401(k) best practices: plan design
Having worked as a 401(k) plan consultant and investment adviser for more than 30 years, I have seen a wide variety of plan designs. For example, Apple, Trek Bikes and IBM all have unique corporate cultures that are reflected in the design of the 401(k) plans they offer their employees.
Your firm has a culture that is expressed in its 401(k) plan, too. I don’t think you should lose that. However, you may want to look at some plan design elements that have become standard in leading-edge 401(k) plans.
These features have been proven as best practices in helping participants achieve retirement-ready balances and are listed immediately below. Following is a section that includes what I believe will be the next wave in 401(k) plan design. Finally, I have shared plan design features that limit plan sponsor liability that all plan sponsors should incorporate into their plans.
Current 401(k) plan design best practices
Auto-enrollment. With opt-out rates of less than 10%, auto-enrollment has become the most effective way to combat employee inertia at enrollment. If you aren’t auto-enrolling new hires right now, you really need to think about starting soon. Initial default contribution percentages are increasing to around 5% or 6% (from what was the standard 3%).
Auto-escalation. Studies show that participants need to add at least 15% to their 401(k) accounts each year to accumulate a retirement-ready balance. Annual auto-escalation of 1% per year to at least 10% helps them get there. If you are auto-enrolling, you should be auto-escalating as well. They go hand-in-hand.
Immediate 401(k) contribution eligibility. Very few progressive employers make their participants wait to begin making 401(k) contributions. Immediate eligibility for both regular pre-tax and Roth 401(k) contributions is the norm now.
A stretched match. To encourage a higher level of participant contributions, many employers are stretching their matching contributions over a broader employee deferral. A traditional match had been 50% of the first 6% of employee deferrals (resulting in a 3% employer match). A stretched matching contribution will provide the same 3% matching contribution over a larger employee deferral — 25% of the first 12%, for example.
Roth 401(k) deferral option. Many young participants will benefit from a contribution strategy that includes the use of Roth 401(k) accounts. After five years, balances in these accounts may be distributed tax-free (for qualified distributions). Participants who contribute to Roth accounts for their entire careers may build an enormous tax-free balance. Also, your executive group will appreciate having the option to use these accounts to execute tax-planning strategies.
Leakage management. Protecting plan participants from themselves has become an important plan design feature. One way of doing that is eliminating opportunities for leakage by reducing or eliminating plan loan and withdrawal options (unless a hardship exists). Loan balances are often defaulted when participants change jobs, permanently removing assets from their retirement balances.
Participant investment advice. The time when all 401(k) participants have access to professional investment advice from multiple sources is here. Many recordkeepers now offer at least two types of investment advice: algorithm based (think robo-adviser) and a more personalized version (either a proprietary option or through a firm like Financial Engines, or both). Costs range from free to 100 basis points.
Professionally managed balanced option. This normally takes the form of a target date series in most plans. Remember, the vast majority of your 401(k) participants want someone else to manage their 401(k) account for them. Stay away from risk-based solutions, model portfolios, and customized target date series. Although sold as being less expensive, they usually aren't and have a number of inherent problems.
The next wave of 401(k) plan design best practices
Annual re-enrollment. Many employers are re-enrolling non-participating employees each year and defaulting their investment choices into target date options. Use of annual re-enrollments typically increases plan participation to at least 90%.
HSA investment options. If you offer a high deductible health plan, then you should also offer health savings accounts to your employees. It is smart retirement planning for all employees to max out their HSA contributions each year. Since it is possible to carry HSA balances into retirement and use them to pay health care expenses, having investment options in HSAs to help balances grow is becoming more important.
Less profit sharing and more matching. Progressive employers understand that profit sharing contributions are less valuable in terms of motivating participants to contribute than employer matching contributions. If possible, replace any employer profit sharing contributions with employer matching contributions.
Online education. Many progressive employers have realized that their employees need help with financial literacy. Not only will improved financial decision-making skills help them make better employee benefit decisions, but those skills will also help them do their jobs better. These employers are combining financial literacy/wellness education with 401(k) plan education and hiring firms to deploy online access to 10 or 15-minute modules. An online approach ensures that education opportunities are offered to millennial’s where and when they want them — on their smartphones at a time of their choosing.
Litigation protection elements
Elect to comply with 404(c). By complying with ERISA section 404(c), employers can shield themselves from lawsuits brought by participants relative to the investment options offered in the plan. Ask your investment adviser to outline what you need to do to comply.
Designate a QDIA. Employers designating a Qualified Default Investment Alternative (QDIA) receive protection from participant lawsuits relative to losses participants may suffer in the QDIA investment. Again, ask your investment adviser to explain.
Safe harbor plan design. If your employee group is small (100 employees or less), it is very likely your owners would benefit from using a safe harbor plan design. These plan designs provide exemptions from non-discrimination testing requirements if a mandatory level of employer contributions is made.
Keep in mind that progressive plan design supports plan objectives that you regularly communicate to your employees. Review your plan soon. Most of these features cost very little to implement.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC.