Building an Economy that Works for Everyone

Why small businesses and workers can’t get into the market for a retirement plan

For a small- or medium-sized business owner, starting a retirement plan can be daunting. The complexity of existing plans makes choosing one a time-consuming and overwhelming process.

One of the most difficult decisions is choosing a company to administer the plan. There are many different investment companies, banks, and insurance companies, each with products geared towards retirement. According to the Employee Benefit Research Institute, which has conducted a survey of small business owners examining retirement plan sponsorship, researching which plan to offer and selecting a company to administer it costs employers a great deal of time.  Small employers who are working long hours trying to make their small company successful are quickly overwhelmed by the choices.

Workers face similarly difficult decisions about where to invest contributions toward their retirement savings. If the employer does have a plan available, individual workers often overinvest in a specific type of fund and infrequently rebalance their portfolio. Research on the frequency of these two fundamental errors suggests individual investors often have difficulty making sound investment decisions.

In theory, workers without employer-provided plans could invest in Individual Retirement Accounts (IRAs), U.S. Treasury bonds, or insurance products. In reality, the complexity of these choices makes it difficult for most people, who do not have a strong understanding of saving and investing alternatives, to identify poor options and to determine which options best fit their needs. Overwhelmed with the number of choices and the complexity of financial markets and investment vehicles, and justifiably skeptical of the financial services industry given recent events, most people do not set aside money for retirement.

Congress recognized the difficulty smaller employers have in establishing retirement plans and developed an easier alternative for small business. The SIMPLE Individual Retirement Account was designed to make it easier for small employers to start a plan at their place of employment. When an employer establishes this plan their employees can contribute to their own individual account. Employers are able to choose to either match dollar-for-dollar, up to 3% of an employee’s compensation or provide a contribution of 2% of compensation to each employee, whether they participate or not. Currently, up to $10,500 per year may be contributed per employee. This type of account is open to businesses with less than 100 employees and has streamlined reporting requirements.

Unfortunately, very few businesses are taking advantage of this option. Only 8% of workers in firms with less than 100 employees participated in a retirement plan in 2005.  One reason may be that while a SIMPLE IRA does reduce or eliminate some of the paperwork and requirements for administering a plan, it does not eliminate a key decision: whether to give employees a choice of companies to manage their investment, or have the business select a company to manage all accounts. In either case, someone is faced with selecting from numerous options, which tends to lead toward inaction.

The costs associated with retirement plans, including start-up, operations, administrative fees, and participant fees, is a second reason more business owners and workers are not setting up retirement accounts. For businesses with fewer than 100 employees, a 401(k)s is typically too expensive to operate. A 401(k) is a type of deferred compensation program that allows an employee to contribute a portion of their salary to a retirement account before paying taxes on their salary. An employer may make a contribution, match the employee’s contribution or both.

This type of plan has many provisions including a plan document and requires fiduciary decisions by the plan sponsor. The cost per employee is much higher for small businesses than large corporations, due to the fixed costs of these plans and the lack of economies of scale that larger workforces enjoy.

According to the Employee Benefit Research Institute, which has conducted a survey of small business owners examining retirement plan sponsorship, businesses are concerned with costs associated with starting a plan, including the time required to research which plan to offer and selecting a company to administer the plan which limits efforts to set up retirement plans.  And there are other costs associated with starting and running a retirement plan.

Contributions are a requirement of certain types of plans that some employers want to avoid, but fees have also been a major concern and topic of recent discussion. Many fees are hidden – difficult for even experts to identify – so much so that the US Congress held a hearing on that very problem in 2007.  Another concern facing small business owners and individuals are high fees typically charged to manage small accounts. Charges for transactions and for account maintenance can eat up most or all earnings and can even cut into the principal invested.

So, how can we fix the market for retirement plans to make it more accessible to workers and easier for small businesses?

NEXT: Overcoming barriers to retirement savings

Note: This is the second in a four-part series based on EOI’s report Stronger Nests, Bigger Eggs. View part 1 here.

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