Why Small Plans Often Outperform Large Plans

Analysis of public Form 5500 reporting data reveals small 401(k) plans often outperform large plans on a number of key metrics, says Judy Diamond Associates.

This finding is based on Judy Diamonds’ proprietary 401(k) plan benchmarking methodology, which assigns a zero (0) to 100 score for publicly reported retirement plans, based on the most recent Form 5500 plan disclosure documents released by the Department of Labor (DOL). Judy Diamond researchers say an analysis of the DOL’s most recent Form 5500 data shows that micro 401(k) plans, those with 10 or fewer participants, had an average plan score of 68.3 out of 100. In contrast, those 401(k) plans with 100 or more participants averaged plan scores of 52.3 over the same period.

As Judy Diamond explains, plan scores are calculated using an algorithm that considers key measures of a plan’s performance compared with other plans nationwide. Higher plan scores can result from comparatively higher participation rates, increases in contributions, higher rates of return, or an absence of certain signs of plan distress, such as corrective distributions or losses due to fraud.

Eric Ryles, managing director of Judy Diamond Associates, tells PLANADVISER that the analysis also takes into account the movement of a plan’s scores on key metrics—so plans that are taking strong action to improve performance on certain metrics can climb quickly up the rankings.

“What we are doing with this kind of grading is taking a look at the plan in question and ranking the way it compares to all the other plans in the database,” Ryles explains. “We group them into ‘deciles,’ or ten equal groups into which a population can be divided according to the distribution of values for a particular series of variables. It’s a powerful way of looking at very large databases, which we have in the public Form 5500 materials.”

The point of analyzing plans this way, Ryles says, is that advisers are not forced to assign a simple, nonnumerical value of “good” or “bad” for any particular plan they serve. Instead, the adviser can clearly see how a plan stacks up overall on a list of important metrics. The adviser can use such data offensively or defensively, Ryles says, either to ensure that their plan clients are performing well compared with their peers—or to target plans that could be improved and which may be looking for a new adviser.

“Let me give you an example—if I told you this 401(k) plan had a return of 4% in a given year, would you say that that good or is that bad? Well the answer depends on the context,” Ryles says. “In 2008, a 4% return would have been great. Last year, when the markets were shooting up—not so much. This type of analysis allows us to really closely factor in the current context around the Form 5500 data.”

When looking at Form 5500 data this way, some very clear trends emerge, says Ryles. Perhaps the clearest outcome is that the smallest retirement plans are punching far above their weight in terms of performance. The smallest plans’ tended to score significantly higher than their large-plan counterparts, he explains.

“There are a few reasons why the smallest plans are really driving ahead, and perhaps the most important factor is the participation rates,” Ryles explains. “If you have a company that has 10 employees and all 10 are participating, that’s 100% participation and that is fantastic.”

Ryles says it’s actually fairly common to see 100% participation in the micro-plan market. “But with the Fortune 500 companies on the other end of the size spectrum, just in their nature as larger employers, there is not much hope that they will get all the way to 100% participation,” he says. “So that’s one clear advantage for the smallest plans.”

Further, small 401(k) plans tend to be offered by more profitable small businesses, Ryles says. Small companies that are not overly profitable or successful are less likely to offer a retirement plan to workers—or if they do, the retirement benefits are more likely to be delivered through the “SIMPLE IRA” arrangement. This type of plan provides small business owners with a simplified method to contribute toward their employees' and their own retirement savings.

In essence, the SIMPLE plan arrangement allows employers to forego a lot of the testing and reporting requirements of a 401(k) plan in exchange for an agreement to provide a set amount of non-elective contributions for all employees. Ryles points to the example of a small, successful doctor’s office to demonstrate the point.

“Maybe it’s a doctor’s office with three physicians and five long-time staff members, and they’ve set up a nice profit-sharing component in there and the business is doing well,” Ryles explains. “In this situation it’s not hard to imagine that most or all of the participants could be putting away close to the $17,500 or whatever the limit happens to be in a given year. So there is an outlay of these very profitable, small businesses that impacts the overall analysis and really boosts the performance among the smallest plans.”

Another important piece of the Judy Diamond analysis to consider is that, while 37% of all plans can be classified in the micro category, just 1.4% of participants are covered by these plans. This divergence means that only a small percentage of workers have access to the strongest plans, Judy Diamond says.

“This research underscores the needs for advisers who work with the largest 401(k) plans to continue to look for ways to improve their performance,” Ryles adds. “This can be accomplished by increasing automatic enrollment, restructuring the company match, and increasing participant education. The good news is that a small portion of large plan sponsors can have a huge impact on the way we save for retirement.”

Indeed, while “giant plans,” or those with 500 or more participants, cover 73.4% of all participants, they represent only 2.9% of all plans.

Other interesting highlights from the research show that, for both the largest and smallest plans, two of the top three industries represented were health care and finance. More information on Judy Diamond, a dedicated provider of 401k plan intelligence services for advisers, is available here.