Some have bemoaned the failure of 401(k) plans to provide for our retirement. Proposals have been made to Congress and in the media concerning a revamp or even a complete abandonment of the system.
Certainly, the current markets have been tough on both 401(k) participants and on the employers who sponsor them, and it should come as no surprise that some participants - especially rank-and-file employees - are finding it more difficult to contribute. Lower employee participation not only impacts those individuals' retirement safety, but can also cause employers problems with 401(k) non-discrimination testing.
But rather than taking drastic measures as a knee-jerk reaction to relatively short-term market performance, maybe the positive aspects of the current system should be considered. During times like these, it's imperative that participants remember the importance of saving and adhere to a sound asset allocation strategy. And employers should consider 401(k) plan designs beyond the norm that can help pass non-discrimination testing, as well as help employees accumulate retirement savings.
INDIVIDUALS: STAY THE COURSE
401(k) investing principles haven't changed. A few fundamental concepts need to be reinforced with plan participants confronting markets like the present:
* Bear markets don't last forever.
* 401(k)s favor long-term investors.
* Selling now locks in losses.
* Selling makes it less likely that a participant will participate in market rallies.
* Asset allocation is important.
* 401(k) savings are secure from the employing company's possible financial insolvency.
Proactive and ongoing communication can be critical to soothing the nerves of 401(k) participants today.
1. Bear markets don't last forever. Substantial recoveries have occurred after previous bear markets. The average return in the 12 months following a bear market is 45 percent.
2. Participate in market rallies. A large amount of market recovery tends to occur in the first few months after a bottom. If those rallies are missed, a 401(k) participant's rate of return could suffer substantially. For example, if a participant was not invested in the first six months of the rallies following bear markets, the average rate of return would have dropped from 45 percent to 12 percent.
3. Pay attention to your asset allocation. Studies have shown that over 90 percent of portfolio volatility is attributed to asset allocation. A proper asset allocation can help reduce risk while potentially providing a solid long-term rate of return, as shown by a look at the past 10 years' performance of a simple 60 percent stock/40 percent bond asset allocation versus placing 100 percent of an investment in either asset class.
4. Your 401(k) savings are safe. 401(k) savings are held in a segregated trust, separate from employer and recordkeeper corporate assets, and are protected from creditors. In the case of financial insolvency, neither the creditors of those involved with the plan nor a participant's creditors can claim 401(k) savings.
EMPLOYERS: TAKE A LOOK AT PLAN DESIGN
In a typical traditional 401(k) design, the employees elect to make contributions while the employer makes some matching and maybe some profit-sharing contributions. That design is beginning to fall by the wayside as the advent of automatic 401(k) features, the decline of pension plans, and the need for more significant savings through 401(k) plans cause 401(k) programs to evolve.
Employee enrollment, contribution increases and investing are increasingly being automated as a means to get employees enrolled, get them saving a meaningful amount for retirement, and get them investing their savings appropriately based on their time horizon or risk tolerance.
Automatic enrollment has helped a variety of employers to increase the number of employees participating in their plan. In a typical auto-enrollment design, employees are enrolled in the 401(k) as soon as they are eligible at a 3 percent contribution rate. These contributions are then invested on each employee's behalf in an asset allocation investment designated by the employer to be appropriate for the employee. Employees are given the ability to opt out and to select other investments offered by the plan, but far more often than not, they allow the automatic features to continue.
A contribution of 3 percent of pay is probably not going to get any employee to a comfortable retirement, but automatic increases can help with that. Each year, the preceding year's contribution percentage can be increased - most frequently, by 1 percent or so until the participant has reached a contribution of 6 percent of pay.
Automatic investment features can solve the problem of the participant who makes poor investment decisions. Target-date investments can make it easy for the participant's account to stay invested as would be appropriate for someone of their approximate age or years to retirement, while risk-based asset allocation investments take into account the participant's risk tolerance. Both types of investments are typically rebalanced for the participant.
A benefit of these automatic features is that they often - but not necessarily - help the plan to pass or improve 401(k) non-discrimination testing by getting employees who would otherwise have a zero percent deferral rate up to at least 3 percent. For plans that continue to fail, a new type of automated plan called a qualified automatic contribution arrangement allows the plan to be treated as passing non-discrimination tests while also being exempt from top-heavy testing.
In order for a plan to qualify as a QACA, in the first year, its automatic deferral rates must be at least 3 percent; and it must automatically increase by at least 1 percent every year until the deferral is at least 6 percent As explained above, the employee can opt out at any time. The number of participants that remain in the plan does not affect the plan's status as a QACA or its exemption from the non-discrimination tests.
A QACA plan requires an employer contribution of either a matching contribution of at least 100 percent on the first 1 percent of deferrals plus at least 50 percent on the next 5 percent of deferrals, or a 3 percent non-elective (profit-sharing) contribution to all eligible participants. These contributions must be 100 percent vested after no more than two years.
If automatic enrollment plan designs are not appropriate for an employer or its employees, other 401(k) plan designs can be considered. Like the QACA, safe-harbor 401(k) designs are treated as passing non-discrimination testing and are exempt from the top-heavy rules. A safe-harbor plan requires that the employer either match employee salary deferrals or contribute 3 percent of each eligible employee's pay even if the employees themselves do not contribute. The match is 100 percent up to 3 percent of pay and 50 percent of the next 2 percent of pay (for a total of 4 percent for those employees who contribute at least 5 percent of pay). Such contributions are always 100 percent vested.
In addition, a variety of different methods can be used to allocate profit-sharing contributions to a 401(k) plan. A new comparability profit-sharing plan design can help an employer customize benefits for key employees who may not accumulate sufficient amounts for retirement through either a standard or an automated 401(k). Adding a new comparability profit-sharing feature to a 401(k) plan can result in key employee allocations of as much as $46,000 for 2008 and $49,000 for 2009, while limiting contributions for non-key employees - often to as low as 5 percent of pay.
These are clearly difficult times for many people. However, whether you are a participant or a plan sponsor, to conclude that 401(k) plans are not working overlooks the long-term benefits of 401(k) investment and the plan designs coming to the forefront today.
We've recovered from a variety of difficult times in the past, and there's little reason to believe that this time will be different.
Jeremy Deleski is managing director of retirement services at Oppenheimer & Co. Inc. in New York. This article is not and is under no circumstances to be construed as an offer to sell or buy any securities.
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