|ALAN J FISHMAN, CLU, is a pension consultant with Key
Advisors Group in Broomall, Pennsylvania. |
CHARLES V. CREIGHTON, CLU, ChFC, is a senior pension advisor with Key Advisors Group
Recent legislation provides some new choices for companies that want to adopt employee savings programs. Those considering new retirement programs or changes in existing ones must understand the different plan designs available. Companies also need to select from among the array of retirement plan providers, including insurance companies, mutual funds, banks and brokerage firms. Although the program features may differ among providers, overall plan benefits have improved in the past 10 years because of increased competition and software sophistication; administration costs also have decreased. This article describes the factors a company should use to select the right plan design and program provider, thereby helping to keep it focused on advancing sales, not on problems of declining plan enrollment or administrative headaches.
Since the early 1980s, only two retirement plans—the 401(k) and the salary reduction/simplified employee pension (SAR/SEP)—allowed for employee deferrals. As 401(k) administration costs dropped and SAR/SEP design restrictions created headaches for small business owners, 401(k) plans became more popular. However, employers still remained frustrated with the strict discrimination rules limiting the extent to which highly compensated employees (HCEs) make 401(k) contributions: Highly paid executives benefit only when non-HCEs participate. Moreover, employees are unhappy when employers do not match a portion of their deferrals. The answer? The Small Business Job Protection Act of 1996 introduced the Savings Incentive Match Plans for Employees (called SIMPLE plans)—an individual retirement account and a 401(k). The SIMPLE IRA replaced the SAR/SEP. Are these plans really simple, and do they address the concerns outlined above?
The Simple Plans
Generally speaking, the introduction of the SIMPLE plans means employers no longer have to perform discrimination tests when they meet certain predetermined conditions. The most restrictive requires the employer to make a matching contribution of up to 3% of employee compensation or a 2% of compensation nonelective contribution for all eligible employees. While the matching contribution applies only to those employees who participate in the plan, the nonelective contribution is similar to a pension contribution and is made for all eligible employees regardless of participation.
Although the SIMPLE IRA and SIMPLE 401(k) plans are similar to each other, some differences are worth noting. The SIMPLE 401(k) permits loans; the SIMPLE IRA does not. Aside from this disadvantage, however, the SIMPLE IRA generally provides more flexibility for the small business owner, including
- Few or no administrative costs.
- Fewer administrative responsibilities.
- Higher contribution limits. Even though the employee contribution limit is the same with both plans ($6,000), maximum contributions differ. The maximum to a SIMPLE IRA is $12,000; to a SIMPLE 401(k), it is $10,800. Why the difference? While plan contributions are based on a $160,000 compensation limit, the Internal Revenue Service left undefined the compensation limit in one area—the employer match in the SIMPLE IRA. If, for example, a company opts for a 3% match, an employee who earns $200,000 need contribute only 3% to reach the $6,000 maximum deferral. In determining the required company match, the SIMPLE 401(k) is limited to $160,000; with the SIMPLE IRA, there is no limit. Therefore, the match required with the SIMPLE 401(k) is $160,000 3 3%, or $4,800. The match required with the SIMPLE IRA is $1,200 more: $200,000 3 3%, or $6,000.
- Withdrawal flexibility. Employees can make withdrawals from a SIMPLE IRA at any time (the Internal Revenue Service imposes a 25% penalty in the first two years). Employees can make withdrawals from a SIMPLE 401(k) only for death, disability, hardship or separation from service. Penalties apply to all distributions made before age 5912.
- Investment flexibility. Generally speaking, contributions to a SIMPLE IRA can be made to any financial institution the employee chooses. Contributions to a SIMPLE 401(k) must be made to the preselected investment options determined by the company.
- Stronger employer fiduciary protection. With the SIMPLE IRA, much of the responsibility rests with the financial institution. With the SIMPLE 401(k), the plan sponsor or the employer has more responsibility.
- More flexibility with matched contributions. The SIMPLE IRA allows for reduced matching contributions—1% of compensation instead of the regular 3%—in no more than two out of any five years.
For the reasons outlined above, the SIMPLE IRA may be a more attractive option for many companies. Therefore, the decision to adopt a company savings program may come down to a choice between the SIMPLE IRA and a traditional 401(k) plan. Exhibit 1 highlights the thought process a CPA may go through in helping a company decide between the two plans. Depending on workforce demographics, company budget and the business owners objectives, the CPA may find one plan design more suitable than the other. Some important components of exhibit 1 are explained below.
SIMPLE IRA vs.
Will the business owner be able to contribute the desired amounts? If an owner is not interested in participating in a 401(k) or does not need to contribute maximum amounts to supplement his or her existing retirement savings, there may be no need to adhere to the conditions imposed by the SIMPLE IRA. A traditional 401(k) may be a better choice. If, however, the 401(k) is the owners main source of retirement savings, the company must determine interest among non-HCEs (those earning less than $80,000 annually) in participating. While some employees will decide not to participate for personal financial reasons or because they are unfamiliar with the programs advantages, the single greatest mistake a company can make is to implement a program that has little employee interest. If employees are very interested in participating, a traditional 401(k) will suffice; if they are not, the SIMPLE IRA may be the companys only option.
Employees earning in excess of $5,000 are considered eligible. Eligibility under a SIMPLE IRA is based on compensation—employees earning a minimum $5,000 in annual compensation can participate. Eligibility under a traditional 401(k) is based on hours worked—a company can exclude part-timers and those who work fewer than 1,000 hours. Although the basis on which each program determines eligibility differs, the main issue is flexibility. With the SIMPLE IRA, eligibility cannot be modified. Eligibility under a traditional 401(k) can be inclusive or restrictive—the employer can decide to include or exclude part-timers. If a company has only full-time employees (who presumably earn more than $5,000), there is little difference in eligibility under the two programs. If the part-time workforce is sizable, the employer whose objective it is to limit benefits should review each programs eligibility rules. If part-timers are likely to earn more than $5,000 but work fewer than 1,000 hours, the traditional 401(k) may be the better choice.
Participant deferrals are limited to $6,000 a year. With a SIMPLE IRA, a participant is allowed a maximum deferral of $6,000. With a traditional 401(k), the maximum employee deferral in 1998 is more than 60% higher—$10,000. This $10,000 threshold, however, is not guaranteed. As discussed earlier, HCEs may have difficulty contributing desired amounts if not enough non-HCEs participate. With a SIMPLE IRA, participation by non-HCEs is irrelevant—reaching the maximum deferral is predicated solely on a participants interest in saving for retirement.
The employer cannot sponsor another retirement plan. With a SIMPLE IRA, the company cannot sponsor another qualified plan. If profits permit and the business owner wants to make maximum 15% contributions to a plan, a traditional 401(k), coupled with a profit-sharing plan, is a good option. If, however, the employer is not interested in sponsoring an ancillary program and employee deferrals are the primary motive, the SIMPLE IRA restriction on additional qualified plans is irrelevant. (A business owner also can supplement a SIMPLE IRA with a nonqualified deferred compensation program).
The employer must make either a match or a nonelective profit-sharing contribution. While the required company contributions under a SIMPLE IRA may appear to be costly relative to a traditional 401(k), this is not always the case. If a business owner considering a retirement plan determines there is little interest among the companys employees (say, only 5 of 12 wish to participate), instead of a 2% nonelective contribution for all 12 employees, the owner can match 3% of compensation for those who do participate. With only 5 participants, the required match is small and not a disadvantage.
All employer contributions vest immediately. Vesting represents the portion of employer-contributed money that has accrued to the employee—for example, an employee who is 60% vested in $10,000 of employer contributions can remove only $6,000 if his or her employment terminates. A major benefit of the traditional 401(k) is that the unvested portion (40% in this example), commonly known as forfeitures, returns to the plan to reduce future matched contributions or administrative costs. While a traditional 401(k) offers this graded match, a SIMPLE IRA does not. All company contributions vest immediately. If a company is interested in a graded match and the potential benefit it offers in reducing plan costs, the traditional 401(k) is the only choice.
The SIMPLE plans are still relatively new and untested. Only time will tell whether SIMPLE IRAs prove to be a popular alternative. In selecting between the two designs, businesses should carefully consider the differences outlined above. Exhibit 2, below, provides a case study of how one business owner made his decision. If participation among non-HCEs is strong, the flexibility of a traditional 401(k) will be a determining factor.
Finding A Provider
Once a company has selected the right plan, it can turn its attention to the available program providers. As SIMPLE plans are relatively new, the discussion following concentrates primarily on providers of traditional 401(k) plans. However, most providers now offer SIMPLE plans with similar features.
Generally speaking, many mutual fund families, stockbrokerage firms, banks and life insurance companies offer 401(k) programs. An intermediary—a stockbroker, insurance agent or other investment professional—frequently is involved. For the most part, 401(k) programs can be differentiated by the parties involved and the investment options they offer.
The parties involved in a 401(k) program include those responsible for
- Making investments.
- Recordkeeping, including participant statements and other procedures such as keeping track of participant loans or rollovers.
- Plan administration, including discrimination testing and preparing government filings such as Form 5500, Return/Report of Employee Benefit Plan
Robert Hopkins, the owner of World-Wide Widget (WWW), recently attended a seminar on the advantages of adopting a retirement program for his company. He believes it would be a terrific benefit to offer his employees. Hopkins also would like to include his wife Mary in the plan—she works part-time (approximately 750 hours a year) as a bookkeeper and earns $8,000. Which plan should Hopkins consider?
Initially, Hopkins considers a traditional 401(k) for WWW. He could modify the eligibility rules to allow his wife to participate—typically, employees who work fewer than 1,000 hours in a plan year can be excluded from participating. However, three other employees who work fewer than 1,000 hours also would become eligible as a result. With a traditional 401(k), Hopkins understands that his own ability to contribute is based largely on the average deferral of his employees. Since the three part-timers have expressed no desire to participate in the plan, Hopkins feels a traditional 401(k) may not be his best choice.
With a SIMPLE IRA, Hopkins can contribute the maximum amount and not be concerned if other employees participate. Although part-timers are eligible (based on minimum compensation of $5,000), the fact that they do not participate does not create a problem. In fact, although Hopkins is required to contribute on his employees behalf to avoid discrimination testing, his choice to match 3% of compensation will not be costly because of the low employee participation. In addition, Mary Hopkins can contribute a maximum $6,000 of her $8,000 salary.
Throughout the 1980s, 401(k) programs typically used the services of a third-party administrator (TPA) to coordinate these functions. The entity making the investments gave the investment information to the TPA, who was responsible for recordkeeping and administration. Although some TPAs still coordinate all three functions today, others assume only the administrative functions. In another variation, the so-called bundled approach, the same entity provides all three functions.
Investment options also differ from one program to another. Although a plan can offer individual stocks or bonds as an investment option, for simplicity the discussion below concentrates solely on mutual funds, because, for many small plans, they afford the employer a level of diversification not easily achieved with a portfolio of individual securities.
Depending on the plan provider, participants can choose from the mutual funds of a single fund family or from among several different families. Typically, single-family providers include mutual fund families large enough to offer a diversified 401(k) program. Banks, insurance companies and brokerages typically offer mutual funds from multiple fund families as well as from their own in-house funds.
Determining which approach is most suitable depends on the employers objectives and budget. With an insurance company, for example, the asset fee charged reimburses the program for including popular funds from other families as investment choices. If a business owner wants recognizable investments, or participation will suffer without those popular funds, a company may wish to concentrate its efforts here. Some programs base their annual administration costs on the number of eligible employees; others, on the number who actually participate. For companies with high participation levels, the difference in annual administration cost is minimal. For companies with low participation, the difference can be considerable. Such companies may wish to restrict their search to programs that charge by the participant.
Loads and Surrender Charges
Aside from investment options, loads and surrender charges differ from one program to another. They come in two varieties: (1) a front-end load, assessed as a percentage of the contribution, and (2) a back-end load, commonly referred to as surrender charges, assessed as a percentage of the amount withdrawn. Typically, surrender charges are assessed—especially with smaller programs—to recoup setup costs and other expenses, including broker commissions, when programs are terminated in the first few years.
Program providers generally do not assess any loads, front- or back-end, when plan assets exceed $1 million. This would be the case, for example, with a company whose 401(k) plan has been in existence for several years and is now looking for a new program provider. Some providers aggressively pursue the small business market and waive all front- and back-end loads when annual contributions are expected to be greater than a minimum amount ($50,000).
There are two types of back-end loads: those assessed to plan participants (when an employee terminates employment) and those assessed to the company (only when the program is terminated). The latter is less restrictive. Back-end loads are highest in year one and reduce each year until they are eliminated—typically in five to seven years. A company should know how those penalties are assessed. Is the five-to-seven-year surrender period based on the contract date or the date of each contribution? The former is less restrictive, since contributions made in year four of a six-year schedule would have only a two-year surrender charge remaining.
Once a company selects a program or service provider, it needs to address program features. Many of todays 401(k) programs boast
- Six to eight investment options.
- Quarterly participant statements.
- Quarterly newsletters.
- A toll-free telephone number for participants to obtain daily investment balances or to transfer funds between accounts.
CPAs should be sure preparation of form 5500 is included. Some providers claim they will furnish a company with all of the information needed to complete the form and others claim to assist in its preparation. Companies should select a provider that will complete form 5500 on a signature ready basis—that is, with all necessary details and lacking only the business owners signature before it is mailed to the IRS. Exhibit 3, above, is a checklist of features companies can use when comparing program providers.
Here are some other factors companies should be concerned about when they are putting together a company savings program.
Choices. A company need not offer more than six to eight investment options. By offering more choices, it runs the risk it will overlap fund objectives or confuse participants. With fewer than six to eight funds, a company risks not offering enough investment choices. Typical selections might include a money market fund or guaranteed investment contract, a corporate or government bond fund, a blue chip stock fund, an aggressive or growth stock fund, an international stock or bond fund and perhaps an index fund.
Matchmaker, matchmaker. Initially, a budget-conscious employer may be reluctant to match employee contributions. However, a 401(k) program that provides a match encourages employees to participate. If participation is strong among non-HCEs, the HCE—presumably the business owner—can obtain maximum benefit from adopting the plan. With normal employee turnover, the unvested portion of company matching contributions reverts back to the plan to reduce future matching contributions or administrative costs. Companies that match contributions should avoid matching formulas such as 100% of the first 3% of participant contributions. An alternative such as 50% of the first 6% accomplishes the same net match and motivates participants to contribute at a higher level.
Educated participants. A company can never stop educating its employees about retirement planning. Sponsoring seminars on investment basics, risk tolerance and asset allocation can help both owner and employee. A well-educated employee is more likely to participate in the 401(k) program and properly allocate his or her investments among several fund options and is less likely to panic when stock or bond markets fluctuate.
Understanding the Differences
A 401(k) plan, at best, is an affordable benefit that can boost employee morale and attract talented workers. At worst, it can be an administrative headache. Companies have little time to waste wrestling with the details. When problems do arise, a CPA well versed in retirement planning can step in to resolve potential conflicts. Understanding the differences outlined in this article is a key factor in ensuring a company makes the right choice.
|Exhibit 3: 401(k) — Program Comparison|