Designing 401 k Plans Wednesday September 13 By

Designing 401(k) Plans Wednesday September 13

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

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”

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 Note: Roughly 80% of DC Plans are 401(k)s

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

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

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!

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 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

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

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)

$401(k) Nondiscrimination HCE’s can benefit from 401(k) only if large fraction of non-HCE employees$

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

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 <2% 2%-8% >8% Then ADPHCE max is 2*ADPnon-HCE + 2% 1. 25*ADPnon-HCE An individual HCE can exceed this limit as long as the average of HCE’s does not

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

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

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

Similar Plans 401(k) SIMPLE – for smaller employers 403(b) – for tax-exempt organizations 457 – 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 $5 k 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 $6 k 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 company Or 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 Contributions Role of plan design Investment Decisions Special case of company stock Withdrawals from 401(k)s Life annuities Minimum distribution requirements

Overview of Participation A defining characteristic of 401(k) plans is that participation is voluntary Overall trend in the 1980 s and 1990 s 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

Participation by Earnings, 2001 All numbers expressed as % Source: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 56 Earnings ALL < $20 k $20 -40 k $40 -60 k $60 -80 k $80 -100 k $100+ Eligibility Participation by among workers eligible workers all workers age 20 -64 52% 28 57 70 76 77 75 74% 50 71 79 83 88 89 39% 14 40 55 64 68 67

Participation by Age, 2001 All numbers expressed as % Source: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 56 Age 20 -29 30 -39 40 -49 50 -59 60 -64 Eligibility Participation by among workers eligible workers all workers age 20 -64 44% 55 57 52 40 66% 76 78 74 80 29% 42 44 39 32

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

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

Contributions by Earnings, 2001 All numbers are medians, expressed as % of earnings Source: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 60 Employee Employer Earnings Contributio ns ns 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

Contributions by Age, 2001 All numbers are medians, expressed as % of earnings Source: 2001 SCF as summarized by Munnell & Sunden “Coming Up Short” 2004 pg. 56 Age 20 -29 30 -39 40 -49 50 -59 60 -64 Employee Contributions Employer Contributions 5. 2% 6. 0 5. 0 3. 0% 3. 0 4. 3

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

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

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?

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

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. php? story. Id=4828792)

Effect of Automatic Enrollment Participation rate with and without automatic enrollment Source: Madrian & Shea 2002, Quarterly Jrnl of Economics Earnings No Automatic Enrollment ALL < $20 k $20 -30 k $30 -40 k $20 -50 k $50 -60 k $60 -70 k $70 -80 k $80+ 49 20 32 50 62 70 79 76 76 86 80 83 89 92 93 95 92 94

Effect of Automatic Enrollment Participation rate with and without automatic enrollment Source: Madrian & Shea 2002, Quarterly Jrnl of Economics Age 20 -29 30 -39 40 -49 50 -59 60 -64 No Automatic Enrollment 37 48 55 64 61 83 86 90 90 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 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!

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.