Designing 401(k) Plans

1. Designing 401(k) Plans Wednesday September 13

2. 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

3. 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”

4. 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

5. DC as Share of Private Pensions Note: Roughly 80% of DC Plans are 401(k)s

6. 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

7. 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

8. Contribution limits • Three limits • Limit on employee’s 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!

9. Limits on Elective Contributions • $15,000 in 2006 • After 2006, the limit will be indexed for inflation in $500 increments

10. 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

11. “Catch Up Provisions” • EGTRRA allows workers 50 years+ to contribute an $5000. • Increases both employee and total contribution level • Not based on past contributions

12. 401(k) Vesting • Employee’s 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)

13. 401(k) Nondiscrimination • HCE’s 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) / Employee’s compensation, averaged over HCE and non-HCE groups

14. 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 <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

15. 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 employee’s accounts whether employee contributes or not • Employer contributions must vest immediately

16. 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

17. 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

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

19. 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

20. 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

21. 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

22. 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

23. 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

24. Participation by Earnings, 2001All numbers expressed as %Source: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 56

25. Participation by Age, 2001All numbers expressed as %Source: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 56

26. 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

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

28. Contributions by Earnings, 2001All numbers are medians, expressed as % of earningsSource: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 60

29. Contributions by Age, 2001All numbers are medians, expressed as % of earningsSource: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 56

30. 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

31. 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

32. 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?

33. 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

34. 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/story.php?storyId=4828792)

35. Effect of Automatic EnrollmentParticipation rate with and without automatic enrollmentSource: Madrian & Shea 2002, Quarterly Jrnl of Economics

36. Effect of Automatic EnrollmentParticipation rate with and without automatic enrollmentSource: Madrian & Shea 2002, Quarterly Jrnl of Economics

37. “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 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!

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