It’s silent, monotonous and often overlooked, but it’s something that is accelerating and becoming substantial for 401k plan sponsors and participants.
The issue? Beneficiary elections.
They can be problematic in any plan, especially for 401ks that have an auto-enrollment or negative election feature. There’s a tendency for large plans that enroll hundreds of employees or plans that do not have a “high touch service advisor” to leave it to the new participant to elect their primary and contingent beneficiaries without any prior guidance.
However, very frequently the beneficiary election is not completed and is rarely updated.
On the surface, this does not seem to be a big complication, but as this group ages—or life happens—the lack of a designated beneficiary or an outdated designation may cause an estate settlement problem for the beneficiaries and a variety of issues for the respective plan sponsor.
To understand the scale of the matter, consider this assessment of one of the top 401k platforms: Fidelity.
Fidelity is the leading 401k platform in terms of total assets under management and total participants. As of December 31, 2016, Fidelity’s corporate defined contribution universe is 22,400 plans with 15.3 million participants. Thirty-one percent of their 401k plans offer auto-enrollment (AE)[1].
For plans with AE, Fidelity has an 86.9 percent participation rate versus 50.2 percent for those plans without AE. The firm’s overall average 401k participation rate is 69.5 percent1. While this clearly illustrates the effectiveness of auto-enrollment, it also hints at the potential magnitude of the beneficiary election problem associated with it.
Employers need to be aware of this and take steps to capture beneficiary information on a proactive and on-going basis.
When an employee passes away without a beneficiary election, the ensuing problems can include tax consequences, potential legal liability, HR department disruption and, ultimately, the plan participant’s original intent not being fulfilled.
One of the most direct consequences of a failure to name or update beneficiaries is the result of an unfortunate adverse tax consequence or probate cost for the family. Estate planning attorney Al Ferrara, in Farmington Hills, Mich., points out several of the consequences that arise.
Without a beneficiary on the 401k, “the account is required to go through probate under state law, may be subject to probate fees, may go to beneficiaries under state probate law that were not the intended beneficiaries and may lose the ability to ‘stretch’ the IRA for tax purposes,” Ferrara points out.
He also states that if beneficiary elections are made but not updated, other issues may arise. In the case of a parent with multiple children and only one stated as beneficiary, if “one child is designated to receive the account…the law allows the one designated child to receive everything and the others are disinherited.”
Beyond tax consequences for the individual and their family, the problem can circle around and have adverse effects on the plan sponsor. Legal issues may result in a significant drain on a plan sponsor’s HR department, while also creating friction and pain between family members.
Michelle Marsh from Retirement Plan Concepts & Services, Inc. (RPSCI), a third party administer located in Indianapolis, has seen such problems many times in the real world.
According to Marsh, “When the money doesn’t go to those who expected it, things get nasty and family members get upset, or families can even be torn apart.”
Unfortunately, we have seen these scenarios play out with some of our plans. We have worked with a plan on a situation in which a young man, who never made a beneficiary election, predeceased his parents. Since his parents had divorced before his passing, and the beneficiary designation was never made, the parents then proceeded to litigate over the funds.
Who was stuck in the middle? The plan sponsor. This caused the plan sponsor a great deal of wasted time handling the matter and was a drain on HR department resources. Had an election been made, all involved would have reached an efficient and satisfactory resolution that reflected the plan participant’s exact wishes.
What can plan sponsors do to prevent such problems? Marsh and RPCSI think that “the best practice is to require all participants to review and update their designated beneficiaries for their retirement plan annually, just like their group life insurance, to avoid these costly mistakes,” thus thwarting messy situations before they occur.
For companies with high turnover rates and automatic election, there is another issue that has to be dealt with continuously. They may think they have conquered the beneficiary problem in one quarter, but in six months, they’ve hired several hundred employees who have subsequently not elected beneficiaries. And the problem repeats itself.
Janet Lanyon, an attorney in Troy, Mich., specializes in employee benefits law and provides valuable insight into the beneficiary problem. Due to the fact that auto-enrollment increases the likelihood that the participant will fail to designate or update their beneficiary, Lanyon says that it is “more likely that it will be necessary to rely upon the plan’s default beneficiary determination provisions in the event of the death of the participant.”
Lanyon also believes that “to avoid the potential proliferation of disputes over such ‘default’ distributions, a plan sponsor should be particularly vigilant in obtaining and maintaining the beneficiary designations of auto-enrolled participants.” The plan sponsor’s vigilance must be multiplied when dealing with high turnover businesses.
There have also been situations where plan sponsors have sought legal advice to remedy problems with their participants, recordkeepers and TPAs. Jason Roberts, a lawyer at Retirement Law Group, weighs in about why there has been an increase in these beneficiary-related issues. Roberts thinks this is not only due to the spread of auto-enrollment, but also due to confusion on the parts of plan sponsors.
Roberts says, “Many plan sponsors incorrectly assume that this (beneficiary designation) is something that recordkeepers or third-party administrators will handle for them…when it comes to making decisions pertaining to the administration of beneficiary-related issues, plan sponsors are often solely responsible.”
Along with a more proactive designation process, Roberts believes that one solution may be to amend plan documents to ensure they provide guidance on resolving beneficiary-related issues.
What other steps can be taken to solve and reduce the problem? Well, advisors, plan sponsors and recordkeepers have different ways of encouraging beneficiary elections by plan sponsors. At Hoover & Associates Financial Services, for example, investment committee meetings have started to include beneficiary election monitoring.
At each meeting, our firm highlights the beneficiary designation percentage of 401k plans. Plan sponsors are typically eager to know the beneficiary election habits of the employees and the progress in reducing beneficiary election deficit. As such, this would be a great data point for recordkeepers to provide in retirement plan reviews.
After all, we’re looking at every deferral percentage, retirement readiness, etc. What good is it to have all these retirement ready assets accumulated if they go to the wrong parties? To date, our firm has not noticed many 401k recordkeepers proactively seeking beneficiary designations from participants.
Transamerica is one exception. Hoover & Associates enrolled a plan with them in 2017. Because it featured auto-enrollment, the plan had a nearly 50 percent beneficiary election rate. Our firm asked for a report of beneficiaries for participants lacking a beneficiary and turned it over to the plan sponsor.
Transamerica has a warning to participants when they login to select a beneficiary if one has not been elected—a fantastic proactive move on behalf of the recordkeeper. Sadly, our firm hasn’t noticed it on many other platforms.
Another one of our plan sponsors is considering having the beneficiary election in the employee new hire paperwork. It would be a mandatory step online, just as if they were putting in their home address or other vital data. The employee will not be able to complete their new hire paperwork if they do not fill out all data fields, including their 401k plan beneficiary.
Even though their data will not be fed to the recordkeeping platform, the employer will at least have a beneficiary should one not be elected during the 401k auto-enrollment process. It may be a great step in collecting beneficiary data from participants that might not otherwise provide it.
One small plan Hoover & Associates works within the Detroit area has facilities in both Michigan and Kentucky. They discovered that only 24 percent of their active participants had beneficiary elections. The investment committee and HR department decided to take action.
In order to successfully encourage beneficiary elections, our firm obtained the list of participants lacking beneficiary designations, and the HR department sent personalized email reminders to the participants. In addition, HR made some phone calls to the employees. The department’s ability to contact participants directly about the beneficiary status proved to be exceptionally fruitful; over the next month, the percentage of designated beneficiaries improved from 24 percent to 91 percent.
Here’s another example of a successful experience with a larger plan. During a review, our firm discovered that this plan, which utilizes auto-enrollment, had less than a quarter of all participants with an elected a beneficiary. With over 90 different locations and 2,500 participants, an email campaign with a cleverly designed notice from the HR department was the best way to reach everyone. Through these efforts, HR was able to increase the plan’s beneficiary election by 19.2 percent.
It is abundantly clear that employers will need to know what their plan document says with regard to employees failing to make a beneficiary election. However, most plan sponsors and consultants rarely scrutinize the plan document for the mechanics surrounding lack of a beneficiary and estate settlement. To the extent that the document is being drafted for the plan sponsor and is not a volume submitter document, thought and creativity may be used to relieve liability and cost from the plan sponsor should a beneficiary fail to be elected.
In summary, recordkeepers and plan sponsors need to improve beneficiary election awareness through rethinking and redesigning the enrollment process.
Randall Hoover ChFC, REBC, CLU, RHU, LIC, AIF, C(k)P is a financial advisor and insurance consultant with Detroit-based Hoover & Associates Financial Services, Inc. 909 N. Mainstreet Royal Oak MI 48067. (248) 298-4000. Randall Hoover offers securities through Sigma Financial Corp, Member FINRA/SIPC. Hoover & Associates is independent of Sigma Financial Corporation.
[1] Building Financial Futures, Fidelity Brokerage Services, LLC, 2018.
Randall Hoover ChFC, REBC, CLU, RHU, LIC, AIF, C(k)P is President of Hoover & Associates Financial Services.
