designing 401(k) plans wednesday september 13. by the end of this lecture, you should be able to:...
TRANSCRIPT
Designing 401(k) Plans
Wednesday September 13
By the end of this lecture, you should be able to:
Explain what a 401(k) plan isDiscuss the growth of 401(k) plans over past two decadesList advantages relative to other pensionsExplain rules governing 401(k)s, and differences from DB plans
Nondiscrimination rulesContribution limits
Discuss patterns of participation and contributions and how firms influence them
What is a 401(k)?
A defined contribution planElective deferrals
Employees given choice to receive compensation as cash or as pensionTax 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”
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
DC as Share of Private Pensions
50%43%
93%
59%53%
84%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Number of Plans Participants (millions) Assets (billions)*
1990 1999
Source: Facts from EBRI, April 2005Private Sector Pension Plans
Note: Roughly 80% of DC Plans are 401(k)s
Why are 401(k) so Popular?Tax deferral – but this applies to all pensionsEmployee Perspective
Easily portable when change jobsSome control over own portfolioBenefit is very tangibleFlexibility to alter desired saving level (including zero!)
EmployerLower administrative costsFully funded by definitionOnly annual funding burden is from match policy
Some Other Differences from DB
Participation decisionUsually automatic in DB planDC plan is voluntary
PayoutsTraditionally, DB paid as life annuity401(k) rarely even offer life annuity option
Subject to slightly different qualification rulesNot insured by the PBGC
Contribution limitsThree limits
Limit on employee’s elective contributionsLimit 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!
Limits on Elective Contributions
$15,000 in 2006
After 2006, the limit will be indexed for inflation in $500 increments
Limits on Total Contributions and Maximum Compensation
Total ContributionsSet at $40,000 in 2002This limit indexed for inflation in $1000 increments.
Maximum Compensation$200,000 in 2002Indexed in $5,000 increments
“Catch Up Provisions”
EGTRRA allows workers 50 years+ to contribute an $5000.Increases both employee and total contribution levelNot based on past contributions
401(k) Vesting
Employee’s elective deferrals are immediately vestedSince 2002, firm matching contributions are required to vest even faster than for DB plansMust be either:
Three year cliff vesting (vs. 5 year for DB)Two-to-Six year graded vesting (vs. 3-to-7)
401(k) NondiscriminationHCE’s can benefit from 401(k) only if large fraction of non-HCE employees participateTo be non-discriminatory, must meet rule based on “Actual Deferred Percentage”ADP = Employee elective deferrals to 401(k) / Employee’s compensation, averaged over HCE and non-HCE groups
Nondiscrimination testThe 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
<2% 2*ADPnon-HCE
2%-8% ADPnon-HCE + 2%
>8% 1.25*ADPnon-HCE
An individual HCE can exceed this limit as long as the average of HCE’s does not
Safe Harbor ProvisionsSmall Business Job Protection Act of 1996If fulfill safe harbor provision, it is automatically nondiscriminatoryMust meet one of two:
Match 100% of pay for first 3% of pay plus 50% of next 2% of payContribute 3% of pay to all employee’s accounts whether employee contributes or not
Employer contributions must vest immediately
Withdrawal Restrictions
59 ½ or 10% penalty (unless buy annuity or make withdrawals based on life expectancy)“Hardship withdrawals” are permitted
Medical expensesEducationBuying a house
Minimum distribution requirements starting at age 70 ½
Payroll Taxes
Usually, employer contributions to qualified plans are free from FICA (SS & Medicare) taxes and unemployment taxesIn case of 401(k)s, contributions are still subject to these taxes
Similar Plans
401(k) SIMPLE – for smaller employers403(b) – for tax-exempt organizations457 – for state and local governments
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 employee’s IRA Can contribute up to $6k per year (year 2000 – now higher)Minimum employer contributions
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 companyOr mutual funds held in custodial accounts
Special contribution limits
457 “Deferred Compensation”
Primarily used by government employers
Gov’t not eligible for 401(k)Only subset allowed to do 403(b)
Other major provisions similar to 401(k), but with minor differences
401(k) Issues We Will Cover
Participation and ContributionsRole of plan design
Investment DecisionsSpecial case of company stock
Withdrawals from 401(k)sLife annuitiesMinimum distribution requirements
Overview of ParticipationA defining characteristic of 401(k) plans is that participation is voluntaryOverall trend in the 1980s and 1990s was toward increasing participation rates among those eligibleBut non-participation rates remain high
In 2001 Survey of Consumer Finances, 26% of eligible workers did not participate
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%
< $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
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
Participation and Plan DesignMatch 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 participationDefault options – will discuss in a few slides
Contributions
Conditional on participation, the next major decision is how much to contributePercentage of earnings contributed shows less variation by age and earnings
Contributions by Earnings, 2001All numbers are medians, expressed as % of earningsSource: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 60
EarningsEmployee
ContributionsEmployer
Contributions
ALL 6.0% 3.0%
< $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
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
AgeEmployee
ContributionsEmployer
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
Effect of Match on Contributions
Effect on average contribution rate is ambiguous. A bigger match …
May increase contributions of those already contributingMay increase participation rates, but new participants may contribute less
Lots of clustering around match cap
Other Contribution IssuesAbility to borrow increases contribution rates by up to 2.6 percentage points (Munnell et al 2002)
Contribution limitsEGTRRA raised the limitsLess than 10% of workers contribute the max, and as expected, it is strongly correlated with income and age
Encouraging Participation
Recall that plan sponsors may have incentive to boost participation and contributes because of non-discrimination rules401(k) plans are built on notion of “elective deferrals” – firm cannot force participationBesides match policy and borrowing policy, what other tools are available?
Financial EducationNearly 90% of employers often offer financial education to encourage participationResearch suggests that education can increase participation rates, but net effect on contributions is smallPeer effects matter
Duflo & Saez (2003) study• Provided $ to attend seminar• Participation increased among non-attendees in
departments that had lots of attendees
Automatic Enrollment
IRS issued regs in 1998 and 2001 allowing employers to automatically enroll employeesEmployees can still choose to opt outNote: 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/story.php?storyId=4828792)
Effect of Automatic EnrollmentParticipation rate with and without automatic enrollmentSource: Madrian & Shea 2002, Quarterly Jrnl of Economics
EarningsNo Automatic
EnrollmentAutomatic Enrollment
ALL 49 86
< $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
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
“Save More Tomorrow”2003 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 increase80% 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!
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.