The future of the 401(k) lies with small businesses

The number of small businesses is growing, in some part due to unhappy workers leaving jobs to set up shop on their own. That has led to more startup 401(k) plans.

Small businesses represent most U.S. companies, and they employ about half of the country’s workforce — yet half or more do not offer retirement plans.

It’s an opportunity the financial services industry has long snubbed, as cost-competitive 401(k) services for small plans have lacked the profit potential of much larger ones. But that is changing quickly, and retirement plan coverage could increase dramatically.

Behind that are the rise of state-sponsored auto IRA programs, the development of pooled employer plans and improvements in technology that have made small 401(k)s easier to provide. It’s also worth mentioning that workplace benefits are increasingly necessary to attract the best job candidates in a competitive market for talent.

“Many small business owners and their workers have historically been disadvantaged in saving for retirement,” said Kirsten Hunter Peterson, Fidelity Investments’ director of workplace thought leadership.

Less than a year ago, the company launched a pooled employer plan, or PEP, which it calls Fidelity Advantage 401(k). That product, which is aimed at businesses with five to 50 workers, has more than 100 employer clients, with an average of about 20 employees at each, Hunter Peterson said. Fidelity is not yet disclosing the assets in that plan.

Among small businesses, “there is demand there, and there has been demand there for a long time, but it was something we couldn’t support [previously] for a variety of reasons,” Hunter Peterson said.

For many companies, that changed with PEPs. Under the 2019 SECURE Act, employers at unrelated businesses can participate in the same plan structure, meaning that providers can aggregate more assets in single plans. That creates economies of scale and in many cases gets participating businesses less expensive plans than they would qualify for on their own. It also hands off most of the fiduciary oversight to plan providers — something that small businesses, and even some larger ones, are more than happy to do.

“We’ve focused on these startup plans,” Hunter Peterson said. “These are first-time retirement savers.”

Clients have come from numerous industries, including retailers, auto body shops, landscaping companies and animal hospitals, she said.

Over the next year, Fidelity plans to continue growing the product among similarly sized businesses. In the future, it could add features such as Roth options, plan conversions or employer matching contributions, Hunter Peterson said. Currently, the PEP does not allow advisers to act in a 3(21) or 3(38) capacity, which pertain to investment selection — but it could in the future, she said.

AUTO IRAS

Three states — Oregon, Illinois and California — have had automatic IRA programs up and running for several years, and Connecticut recently launched its own. Meanwhile, numerous others are in the development phase, showing that it is a trend that has already caught on.

These programs are boosting retirement plan coverage in two ways, with the obvious one being that they require businesses of certain sizes to enroll their workers in the state-sponsored IRA. But that doesn’t apply to businesses that offer retirement plans, and many are opting to sign up for PEPs or start their own 401(k) instead of going with the state option. It’s a marketing opportunity that the retirement plan business has seized on — just try Googling “CalSavers” and see the search results that come from providers marketing alternatives to it.

“The private providers in the market now see [the demand] and have become much more innovative in developing products and platforms — 401(k) and IRA — to market to those workers in those states,” said Angela Antonelli, executive director of Georgetown University’s Center for Retirement Initiatives, which tracks and studies state-run retirement programs designed for the private sector. “Originally, where it was seen as a competitive threat, they now see it as a very beneficial business opportunity.”

ONE EXAMPLE

Louis Day, founder of NS Capital, said the firm launched its PEP, Unity401k, as soon as possible — in January 2021, with 25 plan clients eager to switch over the structure.

With total fees of about 50 basis points, it’s about half the cost of a state auto IRA and much less than most 401(k)s aimed at small businesses, Day said.

To make a PEP work, it’s got to have scale. If it doesn’t have scale, you’re dead.”

Louis Day, founder, NS Capital

“We’ve done our homework on the state-run IRAs,” Day said. “I could easily say that a very good PEP in the long run is going to be something better than a plan that is currently charging 95 bps.”

That, coincidentally, is the upper range for CalSavers, which has total fees ranging from 82.5 bps to 95 bps, depending on the investments a person uses.

Being one of the first to market with a PEP was not easy, Day said. The 25 existing clients were slated to switch over to it beginning in the first quarter, but moving them was slower than expected.

“It was a disaster — nobody knew what they were doing. It took us the whole year of 2021 to get things straightened out,” Day said. “We were lucky that we didn’t have a lot of [existing] plans with different features,” he added, which made it easier to work with vendors during the change.

The company’s PEP now includes about 30 clients, the latest three of which did not previously have a 401(k). To get the existing plan clients over to the PEP, NS Capital adjusted advisory fees and paid termination fees to the old plan providers.

“In order to make a PEP work, it’s got to have scale,” Day said. “If it doesn’t have scale, you’re dead.”

The company differentiates itself by being the 3(38) fiduciary, meaning that it chooses the investment lineup. Some PEPs on the market use third-party fiduciary services, such as from Morningstar, Mesirow and Mercer, Day noted.

“I call that ‘outsourcing the fiduciary handoff,’” NS Capital investment adviser Joe Hart said. “If they’re dictating what you as an adviser can pick … it’s a false fiduciary role.”

The firm has also created a partnership model with its PEP, allowing other RIAs to add a 401(k) option for their clients, Day said.

“We’ve already got two people who have expressed an interest,” he said. “Putting in a 401(k) practice, for an RIA, is difficult.”

[More: RIAs should pursue 401(k) plans]

MORE TO COME

The three auto IRA programs in California, Oregon and Illinois now represent more than $407 million in assets among 46,000 employers and 430,000 workers, according to the Center for Retirement Initiatives.

“The success of the state auto IRA programs [and] state leadership driving to close the access gap … has really focused the entire industry on addressing a problem that for decades has been ignored,” Antonelli said.

“The growth and innovation in the private market is a positive thing, but it does not take away from the value and demand for state-facilitated programs,” she said. “They will fulfill the different needs of different employers.”

Self-employed people and gig workers, for example, can sign up for CalSavers.

That nontraditional section of the workforce — which also includes temps, freelancers, consultants, day laborers, seasonal workers and others — has notoriously low access to retirement saving options. Less than a quarter of nontraditional workers save for retirement in employer-sponsored plans, according to a report last year from The Pew Charitable Trusts.

Early opponents of state-run programs had expressed concern that those structures would lead employers to end their 401(k)s, Antonelli said. So far, that has not been the case.

“What we’ve seen is an actual increase in private plan formation in Oregon,” she said. “The data to date is showing that the existence of a state auto IRA program is contributing to the creation of private plans by employers.”

OPPORTUNITIES ON BOTH SIDES

One company that is benefitting enormously from startup 401(k) plans and the state auto IRA market is Vestwell.

That firm, which has a 401(k) business and is a service provider for the Oregon, Connecticut and Maryland auto IRAs, counts about 25,000 business and 165,000 workers covered by its services.

“The interest is incredible versus what it was just a few years ago. Everyone is looking at small businesses, individuals under-saved, as a great opportunity to engage,” Vestwell CEO Aaron Schumm said.

The Great Resignation has also been good for business.

The number of small businesses in existence is growing, in some part due to unhappy workers leaving jobs to set up shop on their own. That has led to more startup 401(k) plans, Schumm said.

And the trend of workers leaving old jobs for better ones has also made employers that didn’t previously offer 401(k)s add them, he said.

At least 60% of the company’s 401(k) business comes from new plans, with the rest being plan conversions, Schumm said.

“We’re having to rethink how do we get this stuff on-platform faster, because people are anxious to do so,” he said.

One thing that could accelerate retirement plan coverage exponentially would be a federal auto IRA or coverage mandate, a concept that was pursued by the Obama administration and has surfaced in recent bills in Congress but has not advanced.

“The devil’s in the details with the construct of it. But if they did it at a federal level, I think it would be phenomenal,” Schumm said. “Everyone would have to offer a solution.”