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The Best and the Worst of 401k Plan Design Elements

The Best and the Worst of 401k Plan Design Elements
October 27
00:03 2015

What are the most critical 401k plan design elements? It’s that time of year again when all good plan sponsors start to review their 401k plan and when prospective 401k plan sponsors start to consider starting a new 401k plan. They are asking the same question: What is the best way to structure 401k plan? To answer this question, we asked retirement plan professionals from all corners of the nation for their ideas and the best and the worst they’ve seen when it comes to 401k plan design elements. We’ve broken down their answers into two broad categories: Basic Plan Infrastructure and Plan Investment Philosophy. Here’s what they had to say.

Broad Category #1: Basic Plan Infrastructure

How to Handle Loans
Leakage has become a controversial aspect to 401k plans, but the ability to “change one’s mind” reduces the risk of long-term commitment some employees fear. Loans give participants a level of comfort that, for some, removes the obstacles to saving for retirement. “When there is more flexibility, there are less barriers for participation from employees,” says Richard Massaux, Managing Director of Investments at Wells Fargo Advisors in Philadelphia, Pennsylvania. “This would make it less restrictive for people to access their money.”

That’s not to say a plan sponsor can’t go overboard with loans. Leakage, after all, can be a real problem. Paula Friedman, Managing Director at Encore401k, a division of McLean Asset Management Corporation, located in McLean, Virginia, says, “I once worked with a plan that offered up to four loans outstanding at a time. A small portion of their participants had multiple loans outstanding and were taking out loans to repay other loans. It was a disaster!”

For more on this, read “How Should the 401k Fiduciary Address ‘Leakage’?” (FiduciaryNews.com, November 26, 2013)

“Instant Eligibility” Rollover Option
The idea that employees must wait before enrolling in the plan is slowly disappearing. Even with such a delay in salary deferrals, plan design should allow employees to immediately roll over their assets from their former employer’s plan. This helps both the employee and the employee’s former employer (see “Ex-Employees Who Don’t Rollover – Will 401k Fees Increase Plan Sponsor Liability?FiduciaryNews.com, June 28, 2011). “Allowing employees to rollover other retirement accounts into the plan before meeting eligibility requirements is very important to encourage employees to keep their retirement accounts consolidated,” says Friedman says. “Most companies require a waiting period before allowing employees to wait before being able to contribute to the plan; however, by allowing rollovers into the plan prior to meeting eligibility requirements, employees can keep track of old accounts and avoid tapping into their savings before retirement.”

Offering a ROTH Option
This isn’t an investment option, this is a savings option. It is particularly popular with younger workers. Now might be the time to consider adding a ROTH option to your plan design. “As plan sponsors begin to review their 401k plans at the year-end it is critical to re-evaluate the arsenal of plan design options out there and the plan sponsors objectives,” says Matt Cosgriff, a Plan Consultant at Lifewise, located in the greater Minneapolis-St. Paul area. “Many plan sponsors are recognizing the importance of offering a Roth option to the plan and this is quickly becoming table stakes for many plans, particularly with a younger workforce who want the ability to save after-tax dollars that can grow tax free well into the future.”

The Company Match – Best Practices.
There’s been talk recently about whether the company match has really delivered as promised (see “New Study Explains Why the 401k Match FAILs,” FiduciaryNews.com, November 16, 2010). When asked what we the worst plan design element he ever saw, Layton Cox, Director of Retirement Plan Consulting at Pathways Financial Partners in Tucson, Arizona said “a zero match. Any plan that doesn’t have a match eliminates one of the strongest reasons employees join a 401k. If you don’t have a match, start a match. As little as 25% of 4% will do wonders for your enrollment and retirement readiness. The match is always important. One of the most common reasons employees join a 401k is for the ‘free money’ the match creates. Never get rid of the match.”

Friedman agrees. She says, “Employer contributions to employee accounts significantly impact how much employees save for retirement. It is a critical component to building an employee’s account balance, which translates into more potential income in retirement.”

“Safe Harbor matching is a critical component to 401k plan design, we’ve found it to be a simple way to get an employer to begin with matching contributions,” says Stephen Rischall, co-founder of 1080 Financial Group, a Registered Investment Adviser firm in Los Angeles, California. “Over time, employers become comfortable with the 3% match that they often times increase or add features like profit sharing to provide an even better benefit to employees. Any level of matching makes it easier to get employees interested in participating, starting with Safe Harbor makes it even harder for an employee to disregard participating.”

In this sense, it always makes sense to take another look at the plan’s matching policy on a periodic basis. “Revisiting the match is another critical item worth revisiting from a plan design standpoint at the end of the year,” says Cosgriff. “If you instituted a match the previous year did it have the intended impact of increasing participation and the average deferral rate? If not, it might be worth considering if the match can be restructured in a way to increase participation and savings.”

What we’re beginning to see is more creativity in terms of matching formulas. Cox told us one of the most unusual (but effective) plan designs he’s seen is “a flat dollar match for a construction firm. It was a 100% match up to $5,000. So if the employee put in $5,000 then the firm would put in $5,000 – a pretty generous match for any company, especially a construction company. But their ability to change the conversation from percentage to dollars really spoke to their employees.”

In another outstanding case that produced amazing results, Friedman said she “came across a plan that offered a 50% match up to 20% of compensation. It is one of the most generous matching contributions I have seen. Not surprisingly, their employees had healthy balances as a result of high participation and deferral rates.”

The New Standard: Auto-Enrollment/Auto-Escalation
Behavioral finance research has greatly benefited the design of 401k plans (see, “Plan Sponsor Alert: Behavioral Finance Reframing Future of 401k,” FiduciaryNews.com, October 1, 2013). Of all the ideas offered, auto-enrollment and auto-escalation have been the de facto standard for plan design. “Automatic enrollment and automatic escalation are two behavioral based design elements that every plan should have in the next 5 years,” says Cox. “Get people saving today and get them saving more tomorrow. That by itself will do wonders for your employees’ retirement readiness.”

There is no question auto-enrollment has helped improve employee saving. Benjamin Spalter, Vice President Investment Officer at Wells Fargo Advisors in Philadelphia, Pennsylvania, says, “The most effective plan design is auto enrollment which significantly increases participation.” Since auto-enrollment is a relatively new concept, many older plans (especially smaller ones) may have been created before this particular feature became popular. “If the plan doesn’t already have auto-enrollment now is the time to reconsider!” says Cosgriff. “It is hands down one of the best ways to increase participation among participants is to set up auto-enrollment and on top of that it can’t hurt to explore re-enrolling all participants if the plan has a large number of people sitting in cash or cash equivalent fund.”

Alongside auto-enrollment, auto-escalation has also helped employees save more for retirement. “Automatic increasing contributions are a great feature,” says Rischall.” By simply increasing employee contributions by as little as 1% per year, they often times do not notice the difference and will ultimately end up saving more for their retirement. They’ll be thankful they did!”

Still, we can’t rely solely on auto-enrollment and auto-escalation. Company matches remain an important part of the savings program. “Automatic features also promote increased savings; however, due to low default deferral rates they don’t have the same effect on retirement readiness as employer contributions,” says Friedman. “Ideally both of these features will be combined to maximize employee savings and potential.”

For more on this, read “Beyond Auto-Mania: The Future of 401k Plan Design,” (FiduciaryNews.com, October 3, 2014).

Broad Category #2: Plan Investment Philosophy

Investment Change Window Forever Open
One thing to remember about these auto features – they are “opt-out” as opposed to mandatory. This allows employees to retain control over their own money. Massaux says, “Allowing employees to actively control the amount that they contribute is important. Employees can maintain a certain amount of control of their investment amounts and risks. This would allow them to control the amount they are contributing and the amount of risk taken.”

In the same vein, the ability for employees to change investments at any time gives them the kind of control that, like taking hardship withdrawals, can help remove the uncertainty of tying up one’s money for the long term. In the early years, employees could only make changes in their investment line-up a few times a year. While some say the opportunity to change investments may have giving employees enough rope to hang their retirement, the truth is that horse is out of the barn. Spalter says, “The worst plan design element is limiting the employee’s ability to change investment asset allocations only on a quarterly basis.  While employees don’t need the ability to make ongoing changes, they should be able to have the option to make changes whenever they like.”

Removing the Money Market Option
One of the favorite places for employees to stash their long-term investment assets is in the proverbial mattress known as the money market fund. This option is quickly fading away. “The money market fund is dead,” says Cox. “Whether or not you consider this a ‘design’ element is up to you, but stable value funds can help employees much better than a money market. Also eligibility waiting periods are dying out. Instead of having employees waiting a year, let them start saving now. If your employee turnover is low, you should have immediate eligibility.”

Number of Menu Options
Another eye-opening study from behavioral finance revealed what we call “the paradox of choice,” (see “4 Proven Strategies to Reduce Choice Overload in 401k Plans,” FiduciaryNews.com, June 4, 2013) “Offering too many investment options has been shown to overwhelm participants and cause them to make poor choices or abandon the enrollment process altogether,” says Friedman. “Investment menus should be short (no more than 20 investments) and should be combined with ‘do it for me’ solutions such as risk-based model portfolios or target retirement funds.”

“Targeted” Managed Options
More and more retirement savers are looking for the “one-portfolio” solution. This is usually in the form of a flexibly managed fund. “Managed solutions as far as target risk investments and target dated investments are important,” says Spalter. Participants tend to make the wrong investments at the wrong time. If they have confidence in the managers they are utilizing, they tend to stay with the investments longer.”

Rischall says, “Most investors tell us they don’t really know what they’re looking at when choosing 401k investment options. While we may not agree with the allocation of certain target date and lifestyle funds, the simplicity makes it easy for participants to get started and more often than not keeps them in line with a risk and performance expectation that makes sense for their investment horizon.”

For more information on the difference between these two “one-portfolio” options, see “The Big 401k Fiduciary Question: Target Date or Target Risk?FiduciaryNews.com, May 12, 2015).

A Category-based Tiered Menu Option
This is the grand-daddy of all the fruits of behavioral finance research. It’s become a way to reduce the perception of choices without necessarily reducing the number of choices. “Using a tiered or category-based 401k investment menu helps participants make investment choices based on their desired level of involvement in the selection process,” says Friedman. “Through this approach, participants are only shown relevant information (e.g. information about model portfolios instead of a list of single investment options) which makes it easier for them to select a diversified, low-cost portfolio without becoming overwhelmed.”

The basic idea is to have employees chose a general investment category first before picking the actual investments. “In plans that offer tiered solutions there are two plan options: do it yourself and do it for me plans,” says Spalter. “The ‘do it yourself’ plan offers a set of investments to employees so they can build their own portfolios. The ‘do if for me’ plan allows the employee to select from managed portfolios geared towards certain risk level or based on retirement target date. Employees can navigate different menus based on criteria to get them where they want to go faster.” Of course, there’s not a consensus on exactly how may categories or tiers a plan option menu should have, but there is general agreement on limiting the total number of options. “Anything over 20 investments is too confusing for the average investor,” says Cox. Investors should be given three options: Target Date, Target Risk, Do-it-yourself. It’s easy to explain those three categories. Target Dates manage your money for your specific retirement date. Target Risk funds manage your money based on your attitude. If someone wants to do it themselves, you’ll know.”

For more on category-based option menus, see “Adding Categories: A Sample of a New and Improved 401k Investment Option Menu,” FiduciaryNews.com, June 6, 2013)

Danger! Danger, Will Robinson! The Folly of Self-Directed Menu Options
Just because an idea is new or growing in popularity doesn’t mean it’s a good idea. Self-directed menu options may just fall into this category (see, “Is the Fiduciary Liability of Self-Directed Brokerage Options Too Great for 401k Plan Sponsors?FiduciaryNews.com, June 11, 2013). “If you look at the DALBAR average investor return studies, the average investor is a crappy investor,” says Cox. “If you let them invest in whatever they want, they will hurt themselves. This goes back on you as a fiduciary. Limit their choices in order to limit the pain they can inflict on themselves. It’s the same reason you don’t let a toddler run around in a knife store, they don’t know what to touch and what not to touch.” If you’re familiar with the term “double-edged sword,” then you’re familiar with the problem of self-directed funds. “There are two main risks associated with separate account options,” says Spalter. “The first is on the employee side. Employees tend to invest poorly when choosing their own funds in concentrated sectors and tend to follow the crowd which causes them to buy high. The second risk is from the fiduciary perspective of the planned sponsor. It creates additional liability in overseeing an expanded investment menu.”

Specifically for employees, self-directed options can not only slow down the saving process, but it might cause retirement savers to take their eyes off the ball. Rischall says, “When employees have an abundance of investment options it can slow down the process of getting started. Providing employees with access to an expansive fund line up or brokerage window can lead to them focusing more on performance and not the fundamental benefit of making savings a habit. In addition this can lead to employees thinking of their 401k’s less as long term savings and more like a trading account.”

Worse, self-directed options present a great risk to plan sponsors. “The risks associated with brokerage windows are tied to the lack of oversight for the investments selected,” says Friedman. “The employee could be taking on too much or too little risk, timing the market, paying too much in fees, or not properly diversifying their portfolio. Additionally, they may not be closely monitoring the investments which could lead to underperformance over longer time periods.”

Bonus: Broad-Category #3: A New Benchmark

Focusing on Retirement Readiness
When it comes to 401k benchmarks, there’s a new sheriff in town. Recent studies show investments actually have a smaller impact on meeting your retirement goals than previously thought (see “New Study Reveals Three 401k Strategies More Important than Asset Allocation,” FiduciaryNews.com, August 14, 2012). As a result (and perhaps with the growth of the “one-portfolio” solution), there’s less emphasis investments and increased emphasis on retirement readiness. “Retirement readiness is the hot word for plan platform providers,” says Massaux. “Retirement readiness measurements are included to help show participants how their input affects output and end result. If you can quantify for a participant how much retirement income they will generate from decisions they make today, you have a chance to influence their behaviors.”

Retirement readiness is driven by savings behavior. It’s only natural, then, that we see a greater focus on savings-related benchmarks in lieu of investment-related benchmarks. “I’ve seen a growing number of plan sponsors care more about average account balance and average deferral rate than other statistics,” says Cox. “This is great for those plans because it makes it easy for them to see the value in automatic enrollment and automatic escalation.”

Much of what we see highlighted in this article have become the source of the new benchmarks. “Plan design elements, such as automatic features and employer matching contributions, encourage retirement readiness by increasing participation and helping employees overcome the inertia associated with saving for retirement,” says Friedman. “When employers automatically enroll employees into the plan at a deferral rate that maximizes the matching contribution, it has a significant impact on the employee’s account balance.”

For more information on retirement readiness, see “Retirement Readiness: The One True 401k Benchmark Every Fiduciary Should Measure,” FiduciaryNews.com, September 4, 2015)

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s (including information on the new wave of plan designs) every 401k plan sponsor and service provider wants and needs to know. Alternatively, would you like to help plan participants create better savings strategies? You can buy Mr. Carosa’s latest book Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort right now at your favorite on-line or neighborhood book store.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

1 Comment

  1. Chip Logan
    Chip Logan October 30, 13:29

    Great synopsis Chris! I’ll be forwarding as a precursor to plan reviews with my clients. Thank you!

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