This is the first part of a two-part series. This month we feature investment firms and alliance partners. Next month, we will feature insurance companies and banks.
Instantaneous access to balances. An array of fund choices and easy flexibility. Online options galore. The 401(k) industry is grooming a sense of consumerism in the American workforce as defined contribution plans become entrenched as the nation's dominant retirement benefit. While employee entitlement takes root, the list of sponsor options and obligations is expanding in the wake of technological change and legal developments.
Eager to stay competitive, companies have to determine how sophisticated they want their 401(k) plans to be, while ensuring they meet fiduciary responsibilities. Consider the following items that are increasing employee empowerment and putting plan sponsors on the spot:
* The Small Business Job Protection Act of 1996 introduced two laws to encourage extending 401(k) eligibility to new hires. The law became effective January 1, 1999. * Several plan providers, including MassMutual Retirement Services, Putnam Investments, and Fidelity Investments, are including time- weighted returns on statements so that employees know exactly how much their money earned during a specific period. * Last June, the U.S. Court of Appeals for the Ninth Circuit held that the sponsor of an early retirement plan had breached Employee Retirement Income Security Act of 1974 (ERISA) fiduciary duties by failing to warn retiring employees of the serious tax consequences of lump-sum distributions.
Such developments bode well for employees, who should have a greater chance to save money for retirement, better information upon which to base their investment choices, and more-complete information when it comes time for withdrawal. Employers are likely to benefit from an increasingly knowledgeable workforce--so long as plan sponsors diligently educate employees.
New laws dealing with new-hire eligibility will enhance a trend among corporations to enroll new employees immediately. As of year-end 1998, 24 percent of 384 companies surveyed by the Profit Sharing/401(k) Council of America (PSCA) grant newcomers immediate 401(k) eligibility. "That was higher than we expected," says David Wray, president of PSCA, based in Chicago. "Ten years ago, few employers offered immediate enrollment." About 32 percent offer plan participation within three months, according to PSCA. In contrast, 48.3 percent of companies surveyed do not enroll employees in plans until one year or longer on the job.
A tight labor market and intense competition for technically skilled workers--who are often financially savvy as well--make some sponsors believe it is essential to dangle this highly prized benefit in front of prospective hires.
"It's one of the first questions people ask our interviewers, even high school or college graduates going for their first job," says John Diedrich, director of employee health and benefits at Commonwealth Edison Co., the regulated electrical utility owned by Unicom Corp. (both are in Chicago), with $7 billion in sales in 1998. Salaried employees are enrolled immediately, and those ComEd employees who are part of the bargaining unit must wait three months to enroll, but after that everyone is eligible, even part-timers and interns. "It's a way to attract people, particularly second- or third-year college students in engineering, marketing, and finance. It prevents employees from leaving, too," he says.
But most employers have shied away from extending the benefit instantly to recruits, because enrolling new hires can threaten a company's ability to pass nondiscrimination tests. New hires, with limited salaries, are often reluctant to put dollars away for the future. That inhibits the ability of so-called highly compensated employees (HCEs), who earn $80,000 or more annually, to contribute as much as they'd like. One of the discrimination tests, known as actual deferral percentage, or ADP, limits HCE contributions to no more than two percentage points of salary beyond non-HCE (NHCE) contributions.
There are two safe harbors to help employees meet nondiscrimination testing while encouraging new-hire enrollment. The first requires sponsors to support what is called a "rich" plan, often prohibitively expensive. Employers must contribute at least 3 percent of every NHCE salary or match 100 percent of the employee's contribution up to an amount equal to 3 percent of compensation and 50 percent for the next two percentage points of compensation.
The second safe harbor will probably prove to be more popular. It allows companies that provide new-hire eligibility to exclude the NHCEs among them for the purposes of ADP testing. "With this 401(k) safe harbor, you no longer have the link between NHCEs and their effect on contributions," says William Arnone, a partner and national director of employee financial education and counseling at Ernst & Young LLP in New York.
Immediate enrollment can yield unexpected benefits. Allergan Inc., a $1.3 billion specialty pharmaceuticals company in Irvine, California, found eliminating its waiting period three years ago enabled it to pass the ADP test with flying colors, not something the company had easily done in the past. Participation rates have shot up from 70 percent to 85 percent. Allergan took another step last year when it instituted "negative election," in which a new hire is automatically enrolled in the plan. Under California law, the company must disclose to employees that it has automatically enrolled them in the plan, and the individual has 60 days to cancel the contributions--or enhance them. "It's a streamlined approach," says Tom Burnham, vice president of human resources. "It makes our job easier."
Negative plan election is still quite novel. Only 4 percent of sponsors surveyed by Hewitt Associates LLC in 1997 automatically enroll new hires. Some sponsors worry that they take on additional fiduciary duties when they instantly enroll participants--after all, someone has to direct those investments if the participant doesn't.
"A lot of employers are nervous about this," even if the contributions are targeted for stable funds, such as value funds, money market accounts, or balanced funds, says PSCA's Wray. Still, few things beat automatic enrollment for driving participation rates, and Wray predicts many large sponsors will adopt that plan design within the next year or two.
The cost of earlier enrollment is of little concern to employers who believe it's best for employees and for the company. While sponsors may incur some expense for opening and closing accounts for new hires that leave, "administration is easier now," says Edgar Adkins, a partner in Ernst & Young's human resources consulting practice. "With telephone enrollment and the Internet, the systems are more efficient."
Once employees are enrolled, Allergan's Burnham has a method to make sure new hires don't pocket the employer match and leave anyway: there's a three-year vesting period, with employees vesting in the match one-third at a time. In comparison, employees are vested in the company's defined benefit plan after five years
A Personal Rate Of Return
Whether employees are brand-new participants or veteran enrollees, their retirement plans require three critical pieces of information: the regular amount a person is able to save, the time horizon for accumulating the savings, and a person's expected rate of return. The first two questions are easy to answer, but few participants have known precisely what returns they, as individuals, have earned on their 401(k) plan. Until now.
Last year, Fidelity Investments, in Boston, and MassMutual, in Springfield, Massachusetts, became two of the first providers to publish a personal rate of return on their statements. The single figure aggregates the performance of all funds held in the participant's 401(k) account, and measures the impact of all contributions and withdrawals that occur during the quarter.
"That single number is powerful," says Kathryn Hopkins, executive vice president of Fidelity Investment Retirement Services Co. She likens the number to a report card on the assets held and the individual's own activity. "It helps people understand the effect of loans and fund performance on the account."
"A financial statement is a progress report. Am I headed toward my goal or not?" explains Vern Meyer, vice president of marketing at MassMutual. Meyer calls the introduction of an individual return "part of a broader trend to put more information in the hands of the participant, because it is the participant who drives the 401(k) plans."
And sharp 401(k) plan contributors want the information. Employees at New England Circuit Sales Inc. (NECX), which operates a centralized marketplace for buying and selling computer parts, in Peabody, Massachusetts, clamored loudly for an individual rate of return. "At a meeting, they told me, 'Those investment results you're showing aren't correct. We did our own calculations, and they aren't anything like that.'" recalls Roxanne Fleszar, president of Financial Resources Management Corp., NECX's 401(k) consultant, also in Peabody.
The employees wanted the information, but struggled with the calculations, so Fleszar approached the plan's recordkeeper, Independent Pension Consultants, in Chaska, Minnesota, and asked if it could calculate time-weighted performance returns.
The cost to NECX was "marginal," according to Larry Marshall, the company's executive vice president and chief operating officer. "I don't know if it is your responsibility to your employees [to provide individual rates of return] as much as it is a responsibility to run a good business, which means having more-productive employees and meeting their needs whenever you can."
Up until the first quarter of 1999, when MassMutual tacked on the individual return on quarterly statements, Lee Bachman, vice president of finance and treasurer of Bachman's Inc., in Minneapolis, calculated his own individual return. Bachman's is a $75 million, family- owned florist and gift and garden-supply retailer with an employee base of 1,000.
Family member Bachman crunched numbers to determine his return to confirm that his account's actual performance is close to the performance of the funds in the account. Now employees will be assured the same thing without the work. "They can determine if they really are getting what they think they are getting from their investments," he says.
The Desultory Effects of Loans
Sponsors are hopeful that individual rates of return will demonstrate the serious consequences of borrowing from a 401(k) plan on the actual performance of the account. "You can't convince participants that loans are detrimental to their accounts," says Fleszar. "They don't realize that if they take that money out of the stock market for five years, and the market does well during that time, then they are paying much more for that loan than the interest itself."
Although an individual rate of return won't show the negative effects of a loan over time, it will show a big one-time hit during the quarter when the loan is drawn. The individual may register a negative return, for instance, and "negative returns are meant to help you think twice," says Hopkins.
There is no single standard among providers to calculate the personal rate of return. MassMutual's calculation assumes an evenly distributed cash flow throughout the period. Rather than weigh the time involved with each contribution, the insurer's computation assumes all contributions are made in a lump sum at the midpoint of the quarter. This allows MassMutual the flexibility to allow participants to go online to determine their rate of return for any 12-month period over the past two years. Meyer says, "By simplifying the calculation, we can do it on the fly."
Putnam Investments measures the actual performance and cash receipts and disbursements of each account, says Alex Nelson, managing director and chief of client service for the Boston-based investment manager. Fidelity uses a time-weighted cash-flow analysis. Each contribution or withdrawal is weighted by how long the money is invested in the account during the reporting period, says Kathryn Hopkins. "We tried to get a modified dollar-weighted formula that reflects the impact of cash flow into and out of the account and the participant's investment selection," she explains.
A Breach Of Fiduciary Trust
Employees' familiarity with retirement finances may be growing, but employers must be wary of assuming 401(k) participants know enough. Education continues to be a primary concern among plan sponsors. Under ERISA Section 404(c), sponsors can help protect themselves from potential lawsuits if they provide investment education to participants. In the wake of a court case last June, sponsors may feel more pressure to educate participants not only about their asset selection and contributions, but about plan withdrawals as well.
In Farr v. US West Communications, the U.S. Court of Appeals for the Ninth Circuit found that US West had breached its ERISA fiduciary duties by failing to warn early retirees of the tax consequences of lump-sum distributions. The controversy began in 1989, when US West mailed a booklet outlining an early- retirement program to eligible employees. The booklet warned participants that the tax consequences of various distribution options were very complex, and advised them to consult with a tax adviser. The distributions involved both qualified and nonqualified plans, but the booklet did not state that only qualified portions of lump-sum distributions could be rolled over into an IRA and that nonqualified distributions would be taxed. US West also held a live telecast in 1990 about the retirement program, in which it again neglected to mention the tax consequences of nonqualified distributions, partly because it feared the issue would be too confusing.
The U.S. Court of Appeals held that US West had breached its fiduciary duties, adding that while the sponsor did not have a duty to provide the plaintiffs with individualized notices of how the tax laws would affect individual distributions, it did have an obligation to explain the nature of the potential problem and, in general terms, state who might be negatively affected. However, because ERISA allows plaintiffs no recourse to sue for damages, the court found there were no remedies available to the plaintiffs.
The case is likely to have a profound impact on sponsors, argues Arnone of Ernst & Young. "You may look at this narrowly and say this involves only nonqualified plans, but you have blinders on," he says. "This is one of the few cases where the courts have addressed the fiduciary obligations for plan sponsors, and they have found for the plaintiffs--the participants."
Arnone says the case will affect plan sponsors in two ways. One, it will increase the need for preretirement education, and two, it will add fire to a growing movement to amend ERISA to provide monetary compensation. He predicts the decision may spark a congressional overhaul of ERISA.
With baby-boomer workers set to retire beginning in 2010, and continuing rounds of early-retirement incentives, employers must begin to pay more attention to distributions. "The plan sponsor needs to think through how what it is offering will affect employees and give them complete information on which to make a decision," says Roberta Casper Watson, an ERISA attorney with Trenam Kemker, in Tampa. "You cannot leave out material information that one group needs just because it might confuse others."
It is 10 years since US West sent out its booklet, and sponsors have become more aware of their need to educate participants in general. So, when ComEd shut down its Zion, Illinois, nuclear power station in 1998 and laid off 600 workers, it brought in its 401(k) recordkeeper, Fidelity, to fashion a tailored presentation, says benefits director Diedrich.
"We especially focused on what would happen with the assets in the plan and what the tax consequences would be," Diedrich says. "We try to be very conscious that it is a complicated transaction, and [try to ensure] that our employees and dependents have as much information as possible before they make decisions on how to move their assets."
Arnone says that preretirement education should occur long before an employee is set to leave the company. "Whenever you time critical financial information close to a decision, when anxiety is high, you always run the risk of it being perceived as too late," he says. "The key to an effective education program is sustained education that works with time as an ally, not an enemy."
Jeannie Mandelker is a freelance writer based in Montrose, New York.
------------------------------------------------------------------------ LONGER WAITING PERIODS GREATLY REDUCE 401(K) SAVINGS
When Bryan Lee, 26, learned he could not enroll in his new employer's 401(k) plan for nine months, he went home and complained to his mother. In this case, Mom is Dee Lee, president of Harvard Financial Educators, in Harvard, Massachusetts, and co-author of She crunched some numbers and found that her son had reason to be concerned. The nine-month delay will cost him $166,000 in future retirement money, including lost company matches and extra tax liability. "When it's time for Bryan's review, he's going to bring up that number and say he deserves a bonus to compensate him for that loss," the senior Lee says.
Let's face it, with workers changing jobs seven times on average, any delay in 401(k) enrollment can have a devastating effect on retirement savings. For example, according to Dee Lee, a 22-year-old who launches a 401(k) savings program and contributes $4,000 a year will have $1.1 million in her account by age 62, assuming an 8 percent annual return. But if that 22-year-old changes jobs seven times and must sit out a year each time, she will have just $534,000 by age 62--almost half the amount. "And that," says Lee half jokingly, "is the difference between cat food and tuna fish."