to address these issues in a way that is both compliant and cost-effective. On the most extreme end, some of these issues are a violation of ERISA that may require the involvement of an ERISA attorney, while other types of issues may simply be subpar arrangements that can potentially be improved. We will start with the “the ugly”—which is typically an ERISA violation of some sort, an arrangement that has previously been a subject of successful litigation against the plan sponsor or a situation that can result in financial losses for the plan sponsor. We’ll then proceed to “the bad,” which can be something that may expose the plan sponsor to an ERISA violation if not addressed, and, at the very least, is a subpar arrangement that is more costly than necessary. Finally, we’ll tackle “the good,” which is the ideal solution that is both ERISA-compliant and cost-effective.
Revenue Sharing, High Plan AUM Fees, and Fund Expense Ratios
The Ugly
Using revenue sharing to pay for plan administration expenses, resulting in higher costs for plan participants, and passing all plan expenses to participants. This happens a lot more often than it should. The plan sponsor simply passes on the cost of administering the plan to participants, via AUM fees, and the plan is ‘managed’ by a broker or an adviser who receives revenue sharing paid by the mutual funds they recommend and/or commission.
This is typically the case with smaller plans, but some older, larger plans may have funds that pay revenue sharing that is used to cover some or all of the administrative costs for the plan. This arrangement has been a subject of ERISA litigation for many years, so the savvier plan sponsors know to avoid it. It’s for good reason. It is always possible to find a better fund that does not pay revenue sharing, so using funds that pay revenue sharing is not necessary at all, and it may violate the plan sponsor’s fiduciary duty.
The Bad
Having higher-than-necessary AUM fees. Many advisory firms use what is known as benchmarking, or comparing the plan to other plans of similar size. It is well known that smaller plans tend to pay higher-than-average fees, so this type of comparison can justify higher fees for smaller plans. In addition, rather than taking a position on active vs. passive, they are happy to include a mix of investments—some with higher expense ratios—which is the case for actively managed and/or White Label funds (for example, some large firms may sell their own S&P 500 fund and charge 0.2% for it vs. 0.04% that Vanguard would charge).
Some advisory firms may take care to avoid funds that pay revenue sharing, but including higher-cost funds is justified by the fact that smaller plans, on average, have higher expense ratios. By now, it should be widely recognized that actively managed funds are not essential for investment portfolios. This is because most of these funds fail to outperform index funds over the long term, and it is practically impossible to consistently identify the best managers who may outperform the indexes over several decades. Moreover, it is well known that many managed funds invest the bulk of their holdings in indices and then proceed to charge a much higher management fee than the index funds. This is another reason to completely avoid them.
The Good
No AUM fees, only fixed/flat fees that are not tied to assets, using index and passively managed funds with the lowest possible expense ratios. Given that most medical/dental plans will have more assets per capita, AUM fees make no sense for such plans, so fixed/flat fees are best. Having the lowest possible expense ratio is always the way to go in a retirement plan. All top 401(k) record-keepers will have access to the best funds on the market—including Vanguard, DFA, Fidelity, and Schwab—so there is no excuse to have a lineup that has anything other than low-cost index and passively managed funds.
More information here:
How to Reduce Your Practice Retirement Plan Cost
Outside Self-Directed Brokerage Account (SDBA) Issues
The Ugly
Setting Up Outside-of-the-Plan SDBAs for Owners/Partners, But Not Making SDBAs Available to Staff
Many small practice plans started out as SDBA-only, since there were initially just a handful of partners. Over time, these plans grew, and some added a fund menu with a record-keeper. But outside SDBAs often remained, as some partners wanted to keep their money at a custodian where their adviser was managing it. There are still plans that do not even have a fund menu and just have SDBAs, usually opened with different custodians. This is quite common in the medical retirement plan space.
Outside-of-the-plan SDBAs are accounts set up at a retail brokerage that is not intended to be compliant with ERISA. This type of situation occurs when a plan starts out as an SDBA-only and later adds a fund menu with a record-keeper. But the partners keep their outside SDBA accounts while the staff is using a fund menu with no in-plan SDBAs available. This is especially bad if the fund menu consists of high-cost funds and high administrative fees paid by the staff but not by the partners who invest outside of the fund menu. Even when outside SDBAs are technically ‘available,’ rank and file staff have little knowledge and ability to set them up without extensive involvement from the plan sponsor, which makes such accounts practically unavailable. This is a clear violation of ERISA because each plan must be operating in the best interest of all participants; if only the owners have a specific option (SDBA) while others do not, that is a fiduciary breach by the plan sponsor. Technically speaking, this would be a “benefits, rights, and features” violation.
Setting Up a Separate Retirement Plan That Includes Only the Owners
While this is not common, it does happen occasionally. The partners may have set up a separate plan to cover their own SDBAs, while the staff has an expensive fund menu-only plan. This is an example of being too creative for no apparent reason. There are multiple issues with this, and it is not a legal way to set up a plan.
Not Monitoring SDBAs of Individual Partners for Assets Not Allowed Under ERISA
This could include real estate and farmland. Details can be found here and here.
Here’s an example contract from an ERISA-restricted in-plan SDBA, formerly from TD Ameritrade (which is now Schwab PCRA). No such restrictions exist for typical retail SDBAs.
Please note that while real estate can be owned in an IRA or an individual 401(k), it cannot be owned by an individual with an SDBA in a qualified plan. The plan and not the individuals who use the plan must own real estate, and this is not a type of asset that would be prudent to own at the plan level.
The screenshot below comes from a current Schwab/PCRA contract. Current ERISA-compliant Schwab PCRA restrictions selected at the plan level for all SDBAs opened for the plan.
The Bad
Using Only SDBAs for All Participants (Including NHCEs)
This happens when an SDBA-only plan that was started by a handful of original owners adds many new participants over time without making any changes to the plan. While this is not an outright ERISA violation, this can easily lead to one, due to the practical impossibility of monitoring each SDBA account (especially if there are dozens of them). The biggest issue with this is 404(c) compliance, with the details provided here.
One of the challenges of having many SDBA accounts is gathering required statements for annual plan administration and making deposits/distributions. This can become extremely difficult when such actions rely on the cooperation of all the participants and they are not centralized, meaning that mistakes can easily be made by individuals.
Allowing Outside Advisers to Charge Fees to Individual Accounts
Sometimes, allowing outside advisers access is the only way to convince key partners to make changes to the plan, specifically to get rid of outside SDBAs in favor of the in-plan ones. So, as part of the compromise, it is acceptable to allow outside advisers to manage in-plan SDBA accounts. However, this option must be monitored by the plan sponsor to make sure that the plan stays in compliance (for example, if fees are taken out of participant accounts, the plan sponsor must make sure that the fees paid are reasonable).
The Good
Using in-plan ERISA-restricted SDBAs. One of the benefits of using in-plan SDBAs is the ability to limit the investments offered to all participants (look at the second screenshot above). Limiting SDBA investments to basic mutual funds and ETFs is usually the best way to go unless the group decides to offer more options within the SDBA.
When allowing outside adviser access to SDBAs (which should be avoided unless specifically requested by the partners), all fees should be billed to the practice instead. The fees would be paid by the plan sponsor and reimbursed by the participant. Because fees would not be taken out of plan accounts, this will limit the plan sponsor’s liability for making sure that the fees charged by outside advisers are reasonable.
Personal Advisers as Plan Advisers, Non-Fiduciary Advisers/Brokers
Ugly
Using Personal Advisers Who Provide Services to One or More Partners/Owners to Manage the Plan
This is especially true for those advisers who charge high AUM fees. This is a clear conflict of interest and a breach of fiduciary duty by the plan sponsor.
Using Advisers Who Are Not ERISA Fiduciaries to Manage the Plan
Brokers are one type of ‘adviser’ who can provide services to the plan while collecting commission and revenue sharing. The other type is a personal adviser who can be a fiduciary under the Investment Advisers Act of 1940 (for personal engagement purposes). While technically they are an ERISA 3(21), some advisers do not formally take a fiduciary responsibility with respect to ERISA, and they may not know much about their duties and responsibilities. ERISA 3(38) fiduciaries have discretion and they are fully responsible for their advice, so the plan sponsor’s only duty is to prudently select an ERISA 3(38). On the other hand, an ERISA 3(21) has to be monitored by the plan sponsor, who has the final say over their advice.
ERISA 3(21) is a lower standard that is often used as a cover by unscrupulous advisers to include higher cost funds that pay revenue sharing. This is still very common in the industry. This exposes the plan sponsor to potential liability, but most importantly, these types of advisers may not act in the best interest of the plan, resulting in higher-than-necessary fees.
Bad
Using an ERISA 3(21) to Manage the Plan, Expecting Them to Provide Discretionary Advice and to Act in the Best Interest of the Plan Sponsor/Participants
In short, they are a co-fiduciary that is overseen by the plan sponsor. They may be in a relationship where they have no incentive to lower your cost because that would lower their earnings—especially if they get paid via revenue sharing or a bundled arrangement where the plan pays a high AUM all-in fee and the adviser gets a share of that fee.
Having the Most Influential Partner(s) Dictate the Plan Investment Strategy and Selecting Plan Adviser(s)
Senior partners can have considerable influence over the retirement plan arrangement, and when junior partners join the practice and start asking questions about higher fees, they may take it personally. To ensure that the plan is set up in the best interest of all plan participants, it is always best to use an outside/neutral party to provide plan-level advice to the plan sponsor.
Good
Using an independent ERISA 3(38) fiduciary to manage the plan’s investments. It is important for the plan sponsor to prudently select the ERISA 3(38) fiduciary, making sure that their investment philosophy closely aligns with that of the plan sponsor. Ideally, ERISA 3(38) fiduciary compensation would be a fixed/flat fee—not an AUM fee—and they should be committed to using low-cost index and passively managed funds.
More information here:
Small Practice Retirement Plans
Prudent Service Provider Selection
Ugly
Using a small local Third Party Administrator (TPA) to oversee an arrangement that involves an SDBA-only plan with multiple different SDBAs. Small TPAs have no capacity to review each SDBA individually, and they do not offer compliance or ERISA advice. These plans are most likely out of compliance due to the types of assets that the SDBAs are invested in and possibly due to other issues associated with SDBA-only plans (such as lack of 404(c) compliance mentioned above).
Bad
Using a Single Bundled Service Provider and Expecting Top-Level Service and Advice
One big issue with bundled providers (especially large ones) is that the client-facing representatives are not experts, and you are not going to be talking directly to the administrator who works on your plan. Representatives usually do not offer advice to the plan sponsor, and they are mostly making sure that the internal processes are followed. They have limited capacity to deal with compliance and plan design optimization, so this is one area where a good independent TPA is essential.
Setting Up a Plan and Expecting Everything to Run on Autopilot Without Much Human Involvement
While there are platforms that offer this type of service, those are not appropriate for larger medical/dental practices where there are many moving parts. Things can go sideways quickly without oversight.
Good
Using dedicated service providers who are experts in their respective fields, including a record-keeper, a TPA, and an ERISA 3(38) fiduciary. This is called the “open architecture” approach, where a plan is built using the best available components.
Controlled and Affiliated Service Groups
Ugly
Ignoring (or Being Unaware of) Affiliated Service Group (ASG) and/or Controlled Group Rules When Setting Up a Plan for an Entity That Is Part of an ASG or a Controlled Group
Many practices have subsidiary or affiliated surgery centers where partners perform surgery. These surgery centers usually do not have a retirement plan in place for their staff. If the practice and the surgery center form an ASG, a retirement plan should be set up for the surgery center as well (or it should be covered under the plan for the practice). There are exceptions to this arrangement, but exact details should be determined by an ERISA attorney.
Setting Up an Individual 401(k) and/or Cash Balance Plan with K-1 Income from a Partnership
When partners set up individual entities, these are always part of an ASG. Sometimes, individual partners attempt to set up solo 401(k) and/or cash balance plans for their entities. Cash balance plans can only be set up at the partnership level, not at the individual partner’s entity level. If the practice has any non-partner employees, solo 401(k) plans (or SEP-IRAs) cannot be set up for individual entities. A single retirement plan must be set up for the practice entity, and individual entities would all adopt this plan.
Bad
Having two separate plans for two entities that are part of the ASG. Both plans can potentially be different enough to cause issues. If plans are substantially the same, there is no reason to have separate plans due to the complexities related to testing both plans together.
Good
Having an ERISA attorney make the determination that there is indeed an ASG and provide potential solutions/mitigations. Sometimes, the case for ASG is not very strong, so a good ERISA attorney can determine whether ASG can be avoided altogether due to facts and circumstances. If an ASG exists, this simply means that a single plan must be set up for the entities comprising the ASG.
While a group could use individual 401(k) plans which are substantially the same and with coordinated plan provisions if there are no NHCE employees (this would still be classified under ‘Bad” because it is not the most efficient way to set up a plan for a growing group, due to extra compliance burden and total lack of oversight), it is easy to violate the rules. As soon as a single NHCE is hired (a highly compensated W-2 participant is considered to be an NHCE during the first year they are hired), the whole arrangement fails immediately. Therefore, the best practice is to set up a single plan with centralized compliance and administration to avoid any potential issues that individual plans are certain to cause, not the least of which are related to outside SDBA concerns described above.
Cash Balance Plan Design and Investment Risk Mitigation
Ugly
If you select an actual rate of return plan (ARR) vs. a fixed rate without realizing that your plan’s rate of return does not matter since your contribution is limited by the lifetime maximum amount based on your age, going for a higher return will increase the volatility and can result in big losses. An ARR plan can be a good option in some select cases, and it can lower funding volatility. But you still cannot go below zero return, and any shortfall below the original contribution amount would have to be made up at distribution by departing partners.
Another problem would be using an actual rate of return (ARR) design to invest in high-risk investments in a cash balance plan. All ARR plans will typically have a 5% return cap, so whether the plan uses a fixed rate (3%-5% range) or ARR should not make any difference with respect to the investment strategy. The investment strategy should be the same regardless of the crediting rate.
Bad
Having a plan adviser invest any amount of assets in stocks, believing they need to ‘match’ the fixed crediting rate in a cash balance plan without understanding the role of volatility, especially in a group practice plan with sizable assets.
Good
Understanding the right way to manage a portfolio plan so that volatility is minimized. In a cash balance plan, at termination, any excess return above the crediting rate (overfunding) is subject to an excise and income taxes, which can be well over 90%. There is no incentive to try to beat the crediting rate, as it is never known exactly when the plan will be terminated. Keeping the plan investments as steady as possible will minimize the chance that the plan is significantly overfunded or underfunded.
Underfunding is also a problem as partners must make up the shortfall each year, and the larger the assets in the plan, the larger the potential shortfall. This can cause a big headache for the plan since not every partner may be willing to contribute much higher amounts due to underfunding—which is a guarantee if the plan portfolio has high volatility. The plan’s investments must be managed in a way to make sure that portfolio risk is only high enough to provide an average return that is close to the crediting rate, so if the return is lower than the crediting rate, that would be acceptable if the deviation is not very large. This can be accomplished by a bond ladder, which has to be designed by considering the interest rates and the yield curve.
Cash Balance Plan Distribution Risk Mitigation
Ugly
Not Having a Strategy in Place to Manage Partner Retirements/Departures in a Cash Balance Plan with Sizable Assets
This is the quickest way for the practice to lose a lot of money, as departing partners will get 100% of their account balances, and any shortfalls will have to be paid by the practice unless other arrangements are made in advance.
Terminating and Restarting Cash Balance Plans on a 5-Year Schedule
This is done for several reasons: 1) to mitigate contribution volatility risk when those with high balances are subjected to investment volatility that leads to unpredictability with respect to making up investment shortfalls each year, and 2) moving money to a potentially higher return 401(k) plan given that CB plan crediting rate is usually between 3%-5%. While this is not an acceptable practice, some service providers actively promote this risky strategy. This would most certainly fail the permanency requirement and potentially disqualify the plan.
Bad
Waiting too long to start planning for partner distributions. When investment returns are good, this is never an issue, but it does become an issue when there is a large shortfall and partners have accumulated large account balances. There are several ways to ensure that if there is a shortfall that participants pay the difference to themselves, and the details must be worked out with the plan’s actuary and ERISA attorney.
Good
Having a Framework in Place to Allow for Asset Distributions to Departing Partners, Where Any Losses Are Made Up By the Partners
This is not complex or costly; it simply must be done as part of the plan’s implementation. This might require the departing partner to reimburse the practice with outside assets rather than by making contributions to the cash balance plan for any shortfall contributions made by the practice.
Terminating/Restarting a Cash Balance Plan When Appropriate, as Determined By the Plan’s Actuary
Cash balance plans can be terminated and restarted when there are substantial changes to the plan design; this should be determined by the plan actuaries rather than by the partners themselves. Doing so more often than once in the lifetime of the plan should be justified by significant changes to the practice (such as mergers and acquisitions). This strategy cannot be done on a schedule; some practices could do this more than once if the plan has been in existence for decades.
While this is not an exhaustive list, this should give you some idea as to what it would take to have the best possible plan for your practice. It is important to note that none of this should cost extra (except for potential ERISA attorney engagement, which is usually reasonably priced). Service providers doing their job will ensure that you have the best plan that is always compliant, and if there are any issues, those will be resolved quickly and efficiently. For new plans, it is relatively straightforward to set up your plan correctly from the start and to create internal rules and procedures on how your plan will be maintained.
Some groups mistakenly think that just because they set up their plan correctly, it will continue to operate perfectly in the future. Over time, groups experience multiple changes, including mergers and turnover. Plans are rarely reviewed to make sure they are competitively priced.
One issue with medical groups is continuity. Partners come and go, but if you want to make sure that your plan stays in top shape, there must be continuity in terms of how the plan is managed. At the very least, you should be making sure that your plan has no AUM fees (especially if it is a plan with $10 million in assets or more) and that you have a specialist ERISA fiduciary adviser providing investment advice to the plan sponsor. The best results can be obtained by using an open architecture approach with independent specialist service providers and by creating a plan governance structure that includes trustee(s) and an investment committee that, together with the ERISA 3(38) fiduciary, has oversight over the plan and other service providers.
What else can you add to the ugly, bad, and good of these practice group retirement plans? Have you seen a plan go from ugly to good?
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