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The New Breed of 401(k) Plans: |
Pension and Retirement Memo |
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Not long ago the hot issue in Congress was whether social security should be "privatized." The concept was to allow workers to direct the investments of a portion of their social security contributions into stocks and bonds. The arguments for and against privatization went something like this: The proponents of privatization argued that long term investing in the stock market was a "sure thing" to produce higher long term benefits. Impressive charts demonstrated how small amounts (only pennies a week, mind you) invested in stock market index and lifestyle mutual funds over long periods would make retirees wealthy beyond their dreams. They wouldn't be able to spend it all! The opponents to privatization argued that the stock market is too risky. Remember Enron? Opponents viewed privatization as a thinly disguised political payoff to greedy Wall Street types (all in Gucci shoes and driving BMW's) who would get unconscionable fees for fleecing the working poor. It was as plain as day. As we know, the opponents to privatization won, and America was saved from financial disaster. In an ironic twist, however, while the opponents to privatization were celebrating their victory, Congress passed the Pension Protection Act of 2006, which, in effect, let the genetic precursor to social security privatization through the back door in the form of the 401(k) plan. The new generation of 401(k) plans is the Trojan Horse for privatization. Background 401(k) plans have been with us since the early 1980’s. A 401(k) plan allows each participant to defer current pay on a pre-tax basis into the plan. The current DNA of a 401(k) plan is entirely different from that of its earliest ancestors. Those first 401(k)’s were an obscure sub-species of profit sharing plans targeted to only the highest earning employees. In those early years the IRS fought to kill 401(k) plans. Congress came to the rescue and saved 401(k) plans by transforming them from an exotic retirement plan perk for the highly paid into a retirement plan for the blue collar rank and file. Over the next twenty years, legislative, tax, and economic forces made the modern 401(k) plan the principal tax-qualified retirement vehicle for every segment of the workforce, from the president down to the mail clerk. Traditional defined benefit and profit sharing plans have been replaced by the 401(k). The Pension Protection Act of 2006 ("PPA") added bells and whistles to 401(k) plans, which, when implemented in the near future, will make 401(k) plans look like privatized social security. In this memo I'll take a look at this stealth privatization and the current hot issues with 401(k) administration. Automatic Enrollment The PPA added the concept of "automatic enrollment" in 401(k) plans. These rules are effective on January 1, 2008. In the past, eligible employees in 401(k) plans had to take the affirmative step to sign up for the plan and consent to pre-tax contributions to the plan ("elective deferrals," in 401(k) speak). That meant filling out forms and making decisions on how much to defer and then how to have the deferrals invested. That's a lot of work! People smarter than me argued that employees would be more apt to participate in 401(k) plans if they were required to participate when hired but were allowed to opt out if they so chose. Congress gave this a shot with the concept of "automatic enrollment." Automatic enrollment is officially known as a "Qualified Automatic Contribution Arrangement," (or "QACA," I suppose, as in "milk and QACA's"). It works this way. A new employee is automatically enrolled in the plan. In the first year a designated percentage (at least 3% but not more than 10%) of his or her pay is put into the plan. In the second year the minimum is 4%, in the third year it's 5%, and in the fourth year it is 6%. The employer either (i) matches these mandatory-voluntary (?) contributions at the rate of 100% on the first 1% and 50% on the balance up to 6% (for a total of up to 3.5%), or (ii) contributes a flat 3% for all eligible non-highly paid employees, whether or not they stay in the plan. The employer's incentive to establish a QACA is relief from 401(k) non-discrimination testing. There are comprehensive notice and timing requirements. Default Investments Automatic enrollment would not make sense unless the law allowed "default investments." Before the PPA, employers were not allowed to make investment advice available or offer a "safe harbor" investment if plan participants made no investment choices at all. The PPA amended ERISA Section 404(c) to add the concept of Qualified Default Investment Accounts ("QDIA"). The Department of Labor has issued regulations on these default investments. They include so-called "life cycle" mutual funds, balanced mutual funds, or managed accounts. If a participant makes no investment choice, the employer may have his contributions invested in a QDIA without violating ERISA's fiduciary liability rules. Crackdown on Fees The Department of Labor ("DOL") is developing new rules on the disclosure of fees paid by participants in 401(k) plans. Even though ERISA has been on the books since 1974, there are no specific requirements on disclosure of expenses. Right now it is difficult, if not impossible, for many 401(k) participants to know exactly how much they are paying for 401(k) plan administration. Congress held hearings, and now the DOL is soliciting recommendations on how the rules should be designed. Eventually we will have specific rules on fee disclosure, and they will have a significant effect. IRS Audits Recent IRS 401(k) audits focus on "coverage," or making sure that the employer is including the eligible employees in the 401(k) plan and making the correct contributions for them. This is not as simple as it would seem, as there are tricky rules for top-heavy plans and those plans making the 3% safe-harbor election. DOL Audits The DOL is running a speed-trap. Here's how it works. The DOL, the other federal agency that regulates retirement plans, is aggressively auditing 401(k) plans on a single issue: the timing of 401(k) contributions. When a 401(k) participant elects to have some of his pay go into the plan, the DOL regulations say the employer must actually deliver the money to the plan as soon as administratively possible but no later than the 15th business day of the following month. This rule has been in effect for more than ten years. Over time, many companies and plan administrators viewed the "15th day of the next month" as the deadline. Not so says the DOL. On plan audits, the DOL asserts that if the employer's payroll system can accommodate delivery of the participants' contributions sooner than the 15th day of the next month, that earlier date is the deadline. For example, if the employer uses any electronic payroll system, the employer can probably make plan contributions on payday, or perhaps a day later. That's the deadline. I have had several clients ticketed in this DOL speed-trap. The employers had to make extra contributions to the plan to make up for the earnings lost by participants due to the delayed contributions. In fairness to the DOL, however, it is more concerned with accelerating payments to plans than penalizing employers. In most cases, the "penalty" of the additional contribution is modest and the DOL agents have, in my experience, been flexible. I generally advise clients that if participants' 401(k) contributions are not being delivered to the trust for investment each payday, they'd better have a good reason.
Expected Growth of 401(k) Plans There has always been talk that the markets will collapse when the baby boomers begin to retire and withdraw funds from IRA's and 401(k)'s for living expenses. Recent studies have dispelled that concern, and now forecast huge growth of 401(k) and similar retirement arrangements for decades to come. (For example, see www.nber.org/papers/w13083). The accumulated wealth currently in plans will just keep growing and growing. What's Next for 401(k)'s? We are told that the national savings rate is deplorable. A lot of so-called "think tanks" are proposing all sorts of methods to increase savings, and almost every one focuses on 401(k)s and IRAs. (For example, go to www.conversationoncoverage.org and Saving in America at www.aspensinstitute.org). Interestingly, the Conversation on Coverage was developed by a joint effort of traditional adversaries of unions, business, and the financial services industry. A common recommendation in all of these studies is some form of mandatory employer contribution to company retirement plans. Where We Are Now Let's step back and examine the new breed of 401(k) plan.
Conclusion The new 401(k)'s are remarkably close to "privatized social security" which supposedly went down in flames. All that's lacking is mandatory employer contributions to them. But, from where we are now, it is not much of a leap to mandatory 401(k) contributions. For example, a simple change to payroll tax laws could require employers either (i) to increase the employer portion of FICA by 3.5%, or (ii) to maintain an automatic enrollment 401(k) plan with the 3.5% mandatory contribution. Employers can then choose to add more to the federal government's illusory social security trust fund or a 401(k) plan that they can control. I am sure we will be hearing many more and better ideas in the future. My guess is that mandatory 401(k) contributions and increased social security taxes will be part of the same debate, and together they may offer a politically acceptable compromise for greater retirement savings.
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© 2008 Eugene Parrs |
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