Designing 401(k) Plans

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Designing 401(k) Plans

• Wednesday September 13

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By the end of this lecture, you should be able to

• Explain what a 401(k) plan is
• Discuss the growth of 401(k) plans over past two
  decades
• List advantages relative to other pensions
• Explain rules governing 401(k)s, and differences
  from DB plans
• Nondiscrimination rules
• Contribution limits
• Discuss patterns of participation and
  contributions and how firms influence them

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What is a 401(k)?

• A defined contribution plan
• Elective deferrals
• Employees given choice to receive compensation as
  cash or as pension
• Tax deferral on 401(k) contributions
• Firm often provides and employer match
  contribution
• We will match 0.50 for every dollar you
  contribute up to 3 of salary

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401(k) Legal Background

• Section 401(k) of the Internal Revenue Code (IRC)
  says that if plans with elective contributions
  meet a special nondiscrimination test, then the
  plan can be considered a qualified plan
• Nondiscrimination test provides incentives for
  firms to encourage participation, such as through
  match policy

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DC as Share of Private Pensions
Note Roughly 80 of DC Plans are 401(k)s
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Why are 401(k) so Popular?

• Tax deferral but this applies to all pensions
• Employee Perspective
• Easily portable when change jobs
• Some control over own portfolio
• Benefit is very tangible
• Flexibility to alter desired saving level
  (including zero!)
• Employer
• Lower administrative costs
• Fully funded by definition
• Only annual funding burden is from match policy

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Some Other Differences from DB

• Participation decision
• Usually automatic in DB plan
• DC plan is voluntary
• Payouts
• Traditionally, DB paid as life annuity
• 401(k) rarely even offer life annuity option
• Subject to slightly different qualification rules
• Not insured by the PBGC

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Contribution limits

• Three limits
• Limit on employees elective contributions
• Limit on total contributions (including employer)
• Limit on compensation used for contributions
• Recent changes due to EGTRRA (Economic Growth
  and Tax Relief Reconciliation Act)
• Important to keep up with changes!

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Limits on Elective Contributions

• 15,000 in 2006
• After 2006, the limit will be indexed for
  inflation in 500 increments

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Limits on Total Contributions and Maximum
Compensation

• Total Contributions
• Set at 40,000 in 2002
• This limit indexed for inflation in 1000
  increments.
• Maximum Compensation
• 200,000 in 2002
• Indexed in 5,000 increments

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Catch Up Provisions

• EGTRRA allows workers 50 years to contribute an
  5000.
• Increases both employee and total contribution
  level
• Not based on past contributions

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401(k) Vesting

• Employees elective deferrals are immediately
  vested
• Since 2002, firm matching contributions are
  required to vest even faster than for DB plans
• Must be either
• Three year cliff vesting (vs. 5 year for DB)
• Two-to-Six year graded vesting (vs. 3-to-7)

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401(k) Nondiscrimination

• HCEs can benefit from 401(k) only if large
  fraction of non-HCE employees participate
• To be non-discriminatory, must meet rule based on
  Actual Deferred Percentage
• ADP Employee elective deferrals to 401(k) /
  Employees compensation, averaged over HCE and
  non-HCE groups

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Nondiscrimination test

• The actual deferred percentage (ADP) of salary
  deferred for the HCEs must not exceed that for
  non-HCEs by more than allowable amount
• If ADPnon-HCE Then ADPHCE max is
• lt2 2ADPnon-HCE
• 2-8 ADPnon-HCE 2
• gt8 1.25ADPnon-HCE
• An individual HCE can exceed this limit as long
  as the average of HCEs does not

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Safe Harbor Provisions

• Small Business Job Protection Act of 1996
• If fulfill safe harbor provision, it is
  automatically nondiscriminatory
• Must meet one of two
• Match 100 of pay for first 3 of pay plus 50 of
  next 2 of pay
• Contribute 3 of pay to all employees accounts
  whether employee contributes or not
• Employer contributions must vest immediately

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Withdrawal Restrictions

• 59 ½ or 10 penalty (unless buy annuity or make
  withdrawals based on life expectancy)
• Hardship withdrawals are permitted
• Medical expenses
• Education
• Buying a house
• Minimum distribution requirements starting at age
  70 ½

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Payroll Taxes

• Usually, employer contributions to qualified
  plans are free from FICA (SS Medicare) taxes
  and unemployment taxes
• In case of 401(k)s, contributions are still
  subject to these taxes

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Similar Plans

• 401(k)
• SIMPLE for smaller employers
• 403(b) for tax-exempt organizations
• 457 for state and local governments

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SIMPLE

• Savings Incentive Match Plans for Employees
• Firms that have
• Fewer than 100 employees (only count as employee
  if have at least 5k compensation)
• Does not have qualified plan for same year
  (exception for collectively bargained plans)
• Contributions are made to employees IRA
• Can contribute up to 6k per year (year 2000
  now higher)
• Minimum employer contributions

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403(b)

• For tax exempt employers
• 501(c)(3)
• Educational organizations
• Also called tax deferred annuity (TDA)
• Must be invested in annuity contracts from
  insurance company
• Or mutual funds held in custodial accounts
• Special contribution limits

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457 Deferred Compensation

• Primarily used by government employers
• Govt not eligible for 401(k)
• Only subset allowed to do 403(b)
• Other major provisions similar to 401(k), but
  with minor differences

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401(k) Issues We Will Cover

• Participation and Contributions
• Role of plan design
• Investment Decisions
• Special case of company stock
• Withdrawals from 401(k)s
• Life annuities
• Minimum distribution requirements

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Overview of Participation

• A defining characteristic of 401(k) plans is that
  participation is voluntary
• Overall trend in the 1980s and 1990s was toward
  increasing participation rates among those
  eligible
• But non-participation rates remain high
• In 2001 Survey of Consumer Finances, 26 of
  eligible workers did not participate

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Participation by Earnings, 2001All numbers
expressed as Source 2001 SCF as summarized by
Munnell Sunden Coming Up Short 2004 pg. 56
Earnings Eligibility among workers age 20-64 Participation by eligible workers Participation by all workers
ALL 52 74 39
lt 20 k 28 50 14
20-40 k 57 71 40
40-60 k 70 79 55
60-80 k 76 83 64
80-100 k 77 88 68
100 75 89 67
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Participation by Age, 2001All numbers expressed
as Source 2001 SCF as summarized by Munnell
Sunden Coming Up Short 2004 pg. 56
Age Eligibility among workers age 20-64 Participation by eligible workers Participation by all workers
20-29 44 66 29
30-39 55 76 42
40-49 57 78 44
50-59 52 74 39
60-64 40 80 32
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Participation and Plan Design

• Match Policy
• While employers are not obligated to contribute
  to 401(k) plans, over 90 of participants are in
  a plan that does
• Presence of employer match makes it twice as
  likely that employees will participate (match
  generosity is less important than presence)
• Ability to borrow / make hardship withdrawals
  also increases participation
• Default options will discuss in a few slides

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Contributions

• Conditional on participation, the next major
  decision is how much to contribute
• Percentage of earnings contributed shows less
  variation by age and earnings

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Contributions by Earnings, 2001All numbers are
medians, expressed as of earningsSource 2001
SCF as summarized by Munnell Sunden Coming Up
Short 2004 pg. 60
Earnings Employee Contributions Employer Contributions
ALL 6.0 3.0
lt 20 k 5.0 3.0
20-40 k 5.0 3.0
40-60 k 6.0 3.0
60-80 k 6.0 3.0
80-100 k 6.0 4.0
100 7.9 3.0
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Contributions by Age, 2001All numbers are
medians, expressed as of earnings Source
2001 SCF as summarized by Munnell Sunden
Coming Up Short 2004 pg. 56
Age Employee Contributions Employer Contributions
20-29 5.2 3.0
30-39 6.0 3.0
40-49 6.0 3.0
50-59 6.0 3.0
60-64 5.0 4.3
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Effect of Match on Contributions

• Effect on average contribution rate is ambiguous.
  A bigger match
• May increase contributions of those already
  contributing
• May increase participation rates, but new
  participants may contribute less
• Lots of clustering around match cap

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Other Contribution Issues

• Ability to borrow increases contribution rates by
  up to 2.6 percentage points (Munnell et al 2002)
• Contribution limits
• EGTRRA raised the limits
• Less than 10 of workers contribute the max, and
  as expected, it is strongly correlated with
  income and age

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Encouraging Participation

• Recall that plan sponsors may have incentive to
  boost participation and contributes because of
  non-discrimination rules
• 401(k) plans are built on notion of elective
  deferrals firm cannot force participation
• Besides match policy and borrowing policy, what
  other tools are available?

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Financial Education

• Nearly 90 of employers often offer financial
  education to encourage participation
• Research suggests that education can increase
  participation rates, but net effect on
  contributions is small
• Peer effects matter
• Duflo Saez (2003) study
• Provided to attend seminar
• Participation increased among non-attendees in
  departments that had lots of attendees

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Automatic Enrollment

• IRS issued regs in 1998 and 2001 allowing
  employers to automatically enroll employees
• Employees can still choose to opt out
• Note there are no constraints on choice
  individual can make same choice as before!
• By 2002, approx 14 of 401(k) sponsors had
  adopted it (many more considering)
• NPR Story (http//www.npr.org/templates/story/stor
  y.php?storyId4828792)

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Effect of Automatic EnrollmentParticipation rate
with and without automatic enrollmentSource
Madrian Shea 2002, Quarterly Jrnl of Economics
Earnings No Automatic Enrollment Automatic Enrollment
ALL 49 86
lt 20 k 20 80
20-30 k 32 83
30-40 k 50 89
20-50 k 62 92
50-60 k 70 93
60-70 k 79 95
70-80 k 76 92
80 76 94
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Effect of Automatic EnrollmentParticipation rate
with and without automatic enrollmentSource
Madrian Shea 2002, Quarterly Jrnl of Economics
Age No Automatic Enrollment Automatic Enrollment
20-29 37 83
30-39 48 86
40-49 55 90
50-59 64 90
60-64 61 86
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Save More Tomorrow2003 Study by Bernartzi and
Thaler

• Optional program (with freedom to opt out at
  anytime)
• 401(k) program that automatically increased
  contribution rate whenever person receives a pay
  increase
• 80 of those offered, signed up
• Though plan did rely on potentially costly
  intervention by financial advisor who gave strong
  advice
• Participants increased saving rate from 3.5 to
  11.6 in only three years!

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Behavioral Conclusions

1. Consumers are highly sensitive to suggestions
   about how much to save.
2. Retirement savings accounts can be very effective
   savings tools, when accompanied by the right
   psychological framing of the saving decision.