Designing 401(k) Plans

Lecture 5

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

$15,500 in 2008

After 2006, the limit will be indexed for inflation in $500 increments

Limits on Total Contributions and Maximum Compensation

Total ContributionsSet at $46,000 in 2008This limit indexed for inflation in $1000 increments.

Maximum Compensation$230,000 in 2008Indexed in $5,000 increments

“Catch Up Provisions”

EGTRRA allows workers 50 years+ to contribute an additional $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 $10.5k per year (year 2008)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 2007, approx 25% 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.