Get Your 401(k) Design Right

I happened to read a few things today about 401(k) matching contributions. One in particular talked about stretching the match. Apparently that means that if you are willing to spend 3% of pay on your workforce, consider making your match 50 cents on the dollar on the first 6% of pay deferred instead of dollar for dollar on the first 3% of pay deferred. This will encourage employees to save more.

That might be a really good idea ... for some companies. For other companies, it might not be.

First and foremost a 401(k) plan is, and should be, an employee benefit plan. Taken quite literally, that means that it should be for the benefit of employees.

Plan sponsors may look at the plan and say that they get a tax deduction. That's true, but they also get a tax deduction for reasonable compensation. And, there is probably less of a compliance burden with paying cash than there is with maintaining a 401(k) plan.

Where does the typical 401(k) design come from? Usually, it's the brainchild, or lack thereof, of someone internal to the plan sponsor or of an external adviser. Either way, that could be a good thing or a bad thing. Most plan sponsors have plenty of smart and thoughtful employees and many external advisers are really good.

On the other hand, when it comes to designing a 401(k) plan, some people just don't ask the right questions. And, just as important, they don't answer the right questions. We often see this in marketing pieces or other similar propaganda that talk about designing the best plan. We might see that the best plan has all of these features:

• Safe harbor design (to avoid ADP and ACP testing)
• Auto-enrollment (to get higher participation rates)
• Auto-escalation (so that people will save more)
• Target date fund as a QDIA (because virtually every recordkeeper wants you in their target date funds)

All of these could be great features for your 401(k) plan, but on the other hand, they might not be. Let's consider why.

Safe harbor designs are really nice. They eliminate the need for ADP and ACP nondiscrimination testing. They also provide for immediate vesting of matching contributions. Suppose your goal, as plan sponsor, is to use your 401(k) plan at least in part as a retention device. Suppose further that every year, you pass your ADP and ACP tests with ease. Then, one would wonder why you are adopting a plan with immediate vesting whose sole benefit is the elimination of ADP and ACP testing. Perhaps someone told you that safe harbor plans were the best and you listened. Perhaps nobody bothered to find out why you were sponsoring a 401(k) plan and what you expected to gain from having that plan.

Auto-enrollment is another feature that is considered a best practice. (Oh I despise that term and would prefer to call it something other than best, but best practice is a consulting buzzword.) Most surveys that I have read indicate that where auto-enrollment is in place, the most common auto-enrollment level is 3% of pay. Your adviser who just knows that he has to tell you about auto-enrollment tells you that it is a best practice. Perhaps he didn't consider that prior to auto-enrollment, you had 93% participation and that 87% of those 93% already deferred more than 3% of pay. Since he heard it was the thing to do, he advised you to re-enroll everyone and now, you are up to 95% participation, but only 45% of them defer more than 3% of pay. Perhaps nobody bothered to ask you how your current plan was doing.

In the words of a generation younger than me, this is an epic fail.

I could go on and on about other highly recommended features, but the moral of the story is largely the same. Your plan design should fit with your company, your employees, your recruiting and retention needs, and your budget. That your largest competitor has a safe harbor plan doesn't make it right for you. It may not even be right for them. That the company whose headquarters are across the hall from yours has auto-escalation doesn't make it right for you. It may not be right for them either.

If you are designing or redesigning a plan for your company, ask some basic questions before you go there.

• What do you want to accomplish with the plan?
• Enough wealth accumulation so that your employees can retire based solely on that plan?
• Enough so that the plan is competitive?
• Something else?
• Will eliminating nondiscrimination testing be important?
• What is your budget? Will it change from year to year? As a dollar amount? As a percentage of payroll?
• What do you want your employees to think of the plan?
• It's a primary retirement vehicle.
• My employer has a 401(k) plan; that's all I need to know.
• My employer has a great 401(k) plan.
• My 401(k) is a great place to save, but I need additional savings as well.
• Will any complexity that I add to the plan help my company to meet its goals or my employees to meet their goals? If not, why did I add that complexity?

These are the types of questions that your adviser asked you when you designed or last redesigned your plan, aren't they?

They're not?

Perhaps it's time to rethink your plan.

401(k) Plans Without Matching Contributions Will Not Allow the Masses to Retire

I read an article this morning entitled "Encouraging Savings Without a Match." The article was informative enough and it did discuss the importance of getting workers to save. It discussed how auto features (auto-enrollment and auto-escalation) will have positive effects in allowing workers to accumulate balances large enough to retire someday.

The author and her sources are correct. Auto features will help, but they are not enough.

Why not?

Suppose I am a participant in a 401(k) plan and you are my employer. Suppose that in that plan, you provide me with a fairly measly (by today's standards) match of 25 cents on the dollar for the first 4% of pay that I contribute. That's not much; you're only contributing as much as 1% of my pay, but you are motivating (note the lack of use of the non-word incentivize) me to defer at least 4% of my pay. That means that 5% of my pay will go into my account. It's also a first-year return on my investment of 25% before I have even a bit of positive investment performance.

If instead, you provide me with a more generous match of 50 cents on the dollar for my first 6% of pay, the motivation for me to defer at least that 6% is even greater. And, of course, if you provide me with one of the nice safe harbor matches that are even more generous, I am motivated still further.

Auto-enrollment provides no such motivation. Without that motivation, when I hit a financial crunch (perhaps my new-fangled high-deductible health plan is not providing me with the risk management tools that I really need), the first place I may look to for an extra source of weekly or monthly cash is those 401(k) deferrals. Perhaps stopping them allows me to pay my rent or mortgage on time. Perhaps it allows me to make my car payments. Because I don't have an additional incentive beyond the holy grail of retirement to continue saving, ceasing my 401(k) deferrals sure feels like a good idea. And, once I stop, I probably won't start again.

From where I sit, most people today seem to live at or above their means where their means are characterized by their take-home pay. The old defined benefit-based system allowed people to retire because their take-home pay was perhaps a little bit less in order to pay for their retirement benefit which could be a fair amount more. The discipline in that was not employee-driven, but plan design and ERISA-driven.

Now, the motivation is largely gone and the discipline is largely gone. People are living longer and a lot of them are going to have to work for a long, long time.