According to a report from Casey Quirk by Deloitte and McLagan, 72% of money invested into funds went into passive funds in 2015. While some may see this as a strong case for passive investing, the issue for plan sponsors isn’t clear-cut.

Trending passive

Active investing attempts to outperform the stock market, while passive investing involves investing in the same securities in the same proportions as an index like the S&P 500 or Dow Jones Industrial Average. Passive investment portfolio managers don’t make decisions about which securities to buy and sell.

Over the past 20-plus years, the trend has shown an increase toward passive investment strategies. In every year since 1993, there has been a net inflow of dollars to passive mutual funds and exchange-traded funds. In contrast, every year since 2006, there has been a net outflow of dollars from actively managed funds.

What’s the explanation for this trend? The biggest driver seems to be the growing recognition that market averages — particularly for large cap, heavily traded and researched stocks — are tough to beat.

Outperforming the indexes

A Wall Street Journal article last year brought this point home in a chart highlighting the percentage of actively managed U.S. large company mutual funds that beat the S&P 500 Index over various time spans. The chart summarized 1, 3, 5, 10, 15, 20 and 25 years, ending on June 30, 2016. In only the 10-year time segment did the percentage of actively managed funds outperform the S&P 500 by more than 30%. Over the other time periods, the proportion of actively managed funds that outperformed the stock market ranged from around 11% to 25%.

In another telling data set, of the 20 best-performing (relative to their peers) actively managed U.S. stock funds over the 10-year period ending on December 31, 2005, only seven beat the average performer in the subsequent decade.

Fighting the odds

In the face of this data, why include actively managed stock funds (in addition to passive funds) in your retirement plan’s investment lineup? For starters, you’re providing choice based on participants’ risk tolerance, investment objectives and investment strategies to meet the perceived needs of plan participants. As the Journal stated in its compilation of performance data, “The prospect of beating the market — and maximizing your investment potential — is a tantalizing one.”

If some participants are willing to fight the odds against superior returns with an active manager, is it a fiduciary’s place to deny them that opportunity? Not necessarily, assuming you’ve carefully researched the actively managed fund or funds you select, and you provide participants with sufficient information to make an informed choice. Participants who consider themselves astute investors might put more in their 401(k) account than they otherwise would have if given the choice of some active funds.

Another reason for possibly including actively managed funds is that, in a down market, passive funds will suffer the same fate as the market, while active funds can cushion the blow by moving to cash. In addition, in niche stock sectors where stocks are more illiquid and fewer analysts are paying attention, managers of actively managed funds may find good investments.

Getting it right

In addition to monitoring the performance of your plan’s funds, keep an eye on how your participants allocate their retirement dollars. If you do offer volatile actively managed funds and a significant proportion of participants appear to be taking on greater risk than might be appropriate, step up investment education programs to equip risk-takers to consider their investment strategy.

A New Way to Work with us – NetClient CS

In a world where business is done anytime and anywhere, we are pleased to announce a new way to work with us from any highspeed internet connection, 24 hours a day, seven days a week. Using NetClient CS is as easy as online banking and it’s completely secure.

Once you’re up and running on NetClient CS, you’ll have your own secure, password protected online portal that you can access from our website. Just log-in from your web browser for instant access.

A Client Portal allows you to:

• View and print tax documents – including finished tax returns, electronic filing authorizations, and more. Final tax documents and other items can be saved for up to 7 years on the portal; you can also copy the files to your own location for safe keeping.
• Eliminate the bulky paper copies of your tax return, store and access them securely anytime/anyplace.
• Exchange files with us – any file, any time.

State-of-the-Art Security:

Our NetClient CS portals are hosted at some of the largest most secure data centers in the world. It uses the industry’s most advanced security and reliability measures to keep your data safe, including:

• Built-in redundancy: Multiple data locations, internet connections, and power sources keep your portal up and running all the time.
• Secure Password Protection – This protects your data as it travels between the data center and your computer.

Get set up today!

Simply send us an email ShannonTax@Shannon-CPAs.com or contact our office at 253-852-8500 to indicate your interest in getting set up.

Help us walk into a great new year! The months after the holidays are typically periods of financial concern for our community with the greatest needs. We invite you to consider supporting our community this year by donating shoes for children.

Our firm has organized this shoe drive to support the Kent School District. We are asking for your help! For every tax return, we prepare for you between now and April 17th, we are asking you to bring in a new pair of shoes or cash donation. Shannon & Associates will match your donation!

We believe this is a small yet important step for those in need in our community. Please help us have a successful Shoe Drive.

Sizes Needed: Toddler Size 13, Children’s sizes 1-6, Men’s & Women’s sizes 7-10.

This alternate approach can save headaches, but at a price. Do you worry each year about whether your highly compensated employees (HCEs) will have “excess” salary deferrals returned to them due to the plan failing the actual deferral percentage / actual contribution percentage (ADP/ACP) discrimination tests? Most small plan sponsors take advantage of “safe harbor” rules that nearly always eliminate the need to worry about passing these tests. But there are risks to this approach as well.

What are the test formulas?

Currently, the threshold for HCE status is an annual salary of $120,000, or at least 5% company ownership.

Using the ADP test, you first calculate your HCEs’ average deferral rates, including employees eligible to participate in the plan but who choose not to. For example, if you have only two HCEs, and one deferred 5% and another 6%, the average is 5.5%. Also suppose, using the same calculation method, that your non-highly compensated employees’ (NHCEs’) average deferral rate is 4.5%.

Although the HCEs’ ADP exceeded the NHCEs’, you’d pass the test because, when the NHCE average deferral rate is between 2% and 8% (as is typical), the HCEs’ ADP can exceed the NHCEs’ by up to two percentage points. That is, the NHCEs’ average deferral could have been as low as 3.5%, and you’d still pass. (Different formulas kick in when the NHCEs’ average deferral rate is below 2% or above 8%.)

The ACP test is similar, but also includes employer matching
contributions and after-tax employee deferrals.

And the Cost is...

Let’s say you have the alternative of offering a less generous plan, but still pass the actual deferral percentage / actual contribution percentage (ADP/ACP ) discrimination tests. How much would a safe harbor plan “cost” you? The answer depends on:

• How elaborate and aggressive a 401(k)  promotion plan you’d need to convince  enough nonhighly compensated  employees to participate and tilt the  scales, and
• How close to the minimum safe harbor matching and nondiscretionary contribution formulas you’d need to get  to clear the tests.

You’ll have to conduct this analysis to make your estimate. You’ll also need to weigh the dollars at stake against your goals behind sponsoring a 401(k) plan in the first place. You might conclude that spending a bit more by establishing a safe harbor plan is worth the (potentially extra) investment in helping employees save for their future.

What if you don’t pass?

If you’re consistently failing those tests by a wide margin, a safe harbor plan design could look attractive. The rules provide two safe harbor formula categories to choose from to avoid ADP/ACP testing, as well as top-heavy testing:

Minimum matching contribution formulas. This requires plans to either:

• Match 100% of the first 3% of deferred compensation and 50% on deferrals between 3% and 5% (which means the maximum you’d contribute is 4% of employee compensation), or
• Match 100% on the first 4% deferred.

Non-elective contribution rate. The company must contribute 3% of the eligible employee’s compensation, regardless of how much or little NHCEs save on their own.

All safe harbor contribution amounts must vest immediately with the employee.

How about a QACA?

A qualified automatic contribution plan (QACA) is also a form of safe harbor plan. With this approach, you must auto-enroll employees into the plan and a qualified default investment option such as a target date fund. A QACA must have a minimum initial deferral rate of 3% and annual deferral rate increases of at least 1%, until the deferral rate reaches at least 6%, but no more than 10%.

In addition, the plan must match 100% of deferrals on the first 1% deferred, and at least 50% on incremental deferrals up to 6%. (The net result is a maximum required match of 3.5%.) A two-year cliff vesting formula is permissible.

Where to next?

Starting a safe harbor plan takes some planning. If you want to establish a new one, you must do so by October 1 for calendar year plans. Existing 401(k) plans have until January 1 to start as a safe harbor plan.

You must provide participants a notice of intent to be a safe harbor plan for the coming year at least 30 days prior to the new plan year. If you currently have a 401(k) plan, check your plan documents to ensure you can amend them to add a safe harbor plan.

Should you do it?

Going the safe harbor route is the path of least resistance, but it can also be the more expensive one. (See “And the cost is...” on page 3.) Set a time to discuss the pros, cons and applicable documentation with your benefits advisor. He or she can review the ADP/ACP discrimination tests with you, as well as determine whether a safe harbor plan would work for your organization.