Before a company even decides to offer a 401(k) plan, it must first be clear on the reasons it wants to do so, according to group retirement plan experts.
Is it because the business owner or executives want to participate and create a tax-efficient vehicle for themselves, or is it because the company wants an employee benefit that can be used to entice and retain talent?
“The decision from ownership and executives – and what their participation looks like – is a big factor in designing these plans,” says Chad Johansen, director of retirement sales at Plan Design Consultants, Inc. in San Mateo, Calif.
When he works with businesses, he tries to get them to see the big picture, he says, explaining to business owners that if they take all of their money as income, they’ll pay higher taxes on it, but if they form a 401(k) plan and give a small percentage of earnings to the plan participants, the owners and top executives will benefit by having a pre-tax shelter for their income.
After the decision is made, Plan Design Consultants walks business owners through the five Ws of plan customization: Who is going to be eligible for the plan? When are they going to be eligible to participate in the plan? What types of contributions can they put into the plan? Where will the money be invested? And what else do we need to be cognizant of when designing the plan?
Many companies have high employee turnover, Johansen says, so they should consider putting a short waiting period on when employees can participate in the plan and be eligible for an employer matching contribution. He recommends six months to one year. That ensures that they are “dedicated to the business before they are offered a significant benefit like this. The majority of businesses want employees with skin in the game,” he says.
Some advisers believe that companies should not institute a waiting period for employees to begin participating in the plan because it is hard for people to receive six months or more of paychecks and then start seeing money taken out for the retirement plan. They could, however, wait to implement the employer matching contribution until after a waiting period.
To make 401(k) plans better serve the needs of workers, they need to become more like a defined benefit plans, according to Robert C. Lawton, president of Lawton Retirement Plan Consultants in Milwaukee, Wis., and a regular contributor to EBN.
“If we could institutionalize some of the features of defined benefit plans into defined contribution plans, not only would that help participants out in terms of guiding them and putting guardrails on the plan, but it would also help all the DC plans become more successful,” he says.
Many experts call it the DB-ification of DC plans, where companies offer things like automatic enrollment and automatic escalation.
“You take the enrollment process decision away from the plan participants who didn’t take the initiative to enroll in the 401(k) plan,” says Lawton. “We know everyone should be enrolled in 401(k) plans. Let’s just auto enroll them.”
Richard Rausser, senior vice president of client services at Pentegra Retirement Services in White Plains, N.Y., agrees that automatic design features are key, but adds that as part of auto enrollment, plan participants should be enrolled at a higher deferral rate than the typical 3%. The default should be 6% of pay or more, he says, noting that “most employees voluntarily enroll at 5% or 6% so why not make the default that much as well?”
Employers can make the deferral rate really work for employees by offering a matching contribution, say 50% of the first 6% of pay or using a safe harbor match, he says.
“Once a plan participant’s been in the plan a year or so, bump their savings one to two percentage points,” Rausser says. “In my mind, the overall goal is to get each employee or plan participant saving 10-plus percent per year, whether that is their own contributions or combined with the employer match.”
Rausser and Lawton agree that companies should limit the amount of money that can flow out of a 401(k) plan, sometimes referred to as plan leakage, in the way of plan loans.
“Most 401(k) plans need a loan feature. It is difficult for employees to save money long-term and never be able to take money from the plan,” Rausser says. He recommends that companies have a loan option but limit it so plan participants can only have one or two outstanding loans at a time.
“We’ve seen plans that on Jan. 1, people line up for their new loan at the beginning of the new plan year,” he says. “They can take one a year. That is diverting retirement assets for other means, so limit the number of loans outstanding in the plan.”
Lawton points out that many loans never even make it back to the plan.
“A lot of loans are defaulted,” he says. Plan sponsors should either eliminate loan provisions altogether or cut back to one allowable loan, he believes, adding that, if possible, plans should only permit loans in the case of hardship withdrawals.
Financial wellness is another important piece to include in any new or revamped 401(k) plan. That means addressing all facets of financial education, including budgeting, paying off debt and saving for retirement.
“I think the future of employee education and financial wellness is online Internet training in 10- to 15- minute modules. There’s starting to be a lot of firms out there offering this training. For millennials, it has to be short,” Lawton says, maintaining that most people can handle 10 to 15 minutes but will balk at sitting through 30- to 60-minute employer education sessions.
Most experts agree that the majority of plan participants don’t know much about investing or retirement. That is why it’s crucial to include either an advice option in the plan or a managed account option, like a target-date fund, where all of the decisions are made for a participant. And if a plan sponsor doesn’t know much about investing or how to run a retirement plan, they may also want to seek help from a third-party fiduciary service.
There are many companies that outsource fiduciary services to companies that are in need of help, including ERISA 3(16) advisers who help plans create and maintain plan documents and administer the plan in accordance with plan documents. ERISA 3(38) advisers, meanwhile, make all of a plan’s investment decisions; and ERISA 3(21) advisers are those who give investment advice or have any responsibility for administering the retirement plan. But outsourcing some of a company’s fiduciary risk does not take away a company’s fiduciary responsibility, caution the experts. Company executives are still expected to monitor the people they hire to help them with these aspects of their plan to make sure any plan-related decisions are in the best interests of the company’s employees.
A Roth 401(k) is another feature Rausser believes most companies should offer. Not everyone in a company will benefit from having an after-tax retirement savings option, but younger workers have the benefit of being able to save money for years in their Roth, growing that money and its earnings tax-free for when they start withdrawing funds in retirement.
“For somebody in a lower tax bracket who is most likely to be in a higher tax bracket later on,” the tax savings are huge, Rausser says. They may pay a 15% tax on that money when they first deposit it into their Roth 401(k) instead of paying a 25-35% tax on it upon withdrawing it at retirement.
Another plan design feature that has garnered a lot of attention recently is lifetime income options. That means giving plan participants the chance to put some or all of their retirement savings into an annuity that will pay out a steady stream of income when they retire. While it’s another way of making a 401(k) plan more like a DB plan, the idea hasn’t really caught on with plan sponsors, who often cite portability concerns and a lack of interest among plan participants as barriers to offering such options.
Profit sharing is another feature that can be used within most 401(k) plans. It’s a discretionary contribution made by the employer to all plan participants, based on a proportion of their annual salary. And while profit sharing plans are a great way to reward older employees for their loyalty, they are subject to non-discrimination rules, which “prohibit you from giving too much to highly compensated employees and not enough to non-highly compensated employees,” Rausser says.
But profit sharing components are easy to add to an existing retirement plan, Johansen says.
“Because every company wants to have the flexibility to add features or to fund profit sharing or give more in matching contributions if it is a good year, they have to design the written plan in a way for the business that is easy to and so that the employees can truly understand it and engage in it,” he says.
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