At least once each year retirement plan sponsors should meet with their 401(k) plan investment advisor and review the plan’s health. In these 401(k) reviews, the advisor typically goes over investment performance and discusses any proposed changes to the fund line-up.
In addition to a review of investments, the IRS recommends that plans be reviewed for operational compliance. This includes checking to see whether employees are being enrolled into the plan as they become eligible, that participants are receiving the correct employer match, and if loans and distributions are being handled according to plan documents.
These operational reviews are important. Formal 401(k) review procedures can help plan sponsors find and prevent mistakes in administration. Left uncorrected, some mistakes could endanger your plan’s tax-favored status and/or result in fines or expensive corrections.
While investment and operational reviews are critical, it’s also important to run a check-up on overall 401(k) plan health. A healthy plan is one being effectively used by a majority of participants to reach their retirement goals. It’s a plan where most employees are participating and contributing a significant portion of their salaries. A healthy plan is one that offers an investment line-up appropriate for the company’s employees, and where the participants are invested appropriately for their circumstances. Finally, a healthy 401(k) plan benefits all employees, rather than skews those benefits toward the most highly compensated participants. Not only are widespread benefits necessary to comply with IRS non-discrimination rules, but a compliant plan indicates broad participation, and ensures that the 401(k) is serving owners/managers and employees alike.
A thorough evaluation of plan health may be performed during your annual 401(k) review with your advisor, or the review can be done internally. However, you may need the advisor or recordkeeper to provide some key data for a meaningful evaluation of plan health.
Four items to a healthy 401(k) not commonly reviewed
While a number of variables contribute to how well a 401(k) works for its participants, four factors are critical to plan health – but, based on our reviews of hundreds of plans, are not typically reviewed by the average 401(k) advisor. A positive report on all of them is required for a truly healthy 401(k). These four measures of health are widespread participation, high savings rates, adequate investment diversification and compliance with nondiscrimination rules.
These four qualities are presented in the table below along with suggestions on how they should be measured, and possible remedies if the plan is diagnosed as weak in an area.
|### Four Indicators to Include in your Next 401(k) Plan Review|
|**Indicator**||**Measures**||**Remedies (If Necessary)**|
|**Participation**||- Average participation rate - Participation rate by demographic - Comparisons to industry averages||- Auto-enrollment - Improved employee education and communication - Easier enrollment paperwork - Higher employer match or threshold - Simplified investment options|
|**Savings**||- Average deferral rate - Deferral rate by demographic - Comparisons to industry averages - Account balance by age group||- Higher auto deferral rate - Auto-escalation - Improved employee communication - Higher employer match or threshold|
|**Diversification**||- Age appropriate mix of stocks & bonds (glidepath analysis) - Appropriate QDIA - Reasonable employer stock exposure||- Include Target Date Funds in 401(k) fund line-up - Cap on company stock - Improved employee communication - One-on-one counseling|
|**HCE vs.NHCE Participation**||- Coverage test - ADP test - ACP test||- Safe harbor approach - Higher auto deferral rate - Auto-escalation - Frequent testing - Improved employee communication|
Why review your 401(k) plan’s participation rate
A plan’s participation rate is one of the best, and most common, indicators of 401(k) plan health. Yet it’s not always easy getting employees to participate in a plan that requires them to take action to join. According to Vanguard’s research on participants in its own small businesses plans, those with voluntary enrollment have a participation rate of just 57%. Even employees with 4 to 6 years on the job have only a 66% participation rate when required to opt-in to the plan. Meanwhile the average participation is 82% for plans with automatic enrollment. That average rate is higher than the participation rate for employees with 10 or more years of job tenure under voluntary enrollment.
Breaking down the participation rate in at least three ways can help plan sponsors better understand and review if the 401(k) plan is working for all employees, regardless of demographic. Looking at participation rate by income segment, for example, is important because lower paid employers typically have lower participation rates than those with higher earnings. Yet it is critical that these employees set aside a meaningful portion of their salary to build retirement assets.
Another key breakdown is by age. Younger employees are usually the least likely to participate given that retirement is so distant. And, younger employers are likely to be among those lower paid employers, and thus face the challenges of saving while meeting current living expenses. But those young employees have a great chance to meet their retirement goals as they have more years to compound returns. So, if few young people are participating, perhaps employee education and communication efforts should be steered toward that segment. (Read our tips on getting millennials to save into the 401(k) here.)
Finally, participation by job tenure is a particularly important metric. If the participation rate is low for employees who have been eligible to join the plan for years, it’s time for a thorough plan review to determine what barriers are preventing employees from joining the 401(k).
The cure for low 401(k) participation
The obvious antidote to a low participation rate is to begin automatic enrollment. Such a change will require educating the employees about this new wrinkle in the plan, and a renewed emphasis should be placed on ensuring employees understand the investment line-up. This may require different or more frequent interaction with the investment advisor. In particular, employees should fully understand the default investment option, as that’s where those automatic deferrals will be going unless the employee makes a change.
In addition, care must be taken with the automatic deferral rate. As explained in the next section, a deferral rate that is too low may stay low since employees have a tendency to leave deferrals unchanged from year to year.
Another way entice employees to enroll in the 401(k) is to offer a meaningful employee match. Interestingly, some research suggests that raising the threshold associated with the match is more effective than raising the match rate itself. That is, if a firm is matching 50% of the first 6% of salary, a shift to matching 25% of the first 12% of salary, while costing the company the same, is likely to increase participation.
Whether employees are required to opt-in to the plan or are auto enrolled, making sure that it’s easy to understand and join the plan is key to improved participation and a healthy 401(k).
Why review 401(k) deferral rates
And as with participation rates, deferral rates should be examined across salary levels, tenure and age groups. If your plan’s average savings rate is around 7%, you just might have a healthy plan. However, if that number is skewed by older employees maxing out their contributions while younger employees are saving in the low single digits, perhaps your plan could use some tweaking.
The table below presents deferrals rates by age of participants in small business plans where Vanguard serves as recordkeeper.
|### 2016 Deferral Rates by Age|
|**Voluntary Enrollment**||**Automatic Enrollment**|
Younger employees tend to divert less of their salary toward retirement than older employees. But notice that all age groups save less in plans with automatic enrollment than those where joining the 401(k) is voluntary. This is the result of many plan sponsors combining automatic enrollment with a low deferral rate. A Vanguard study of all of its plans, not just smaller ones, revealed that 44% of plans with automatic enrollment chose 3% as the default contribution rate.
The table below presents deferral rates for Vanguard’s small business plans by salary level.
|### 2016 Deferral Rates by Income|
|**Voluntary Enrollment**||**Automatic Enrollment**|
While the 2016 maximum employee contribution was $18,000 (plus another $6,000 for employees 50 and older), most employees are saving well below the maximum. But given that Vanguard found that higher automatic deferrals don’t result in more participants leaving the plan, one remedy for low deferral rates is to raise the default enrollment rate. At ForUsAll we suggest a 6% deferral rate with auto escalation. The auto escalation feature is great way to help employees reach their retirement goals even if they forget to change the rate each year.
Why review 401(k) investment diversification
Each employee should be adequately diversified to deliver a high probability for long term savings growth and retirement success. One measure of diversification is the percentage of company stock held in employee portfolios. A closer look at individual accounts could also reveal the percentage of employees holding both equity and fixed income exposure, and if your advisor is not examining your employees’ diversification and glidepath there could be people who are saving, but not maximizing their odds of having created enough assets for retirement. Certainly, plans where employees are heavily exposed to company stock, or conversely, are under exposed to equities, should take steps to improve the overall health of the plan.
One way to help participants maintain a portfolio suitable for their particular circumstances is to include target date funds in the line-up. Target date funds shift the employee’s asset allocation for them as they grow closer to retirement. Target date funds are a great default option for companies where few employees are well versed in personal finance and have little investment experience. The right target date funds can be some of the best funds for your company’s 401(k) plan.
Why review highly compensated (HCE) vs. non-highly compensated employee (NHCE) participation
Broad participation by NHCEs is needed for a 401(k) plan to comply with ERISA/IRS rules. NHCEs must not only participate, they must contribute to the degree that the plan is non-discriminatory as measured by the ADP (actual deferral percentage) test. This is also the case if the small business owner(s) wants to maximize their 401(k) contributions with an employer match – enough employees must contribute enough of their salaries so that the plan passes the ACP test, allowing the business owner to maximize their own tax-deferred savings.
Some small businesses owners find that passing these tests is too unpredictable from year to year so they adopt a safe harbor plan. This type of plan is exempt from the annual ADP, ACP, and top heavy tests, and allows owners to make significant contributions. This may be the best route for some small businesses, but safe harbor plans can be expensive as they can require an employer match of 4%.
An alternative to a safe harbor set up is a 401(k) plan that is great at getting people to use the plan. The measures outlined above are the very measures that can be taken to ensure that a plan is not discriminatory: Automatic enrollment, a minimum 6% automatic deferral, auto escalation, and easy onboarding. Remember, the plan must engage employees so that they are aware of the benefits of high contributions and that they understand how the plan works. For example, plan enrollment via mobile devices can help employees become familiar with their plan without imposing high costs on a small business and without forcing employees and HR teams to deal with confusing paperwork.