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June 12, 2008
Scott Thole, HORAN
The passage of the Pension Protection Act (PPA) in late 2006 made more features available to plan sponsors for their 401(k) plans. PPA brought automatic enrollment, automatic increase, qualified default investment accounts (QDIA) and Roth 401(k). Another change in recent years is the addition of Target Date or Lifecycle funds to a majority of plans. In addition, a reduction in the service requirements to participate in 401k plans was instituted.
Automatic Enrollment has been around for many years. The passage of PPA allowed many plan sponsors to add automatic enrollment to their plan with fiduciary protection. In the past, many states did not allow companies to withhold money from employee's checks without the employee approving it. PPA overrode state laws to allow this withholding without employee approval.
Plans using this feature enroll participants at a pre set percentage, usually between 3 and 6 percent. The participant can opt out or change their deferral percentage at anytime. If participants enroll automatically, their money is directed to a QDIA.
The increased deferrals and participation, benefits employers and may allow them to pass non-discrimination tests that were failed in the past. In addition, a safe harbor is available if employers meet certain criteria that allow them to avoid non-discrimination testing totally. Plan sponsors are providing a jump-start to get employees to save for their retirement that normally would not.
Automatic Increase, a feature coupled with automatic enrollment, increases the percentage participants defer from their check by 1 or 2 percent on an annual basis to a predetermined level. This level is usually 6 to 10 percent. Plans need this feature if they utilize the safe harbor mentioned above. It gives participants a better chance of having a comfortable retirement because for most deferring only 3 percent will not provide them a comfortable retirement and most participants do not make changes to their plan after initial enrollment.
Qualified Default Investments Accounts (QDIA) result when participants do not make an investment election themselves. This situation usually happens when the plan utilizes automatic enrollment or offers a profit sharing/ employer contribution that goes to all eligible employees of the company. The three allowable QDIA's are:
- Life cycle or target date funds
- Balanced mutual fund
- Professionally managed account or asset allocation service
Many plans had a money market or stable value fund as their default investment in the past. A plan can still use these funds, but there is no fiduciary protection offered to plan sponsors after the first 120 days. Though money is safe in a money market, the return will probably not even keep pace with inflation. This allocation leaves participants short of needed income in their retirement years
Roth 401(k) allows participants to defer after tax money that will grow tax free throughout their working years. Unlike a Roth IRA, no income limitations exist to use it and participants can defer up to the 415 limit of $15,500 each year. Participants can also split their deferrals between Roth and pretax to give them multiple money sources to draw on during retirement. Many variables determine if the Roth makes sense, including age, current and expected tax bracket and income. In a Roth IRA, participants can only put in up to $5000 per year. Research shows the service sector, including professional firms, has dominated the early adoption of the Roth 401(k) feature.
Target Date and Lifecycle Funds are one-stop investment vehicles for participants who do not want to invest the time to pick their own line up of funds. Both types of funds consist of a number of different types of mutual funds to provide an asset allocation to fit the participant's current life situation. The target date funds focus on the projected year of retirement and set an allocation that will automatically become more conservative as the retirement date nears. Normally 3 to 5 lifecycle funds are offered in the plan. They range from conservative to aggressive portfolios. The participant is responsible for switching to another portfolio as they near retirement or go through life changes. Often a series of questions to answer to identify which funds is the best fit.
Eligibility service requirements are becoming shorter every year. In the past, it was common for participants to have to wait a year before becoming eligible to put money into the plan. Over the past few years, the trend has been to reduce this wait time to 3 months or less. Dual eligibility, where participants become eligible to defer money from their check in 3 months or less but have to wait 6 months to a year to get employer money, is becoming more common. By reducing the waiting period, employers allow newly hired participants to continue putting money away and not have any time out of the market. It is also a tool used in recruiting; prospective employees are becoming more aware of their retirement needs and having to wait up to a year plays into their decision process when evaluating potential employers.
We invite additional questions about these features and how they relate to your 401(k) plan. Please contact Andrew Sweeny Jr. or Scott Thole at 513-745-0707.
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