Profit-Sharing Best Bet for Small-Firm Benefits

Q: The company for which I work has 65 employees and a modest profit-sharing plan administered by the owner. I would like him to offer us a 401(k) plan, but he says it is too costly and time-consuming to administer and manage. Is that true? How difficult is it really for a company of our size to start and maintain a 401(k) plan? Could we have both a profit-sharing and a 401(k) plan? --W.L.

A: Establishing a 401(k) plan is the easy part. Maintaining it is another issue entirely. And according to the experts we consulted, your employer is right: It is costly and time-consuming to administer a 401(k) plan, especially for a relatively small company such as yours. Further, depending on an employee’s age and tax bracket, a 401(k) plan could be less financially rewarding than a straight profit-sharing plan. However, there are still some considerable advantages to a 401(k) plan for both employers and employees.

Practically speaking, employers do not offer both a profit-sharing plan and a 401(k) plan, which is simply a type of profit-sharing program. What sets 401(k) plans apart from other profit-sharing plans is the tax-deferred status of employee and employer contributions to the accounts.

According to Lou Kravitz, an Encino employee benefits consultant, employers can expect to spend at least an additional 50% annually to operate their profit-sharing plan as a bare-bones 401(k) program. Why? For starters, the plans require regular payroll deductions. Then, you have to keep the books for each employee’s account and handle hardship withdrawals and other paperwork. And, at the minimum, employees must be notified annually how their accounts are faring. Employers can expect ever higher costs if they offer more frequent account updates and multiple investment choices for participants.

So, why then do so many employers even bother with these plans?

Employees, like you, say they really want them as a type of forced savings for their old age as well as a tax-avoidance scheme for now. Their major appeal is the tax-deferred accumulation of savings for retirement at a time of increasing concern that traditional pensions and Social Security will be insufficient to cover their basic needs.

Another major draw is the fact that most employers allocate what they once spent on their traditional profit-sharing funds to match employee deposits in their 401(k) accounts. This enormous popularity of 401(k) plans among employees had led many leading companies, already burdened by the tremendous increase in employee health insurance costs, to shift their traditional pension plans to 401(k) programs to save money.

At the same time, employers have discovered that they actually end up contributing less to 401(k) plans than they paid out in profit-sharing--even after paying the extra administrative charges.

Why? Under a profit-sharing plan, only the employers put in money. But with a 401(k) plan, the employer generally only matches, usually by 50% or less, the contributions made by employees. (In a few cases, companies make additional, unmatched contributions to their employees’ accounts.)

Overall, because not all employees want or can afford to set up a tax-deferred savings account, companies usually end up contributing less to 401(k) plans than they did to the straight profit-sharing program. According to one informal study made by a bank trust department, employers who traditionally contributed 10% to 12% of their payroll into a profit-sharing plan, pay out 5% or less into a 401(k) program.

Do employees really come out ahead with a 401(k) plan--or are they better off with a straight profit-sharing check every year? There is no single answer that applies to every worker.

If you need your profit-sharing check to make ends meet, a 401(k) plan is not going to help you much since you will likely get nothing from your employer without contributing to your account. And whatever you do get won’t be freely available to you until you turn age 59 1/2.

If you simply spend your profit-sharing money because “it’s there,” a 401(k) plan could be just the savings discipline you need, regardless of whether you really want it.

However, if you’re a “saver,” a 401(k) plan has to look like heaven to you because your money is matched and accumulates tax-deferred.

One final caveat about 401(k) plans bears underscoring: These accounts can be difficult for employees to manage.

Unlike unilateral profit-sharing plans in which funds are administered by corporate executives or professional money managers, most 401(k) plans offer employees a wide and often mind-boggling array of investments from which they must select for themselves. There are stock funds aimed at growth and stock funds aimed at generating dividend income. There are bond funds, international stock funds and funds mysteriously called “balanced.” Who can figure it? Few of us are trained to make these momentous and sophisticated decisions. But with 401(k) plans, we are usually entirely responsible for the performance of our accounts. If we choose the wrong funds or move our money around at the wrong time, our investment could languish or--worse yet--be wiped out.

Do you still want your employer to switch to a 401(k) plan? Well, just remember that old saying: Be careful what you wish for; you could get it.