Monitor: Improving Returns on 401(k) Plans

It's easy to take 401(k) plans for granted. They're relatively simple to administer; they're popular with employees, and they provide a valuable benefit that most companies consider a "needed to play" item in attracting and retaining talent.

But is your 401(k) plan as effective as it can be in helping employees save for their retirement? Does it have auto-enrollment and other useful features that are available today from providers? These features can enhance the appeal of your employee savings programs and increase usage, making them even more effective.

Auto-enrollment at a glance

The Pension Protection Act (PPA) adds a new safe harbor called a qualified automatic contribution arrangement (QACA) to avoid ADP testing for plans with an automatic enrollment feature. With a QACA, there are automatic deferrals from a participant's compensation at a specified minimum percentage based on years of service. The automatic contributions must be at least:

• 3% of pay during the first year of plan participation
• 4% of pay during the second year
• 5% of pay during the third year
• 6% of pay in the fourth year and thereafter.

Also, non-highly compensated employees must receive:

• a 3% nonelective contribution from the company or
• a 100% match on the first 1% of elective employee contributions, plus a 50% match on the next 5% of elective employee contributions.

Employer safe-harbor contributions must fully vest within two years, and employees must receive a notice explaining their right to opt out and how contributions under the arrangement will be invested. 

Automatic contribution increases

However, auto-enrollment alone does not necessarily lead to adequate retirement savings for employees because in many instances they elect to contribute only a fraction of the pay that they are entitled to set aside — especially people in the lower salary grades.

Employers can address this to some extent by adding an auto-escalation feature. It adjusts an employee's contribution rate (or deferral rate) automatically each year at a specified time, such as the end of the fiscal or calendar year. For example, it can increase an individual's plan contributions by an additional 1% of eligible pay each year until a certain threshold (e.g., 6%) is reached.

Under the assumptions and scenarios modeled in a Towers Perrin survey of financial executives at 126 midsize and large U.S. companies, the auto-escalation feature is likely to increase overall 401(k) accumulations from 11% to 28% for participants in the lowest-income quartile and 5% to 12% for those in the highest-income quartile. Simply put, it narrows the gap in contribution rates between high-paid and low-paid employees.

Auto-default investments

The PPA also removes one of the final impediments to auto-enrollment — employer fears about legal liability for market fluctuations that discouraged many companies from adopting it or led them to invest workers' contributions in low-risk, low-return default investments.

Now, however, a participant will be deemed to have exercised investment control, and the fiduciary will be relieved of liability for investment results, if the new Department of Labor requirements for a qualified default investment alternative (QDIA) are satisfied:

• Participants and beneficiaries must have been given an opportunity to provide investment direction, but not have done so.
• A notice generally must be furnished to participants and beneficiaries in advance of the first investment in the QDIA and annually thereafter.
• Information like investment prospectuses must be furnished to participants and beneficiaries.
• Participants and beneficiaries must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly.
• There must be compliance with the limits on the fees that can be imposed on participants who opt out or decide to direct their investments

In addition, the plan must offer a broad range of investment alternatives, including these four types of QDIAs:

• a product with a mix of investments that takes into account the individual's age or retirement date, e.g., a life-cycle or targeted-retirement-date fund
• an investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual's age or retirement date, e.g., a professionally managed account
• a product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (e.g., a balanced fund)
• a capital preservation product for the first 120 days of participation only.

With a QDIA feature in place, employees' contributions are often automatically invested in lifestyle, or life-cycle, accounts — premixed investment funds designed to fit a range of risk tolerances or for employees in different stages of their lives. These funds are often described as "conservative," "moderate" or "aggressive" to help employees understand the risk level.

Auto-investing in a QDIA makes investing easy for employees by helping them invest their 401(k) balances appropriately. A life-cycle fund, for example, would typically offer a higher allocation to equities for a young worker and shift the mix more toward fixed-income and cash equivalents designed for preservation of capital as the employee approaches retirement age.

Auto-rebalancing feature

For 401(k) participants who are passive investors and don't review their investments regularly, the auto-rebalancing feature can be a great help. It regularly rebalances participants' accounts automatically to restore the original level of targeted investment in various asset classes (e.g., large-cap stocks, small-cap stocks, fixed-income investments, cash equivalents).

The future of retirement

Without question, the government is encouraging employers to help employees manage their saving accounts in a responsible manner. We think automatic 401(k) features can have a variety of subtle (and some not so subtle) benefits for your plan:

• Enhance the perceived value of your 401(k) program among employees.
• Help support a culture of shared responsibility with your employees for financial security in retirement.
• Help ensure the level of financial security necessary to enable your employees to retire.
• Strengthen the company's value proposition to its employees and help brand your company as an employer of choice.
• Enhance employee retention.

For a growing number of companies today, maybe even yours, making 401(k) participation automatic appears to be an idea whose time has come.