Retirement planning vehicles 401(k) plans are the most popular choice of retirement plans for larger employers. Plan designs can have an enormous impact on the rates of return that are earned by participants, especially over longer periods of time. A well-designed plan will be able to get workers who make regular contributions where they want to go by retirement.
But these plans are often riddled with flaws that can impede retirement savers in many ways. Here are ten of the most common imperfections that are found in 401(k) plans today. (For more, see: 6 Problems With 401(k) Plans.)
- Poor rates of automatic enrollment. Although many employers have taken advantage of automatic enrollment as a way to bolster participation in their 401(k) plans, the rate of salary deferral that they use is often far below what is recommended by financial advisors.
- Poor rates of automatic escalation of contribution levels. Although this feature can be used to help combat low levels of plan deferrals, only about two-thirds of all plans employ this feature. Most retirement experts recommend an annual increase of 2-3% until the contribution level is at least 10%.
- Not using auto-escalation as an automatic feature. A rather low level of plan participants opt to use the automatic increase in contributions, and employers would be wise to make this happen automatically instead.
- Not giving participants a chance to decide their own level of deferrals. Auto-enrollment plans may arbitrarily set an employee’s level of savings at a low level and not give him or her the chance to set it at a higher level when they enroll. This can prevent some employees from deferring as much as they might choose to under a voluntary arrangement.
- Failure to use the “stretch” matching plan. Employers who match the first 5% of their employee’s contributions leave them with no incentive to contribute any more to their plans. But a 50% match of the first 10% of their earnings will cost the employer the same amount, but will incentivize employees to defer twice as much in order to receive the full match. (For related reading, see: Retirement Planning: Introduction.)
- Too many investment choices. Although it is a good idea to have an adequate selection of offerings in a company retirement plan, having too many choices can leave plan participants feeling bewildered. Some plans have dozens or even hundreds of funds, investment contracts, annuities and cash alternatives in addition to a self-directed brokerage account. This can lead to a deer-in-the-headlights reaction by plan participants, who may simply choose to opt out of the plan altogether.
- Failure to automatically re-enroll plan participants. Employers who automatically re-enroll their employees on a period basis can increase their overall participation rate by catching those who may have initially opted out of enrollment.
- Failure to offer new plan features to current participants. Some employers only provide new features that are incorporated into their retirement plan to new employees instead of allowing their previous participants to partake in them as well. This can prevent previous participants from benefiting from new features such as automatic escalation or matching contributions.
- Offering investment choices that are too specific. Sector and subsector funds are generally appropriate for more sophisticated investors, and many of them may fail to meet the new fiduciary standards set forth by the DoL. Employers should stick to general funds that invest in the overall markets in order to minimize potential liability. (For related reading, see: What the DoL Fiduciary Policy Means for Advisors.)
- A permissive loan policy. Although being able to take out a loan from a 401(k) plan can be a lifesaver for some employees who need cash quickly, employers who permit more than one loan from the plan can essentially send the message that the plan can be viewed as a type of bank account—that will hinder most investors from reaching their retirement goals.
- Failure to offer a Roth account. Many key employees and executives who participate in 401(k) plans have incomes that are too high to allow for direct Roth IRA contributions. But they can still participate in a Roth 401(k) plan if this is available to them. Not having this option cuts off their only means of accumulating tax-free income.
The Bottom Line
Although 401(k) plans constitute a vital segment of retirement savings for millions of Americans, how they are designed can make a huge difference in the plans' level of effectiveness. For more information on 401(k) plan design and taxation, download Publication 575 from the IRS website at www.irs.gov. (For related reading see: Are Roth 401(k) Plans Matched by Employers?)