Having worked as a 401k plan consultant and investment advisor for more than 30 years, I have seen a wide variety of plan designs. For example, Apple, Trek Bikes and IBM all have unique corporate cultures that are reflected in the 401k plan design of their plans.
Plan sponsors likely have a culture that is expressed in their 401k plan design, too. I don’t think that should be lost. However, it’s never a bad idea to look at some 401k plan design elements that have become standard in leading-edge 401k plans.
These features have been proven as best practices in helping participants achieve retirement-ready balances and are listed immediately below. Following is a section that includes what I believe will be the next wave in 401k plan design. Finally, I have shared 401k plan design features that limit plan sponsor liability that all plan sponsors should be advised to incorporate into their plans.
1). Current 401k Plan Design Best Practices
With opt-out rates of less than 10 percent, auto-enrollment has become the most effective way to combat employee inertia at enrollment. If plan sponsors aren’t auto-enrolling new hires right now, they really need to think about starting soon. Initial default contribution percentages are increasing to around 5 percent or 6 percent (from what was the standard 3 percent).
Studies show that participants need to add at least 15 percent to their 401k accounts each year to accumulate a retirement-ready balance. Annual auto-escalation of 1 percent per year to at least 10 percent helps them get there. If plan sponsors are auto-enrolling, they should be auto-escalating, as well. They go hand-in-hand.
Immediate 401k contribution eligibility
Very few progressive employers make their participants wait to begin making 401k contributions. Immediate eligibility for both regular pre-tax and Roth 401k contributions is the norm now.
A stretched match
To encourage a higher level of participant contributions, many employers are stretching their matching contributions over a broader employee deferral. A traditional match had been 50 percent of the first 6 percent of employee deferrals (resulting in a 3 percent employer match). A stretched matching contribution will provide the same 3 percent matching contribution over a larger employee deferral — 25 percent of the first 12 percent, for example.
Roth 401k deferral option
Many young participants will benefit from a contribution strategy that includes the use of Roth 401k accounts. After five years, balances in these accounts may be distributed tax-free (for qualified distributions). Participants who contribute to Roth accounts for their entire careers may build an enormous tax-free balance. Also, executive groups appreciate having the option to use these accounts to execute tax-planning strategies.
Protecting plan participants from themselves has become an important plan design feature. One way of doing that is by advising plan sponsors to eliminate opportunities for leakage by reducing or eliminating plan loan and withdrawal options (unless a hardship exists). Loan balances are often defaulted when participants change jobs, permanently removing assets from their retirement balances.
Participant investment advice
The time when all 401k participants have access to professional investment advice from multiple sources is here. Many recordkeepers now offer at least two types of investment advice: algorithm based (think robo-advisor) and a more personalized version (either a proprietary option or through a firm like Financial Engines, or both). Costs range from free to 100 basis points.
Professionally managed balanced option
This normally takes the form of a target date series in most plans. Remember, the vast majority of 401k participants want someone else to manage their 401k account for them. Plan sponsors should stay away from risk-based solutions, model portfolios and customized target date series. Although sold as being less expensive, they usually aren’t and have a number of inherent problems.
2). The Next Wave of 401k Plan Design Best Practices
Many employers are re-enrolling non-participating employees each year and defaulting their investment choices into target date options. Use of annual re-enrollments typically increases plan participation to at least 90 percent.
HSA investment options
If a plan sponsor offers a High Deductible Health Plan (HDHP), then they should also offer Health Savings Accounts (HSAs) to employees. It is smart retirement planning for all employees to max out their HSA contributions each year. Since it is possible to carry HSA balances into retirement and use them to pay health care expenses, having investment options in HSAs to help the balances grow is becoming more important.
Less profit sharing and more matching
Progressive employers understand that profit sharing contributions are less valuable in terms of motivating participants to contribute than employer matching contributions. If possible, advise plan sponsor clients to replace any employer profit sharing contributions with employer matching contributions.
Many progressive employers have realized that their employees need help with financial literacy. Not only will improved financial decision-making skills help them make better employee benefit decisions, but those skills will also help them do their jobs better. These employers are combining financial literacy/wellness education with 401k plan education and hiring firms to deploy online access to 10 or 15-minute modules. An online approach ensures that education opportunities are offered to millennial’s where and when they want them — on their smartphones at a time of their choosing.
3). Litigation Protection Elements
Elect to comply with 404(c)
By complying with ERISA section 404(c), employers can shield themselves from lawsuits brought by participants relative to the investment options offered in the plan. Investment advisors should outline what plan sponsors need to do to comply.
Designate a QDIA
Employers designating a Qualified Default Investment Alternative (QDIA) receive protection from participant lawsuits relative to losses participants may suffer in the QDIA investment. Again, advisors should explain.
Safe harbor plan design
If an employee group is small (100 employees or less), it is very likely owners would benefit from using a safe harbor plan design. These plan designs provide exemptions from non-discrimination testing requirements if a mandatory level of employer contributions is made.
Keep in mind that progressive plan design supports plan objectives that sponsors regularly communicate to employees. Encourage sponsors to review their plan soon. Most of these features cost very little to implement.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs, and many others. Mr. Lawton may be contacted at (414) 828-4015 or [email protected]