Fixing Retirement Inequality

Just last week, I suggested that retirement inequality is nearing an apocalypse. It's an awfully strong statement to make as both the US and the world have plenty of problems to deal with. Since this one is US-centric (I have nowhere near sufficient expertise nor do I have the requisite data to offer an informed opinion outside the US), I thought I would step up and make some suggestions.

First, the problem: according to the most optimistic data points I have seen, somewhere between 60 and 70 percent of working Americans are "on track" to retire. And, these studies, when they are nice enough to disclose their assumptions use pretty aggressive assumptions, e.g., 7 to 8 percent annual returns on assets (the same people who tout that these are achievable condemn pension plans that make the same assumptions) as well as no leakage (the adverse effects of job loss, plan loans, hardship withdrawals, and deferral or match reductions). The optimists don't make it easy for you by telling you that even their optimistic studies result in 30 to 40 percent of working Americans not being on track to retire (a horrible result). They also tend to pick and choose data to suit their arguments using means when they are advantageous, but medians when they are more so.

Yes, we do have a retirement crisis and as the Economic Policy Institute (EPI) study was good enough to make clear, it is severely biased against the average worker.

The EPI study presented data on account balances and similar issues. It did not get into interviewing actual workers (if it did, I missed that part and apologize to EPI). But, I did. I surveyed 25 people at random in the airline club at the largest hub airport of a major US-based airline. People who wait in those clubs at rush hour are not your typical American worker; they tend to be far better off. I asked them two questions (the second only if they answered yes to the first):

• Are you worried about being able to retire some day? 19 answered yes.
• Would you be more productive at work if you felt that you could retire comfortably? All 19 who answered yes to the first question answered yes to the second as well.

While I didn't ask further questions, many groused about fear of outliving their wealth. Some talked about issues that fall under leakage. A few, completely unprompted remarked that if they only had a pension ...

For at least the last 13 years and probably more than that, retirement policy inside the Beltway has been focused on improving 401(k) plans with the thought that pensions are or should be dead. Even the Pension Protection Act of 2006 (PPA) was more about making 401(k)s more attractive than about protecting pensions. Yet, 13 years later with an entire decade of booming equity markets, even the optimists say that one-third of American workers are not on track to retire.

We've given every break that Congress can come up with to make 401(k)s the be all and end all of US retirement policy. They've not succeeded. 

Think back though to when the cornerstone of the US retirement system was the pension plan. The people who had them are often the ones who are on track to retire. 

Yes, I know all the arguments against them and here are a few:

• Workers don't spend their careers at one company, so they need something account-based and or portable.
• Companies can't stand volatility in accounting charges and in cash contribution requirements.
• Nobody understands them.
• They are difficult to administer.

PPA took a step toward solving all of those problems, but by the time we had regulations to interpret those changes, the "Great Recession" had happened and the world had already changed. Despite now having new pension designs available that address not just one, but all four of the bullet points above, companies have been slow to adopt these solutions. To do so, they need perhaps as many as three pushes:

• A cry from employees that they want a modern pension in order to provide them with usable lifetime income solutions.
• A recognition from Congress and from the regulating agencies that such plans will be inherently appropriately funded and therefore (so long as companies do make required contributions on a timely basis) do not pose undue risk to companies, to the government, to employees, or to the Pension Benefit Guaranty Corporation (PBGC) (the governmental corporation that insures corporate pensions) and therefore should be encouraged not discouraged.
• Recognition from the accounting profession in the form of the Financial Accounting Standards Board (FASB) that plans that have an appropriate match between benefit obligations and plan assets do not need to be subjected to volatile swings in profit and loss.

Give us those three things and the pensions sanctioned by the Pension Protection Act can fix retirement for the future. As the EPI study points out, we'll make a huge dent in the retirement crisis and we'll do in a way that makes the problem far less unequal.

It's the right thing to do. It's right for all working Americans.

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.

Employer Retirement Plan Priorities -- Cut Risks and Costs Says Survey

This morning, I opened up my daily NewsDash email from Plan Sponsor and found an article telling me that employers that sponsor retirement plans (almost all employers of more than a few people do) are looking to curb risks and cut costs. While it's nice to know that a survey confirms prevailing opinion, this is not exactly a revelation.

As disclosures have become more comprehensive, two elements of retirement plans that have gotten particular scrutiny from outside observers are unnecessary risks and unnecessary costs. Interestingly, if a company chooses to make a generous retirement program part of its overall broad-based rewards program, outside observers generally have no problem with this.

Risk in this case is usually measured in terms of volatility. However, just plain old volatility should not be a concern. What should be a concern is volatility in plan costs as it relates to some useful metric or metrics.

Consider a hypothetical company (HC) with free cash flow of $100 million. Suppose the volatility that they are looking at is in pension contributions and that HC is expecting (baseline deterministic scenario) to have to make a contribution in 2015 of $500,000. In looking at forecasts provided by its actuary, HC notices that the 95th percentile of required pension contributions is $2 million. While that is a big increase in relative terms, it may not be enough to have any meaningful effects on the way HC runs its business (it may, depending on circumstances, but in this hypothetical situation, it does not). Depending upon HC's tolerance for risk, this may be a situation where no action needs to be taken.

On the other hand, Failing Business (FB) has a legacy frozen pension plan with expected 2016 required pension contributions of $50 million. FB has significant debt and if it contributes the full $50 million, it will just barely be able to run its operations and service its debt. If that number hits $52 million, FB will default on its largest loan.

What should FB do?

There are several schools of thought here. One is to mitigate pension contribution risk to the extent possible thereby ensuring that the ominous $52 million pension contribution number will not be reached. But, is that really a good strategy? Or is it just part of a spiral to a lingering death? The other school of thought says that FB is an ideal candidate to take on risk for potential reward. If the risk turns out to produce bad results, FB may go out of business, but it looks like whether that happens or not is only a matter of time. On the other hand, if taking the risk generates a big upside, FB will be in a much better position to revive its business.

FB is purely hypothetical and we don't know all the facts here. But, my point is that just because the trend says to do something doesn't mean its right for your company.

On the defined contribution (DC) side, the analysis is a bit different. Today, most companies (I don't have a percentage for you) offer 401(k) plans with some level of employer matching contributions. In this scenario, many companies have thought about the costs, but few have thought about the financial risks.

What are the costs that companies are thinking about? Here are a few:

• The cost of plan administration (recordkeeper, custodial, legal, accounting)
• The fund management fees
• Institutional class versus retail class
• Passive versus active management
• Open architecture versus proprietary

Generally, these are costs that a plan sponsor can control by careful selection of vendors and evaluation of options. Take a look. It may be that your current providers have let their fees to you creep up while their service to you has gone down.

Then, there's the risk. 

One of the other concerns in the DC industry is that employees are not saving enough money. So, many employers are taking steps to encourage their employees to defer more. However, if they defer more, the cost of matching contributions will increase. In my experience, almost no companies actually consider this risk, but I have seen a few CFOs who have been really upset when those matching contributions got big enough that they affected the company's financials.

There are plan designs that can help to control this. Perhaps you should consider one.

Click this link if you want to ask me how.

AOL Reacts to Media and Employee Pressure

AOL had made a decision to follow in what many were calling the IBM mold. Rather than providing matching contributions in its 401(k) plan on a payroll period basis, it had decided to make single matching contributions after the end of the plan year. Therefore, employees who left during the year would not receive matching contributions.

The media were up in arms. Employees were up in arms. AOL gave in and is returning to its former policy of matching on a payroll period by payroll period basis.

And, this is big news!?

What really got to me about the media coverage was the spin that they managed to put on it. Employees could be losing out on the massive run-up on the matching contributions. Not said was that those balances could lose money as well. It's not fair that employees who leave during the year won't get matching contributions. What makes this fair or unfair? If you know the rules up front and you are evaluating leaving during the year, this should be one of your considerations.

How bad is it really? I'm going to oversimplify my example so that the math doesn't strain my brain. Suppose Employee Z has wages of $100,000 per year and a company matches 50 cents on the dollar on the first 6% of pay contributed. This is not an unusual design. Further suppose (and this is not quite right) that matching contributions are usually made on average exactly halfway through the year. Also assume that under the IBM design that matching contributions are made on the January 1 after the end of the year. Finally, assume that balances earn, on average, 10% returns (I want that investment adviser).

Suppose Z does not leave the company during the year. Then the difference during that year is is approximately 5% of $3,000. In other words, under the more traditional design, Z will have an account balance that is $150 larger. Yes, there are the effects of compounding, but this is really not as big a deal as the media made it out to be.

Surely, AOL has already determined how much money it plans to spend on its employees. if it spends more on the 401(k) plan, rest assured it will spend less somewhere else. It all comes out in the wash. But, it sure does make for an exciting story when a bunch of reporters, many of who think the plan is called a 401 [without the (k)], get a hold of it.

Really, it isn't.

Distribution Patterns from 401(k) Plans

I read this morning about target date funds (TDFs) being designed to match up with patterns of distributions that participants are taking. The understanding of these patterns of distribution has been discerned from actual participant behavior. This is good.

Loyal readers though know that I rarely write about anything that's good. So, what's up? Why is John wasting his time on this topic?

As we all know, the past may not be the best predictor of the future. Over time, it may be, but not necessarily in the short run.

If we consider older workers -- for this purpose, I'm going to use this term to apply to anyone in the work force who is at least 50 years old. What do we know about them?

• Many of them have accrued benefits in defined benefit (DB) plans, even if the plans have been frozen or terminated recently.
• A reasonable number of them experienced the insane run-up in equity markets during at least part of the 90s. I don't think we will ever see anything like that again.
• Very few of them have much, if any, money in Roth accounts.

All of this is changing. The wave of the future is much more likely to be that participants have more money in Roth accounts, that they do not have the annuity stream from DB plans, and that very few have surpluses from a prolonged bull market.

As most of you know, currently, penalty-free distributions are generally available as early as age 59 1/2 and required distributions begin at age 70 1/2. When these provisions were put into the Internal Revenue Code, many participants were retiring before age 60 and few worked even close to age 70. Today, this is not the case.

It occurs to me that in the future, participants are going to need a more systematic means of distribution that can be delayed significantly. Part of it leads to new designs of TDFs. Part should lead to changes in the Code.

I plan to comment more on these topics in the future, but that's it for today.

401(k) 3.0?

Mark Iwry (pronounced eevry) gave a speech at the 2012 PLANSPONSOR National Conference in Chicago. I wasn't there, so I am taking PLANSPONSOR's reporting on it as the gospel. Mr. Iwry apparently spoke on the topic of version 3.0 of 401(k) plans.

Before discussing Mr. Iwry's recommendations, I think it's appropriate to provide a little of his impressive resume for those who don't know. Currently, he is senior adviser to the secretary and deputy assistant secretary (retirement and health policy), U.S. Department of Treasury. If you were unable to work it out from the title, that means he is a policy adviser for the federal government. Previous to that, he has been a Principal with the Retirement Security Project, a Senior Fellow with the Brookings Institution, and Counsel with the Department of Treasury. The two roles previous to his current one were related as the Retirement Security Project appears to be a part of the Brookings Institution.

This c.v. would seem to establish that Mr. Iwry is an intelligent man. He has spent a career working in positions in the government and in think tanks that require significant intellect. But, note something that is missing in Mr. Iwry's resume -- he appears to have never been employed by a traditional corporate entity. None of his employers have been focused on profits.

According to the PLANSPONSOR summary, Mr. Iwry laid out five ideas as part of 401(k) version 3.0:

1. Increase the use of automatic enrollment and do it at higher levels than 3% [presumably through automatic escalation]. Use automatic enrollment for existing employees as well as new ones.
2. Stretch the match by doing something like providing a 33 cents on the dollar match on the first 10% of pay deferred instead of a more traditional 50 cents on the first 6%.
3. Give lower-paid employees a higher rate of match.
4. Decrease the eligibility waiting period, or at least decrease it for employee deferrals.
5. Accept rollovers from other plans.

You see, there is a reason that I laid out Mr. Iwry's resume. While any of these ideas might improve the ability of our workforce, taken as a whole to retire, most have another side of the proverbial coin.

Automatic enrollment works really well in some cases. However, I have looked at a lot of 401(k) data. Two things have jumped out to my eyes with plans that use automatic enrollment:

• New employees tend to defer at the automatic rate.
• When automatic enrollment is forced on existing employees, a large number wind up decreasing their deferrals, because they simply do not read their communications from HR and they get-auto-enrolled at levels lower than those at which they were deferring.

Mr. Iwry's second idea may have a lot of merit. In fact, I blogged about it more than 18 months ago. In that post, I discussed a Principal survey based on their client base. It suggested that changing from a match of dollar for dollar on the first 2% deferred to a match of 25 cents on the dollar for the first 8% deferred tended to cost the employer less, but left employees better prepared for retirement. I would love to see similar data prepared by other 401(k) recordkeepers to see if it holds true across a broader universe. 

The third idea is nice. Theoretically, it's nice. Many companies would tell you, however, that it does not make business sense to do this. In fact, I called a corporate Vice President of Human Resources while I was working on this post. He told me, under promise of anonymity, that this is a nice idea, but makes no practical sense. He went on that that there are two ways to accomplish this -- either increase the match for lower-paid employees which cost more money, or cut the match for high-paid employees which hurts morale among the producers.

In my experience, many companies that have a waiting period for a particular benefit do it for one of three reasons:

• It's expensive to set up a record for someone who may not be around for long.
• It's a waste of money to provide a benefit to someone who may not be around for long (yes, I know that they can put a vesting schedule on a match).
• They have so many new employees who don't last long that the increased level of paperwork would overburden HR.

Accepting rollover contributions seems to be a no-brainer. For plans of any meaningful size, the only reason not to do it is the additional fees that a plan might be paying on the additional asset base. But, there is an answer to this. Negotiate up front that this won't cost extra money. If you can't negotiate it out, decide if you can live with the extra cost.

However, 401(k) 3.0? These are not a bunch of revolutionary ideas. There is nothing in here about investments. There is nothing in here about lifetime income options. It just doesn't seem that new.

Of Course It's Time for a Better QDIA

The Pension Protection Act of 2006 (PPA) brought us lots of new terms and concepts. One of the more controversial has been the qualified default investment alternative or QDIA. Essentially, what it did was to require participants who did not make affirmative elections otherwise in defined contribution (DC) plans to be defaulted into a QDIA. On an ongoing basis, and oversimplifying somewhat, the Department of Labor (DOL) regulations give plan sponsors three broad alternatives in selecting their QDIAs:

1. Age-based funds
2. Risk-based funds
3. Managed accounts

Our observations suggest that the most prevalent have been age-based funds, largely in the label of Target Date Funds or TDFs. In a nutshell, a participant picks a year in which they expect to retire, rounds to the nearest multiple of five, and voila, they have a fund. Or, in the situation where a participant is defaulted into a TDF, the plan document uses the same algorithm and without the active consent of the participant, his or her money is in a fund.

The companies that serve as both DC recordkeepers and asset managers love this. To my knowledge, they all have TDFs that they actively market as part of their recordkeeping bundles, and each of these families of TDFs are proprietary funds of funds. In other words, a Fidelity TDF is composed of Fidelity funds and a Vanguard TDF is composed of Vanguard funds. The same could be said about the other asset management firms who are also DC recordkeepers. Perhaps there are one or two out there that do not fit the mold, but I am not aware of them.

This is not to denigrate the current state of TDFs, but I think we can do better. And, so, in fact, do plan sponsors. In a November 2010 study commissioned by PlanSponsor and Janus Capital, only 34% of plan sponsors (down from 57% in November 2009) thought a TDF was the best QDIA available for their DC plan. Or, stated differently, nearly two-thirds of plans (clients) don't like the product that is being pushed upon them. If you were a car manufacturer and two-thirds of potential consumers didn't like your product, you would likely need a bailout. If you made computers and two-thirds of the users thought your machines had the wrong features, you would need to re-think what you were producing.

Well, the large players in the market don't appear to see the motivation to re-invent the TDF, so as I am wont to do, I am going to consider the re-invention for them.

Today, when a participant is defaulted into a TDF, the sponsor (and recordkeeper) uses one data item to make that decision -- age. You would think that was the only data point they had. Well, if Bill Gates and I were both in the same DC plan, we would probably both be defaulted into the 2020 Fund. And, trust me, Bill Gates and I are not in the same financial circumstances. I know you find this shocking, but it just isn't so. The fact is that we do not have the same net worth as each other (I'll leave it up to my readers to work out who is worth more).

But, assuming that we were active participants in the same plan, here is some other data that our plan sponsor would have on us:

• Compensation
• Years of service with the company
• Account balance
• Rollover balance
• Savings rate
• Gender
• Whether our jobs are white-collar or blue-collar
• Accrued benefit in a defined benefit (DB) plan, if our employer sponsors one
• Whether we are eligible for company-provided equity

Each of these is likely to have an effect on our readiness for retirement at any point in time. Let's go through them quickly to see how.

Compensation. That's an easy one, but in general, the more money that an individual makes, the more likely it is that they will be able to retire earlier as compared to later.

Years of service. Continuity with the same company tends to result in larger DC account balances and larger DB accrued benefits making it more likely that a participant will be able to retire at a younger age.

Account balance and rollover balance. The bigger your balance, the closer you are to your retirement goal.

Savings rate. The more you are saving, the less time it will take you to get from where you are to your retirement goal.

Gender. Without regard to other factors such as health and family history, women will, on average, outlive similarly situated men, and therefore need a larger account balance to fund their retirements.

White-collar or blue-collar jobs. Studies done by the Society of Actuaries have shown that white-collar workers outlive blue-collar workers. This suggests that white-collar workers need larger account balances at the same retirement ages.

And, the other two elements may do more to affect the appropriate asset mix for a participant.

Accrued benefit in a DB plan. Accrued benefits in a DB plan can be thought of as a fixed income investment. That is, their value grows (largely) at a discount rate. Having a large DB accrued benefit means that the remainder of a participant's account balance could, and perhaps should, be invested more aggressively.

Access to company provided equity. If a meaningful portion of your compensation is in the form of equity, then you tend to possess a significant undiversified asset. This would suggest that your TDF should have significant diversification.

Again, who has this data? Your employer, the plan sponsor does. Combined with age, this list of parameters could give your employer ten data points with which to appropriately place you in a TDF instead of one. In the coming world of TDFs, this is what should happen.

Perhaps the TDFs of the future will not have years attached to their names, but instead will have letters, numbers, or some combination of the two. And, perhaps, these ten data items (or others like them) can be used as part of an algorithm to place participants into their proper TDFs. 

Finally, while we are redesigning, do we really think that any one asset management firm has a monopoly on all the best funds? I don't think so. Without naming names, I have an opinion on some of the best fixed income funds available in the marketplace. Surprisingly enough (not really), none of the firms that manages those fixed income funds also has, in my opinion, the best large cap equity funds, international equity funds, and real estate funds. So, wouldn't our new age TDFs be better if composed of funds from a variety of providers? I think so. And, if we suddenly had reason to believe that the great-performing real estate fund that we were using in our TDFs might no longer be as great (the main portfolio manager decided to retire), wouldn't we like to have the ability to change real estate funds? I think so.

It's time. Who is going to start the trend?

How Do You Design Your Benefits Programs?

When I first got into this business, sometime during Anno Domini, benefits design and redesign assignments were fairly common. The commonality was not just in the frequency either, but in the underlying themes. Almost without exception, the focus was on one or more of these:

• Recruitment -- making sure that those elements that would appeal to potential new employees were there
• Retention -- making sure there were sufficient handcuffs to retain existing employees
• Competitiveness -- ensuring that the program in total fared well against the programs of comparator companies, and sometimes getting even more granular and doing this on a component-by-component basis
• Being leading edge -- being the first kid on the block, so to speak, to have a particular type of new program

To the naked eye, each of these seems to make sense. As we all know, the costs of recruiting the best and the brightest are high. And, while studies that have attempted to quantify the cost have provided disparate results, many that I have read have suggested that the cost of replacing talent that leaves when you would prefer they stay can range from one-half to more than three times pay with multiples tending to increase as levels of pay increase.

So, of course, as time has gone by, and we have all gotten smarter, the focus is on these same elements even more, isn't it? Well, no it's not. In 2011, a meaningfully larger part of Anno Domini than when I began this segment of my working lifetime, the trends are very different. What's important now? Consider these:

• Recruiting -- with a rare exception, figuring out which benefits are absolutely needed to play and offering just those ... in other words, offer health care, paid time off, and flexible work options such as telecommuting and customizable work schedules
• Retention -- providing oftentimes deceptive communications to make adverse benefit changes not look so bad
• Competitiveness -- it's no longer about being competitive with your peer group, it's about not looking too uncompetitive
• Leading edge -- will you be the first kid on your block to find a new benefits reduction technique to save money without appearing to miserly to your employees

Wow! If I were an employee of a large company that thinks that way, I would not be happy. But, the fact is that I am a benefits professional and I can see through changes like this when they are made. But, to the average employee, the change from a final average pay pension plan to a cash balance plan may not seem like much. They still have a pension, don't they? And, their new pension is easier to understand. Later, the cash balance plan with, say, 5% of pay employer allocations (pay credits) gets replaced by an enhanced 401(k) plan match (less than 5% of pay). But, nobody talks about pension anymore. On the other hand, lots of people talk about these wonderful plans with their neighbors (401(k), 401k, 401, 201k, 101k, 4OK). Yes, I've heard them all, and if an employee thinks they have a good 401(k) plan, they may think they have a good deal. Sometimes, just having a 401(k) plan without an employer match seems to be enough.

Many of the most admired companies do things differently. They still offer benefits and other similar programs to their employees that they can't get elsewhere in town. They spend more on their benefits programs and they are, in my opinion, rewarded for it. How does this work?

• Employees figure it out when they get something better
• Employees that get something better are happier
• That happiness translates to higher productivity
• That happiness also translates to better customer service ... the smiles come through in person, on the phone, and in those little conversations with neighbors
• Profitability is higher because of that better customer service and higher productivity
• Rewards are passed on to employees
• Unwanted turnover is negligible
• The world is saved

Well, that last one may be a bit foolhardy, but the rest of them are not far-fetched. I know that you can't just up and change your miserly benefits program to rich one, but when you are making long-term plans, consider how you can gradually make changes where you spend money to improve the bottom line.

I know, it's a new concept. Nobody will ever do it. Go ahead. Buck the trend. Blame it on me.

The 401(k) Design Quandary

It's a question that is really in vogue these days: what is the optimal 401(k) design? Should you auto-enroll? Should you match? How big should the match be? How quickly should the match fully accrue?

I read an article yesterday that was written as if it had the authoritative answers. I was amused, to say the least. It said that if you are currently matching 100% on the first 3% of pay deferrals, you should switch to 50% on the first 6% of deferrals. People would still get the same match, but they would defer more in order to get it and the plan sponsor's cost wouldn't change.

Whoa! Hold on.

What are your goals? Can your typical participant afford to defer 6% of pay? If they are currently deferring 3% of pay to get the full match, how much will they have to change their use of their take-home pay in order to be comfortable deferring 6% of pay? Will this affect your ADP and ACP nondiscrimination testing?

Many of the fund houses that are recordkeepers write (and speak) as if they have all the answers. Don't they have an ulterior motive though? They want to get more assets under management. They make more money that way.

Don't get me wrong. This is not intended to say that participants shouldn't be encouraged to save more. They should save as much as possible. But, it's not fair to make blanket statements like the one that was made, and purport that they apply to a general situation.

Plan design studies should not be done based on articles found in internet searches. Just like any other study, they should start with an enunciation of parameters -- goals, constraints, and desired outcomes. And, don't forget risks. No new design should leave a company exposed to risks that are too extreme.

I'll give you a real-life example. I was working with a large company last year that was considering a change to their 401(k) plan. Fortunately, this is an extremely cash-rich company, so if they had decided to make the change they were contemplating, even though the cost increase would have been measured in 10s of millions of dollars, this would not have broken the bank.

Currently, the company offers a match of something like (I don't recall the details exactly) 100% on the first 5% of pay deferred either pre-tax or Roth. They also allow after-tax contributions. They were considering a change to match both (not either, but both) pre-tax (orRoth) and after-tax contributions dollar for dollar on the first 5% of pay. It didn't occur to them that their highly educated workforce would find a way to defer at least 5% of pay pre-tax (or Roth) AND 5% after-tax, to double their match. I'm not sure why.

In any event, do your work properly. Understand your goals, risks, constraints, and desired outcomes. And, just because a design is popular or written up in an article, that doesn't mean it's the right one for you.

401(k) Design: How Do Matching Contributions Affect Participant Behavior?

You can find survey upon survey, and study upon study. Just how does 401(k) plan design affect participant behavior? Intuition says that when you increase the employer matching contributions, participants will defer more. However, a study by Choi et al suggests the contrary to be true (you can see my comments on that study here: http://johnhlowell.blogspot.com/2010/11/does-401k-match-not-promote-savings.html ). Conversely, a large number of studies suggest that as employers increase their matching contributions, employees increase their 401(k) plan deferrals.

But, how does specific design affect participant behaviors? Which way of offering a 2% of pay match gets participants to defer the most? The Principal Financial Corporation did an interesting analysis of this question. They considered these three matching schemes:

• 100% on the first 2% of pay deferred
• 50% on the first 4% of pay deferred
• 25% on the first 8% of pay deferred

In the first scenario, they found that the average participant deferral was 5.3% of pay. In the second scenario, it was 5.6% of pay, and in the third scenario, it was 7.0% of pay. And, for the three scenarios, total additions to participant accounts were 7.3%, 7.6%, and 8.8% of pay respectively. Interestingly, the third scenario costs the employers the least, but prepares participants best for retirement.

Excellent food for thought. You can read Principal's summary here: http://www.principal.com/about/news/2010/ris-match-stats113010.htm