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4477
Phone: 281.880.6525
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Is Your Retirement Savings Potential
Limited by a Poor Plan Design?
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You might be surprised at the difference a few thousand dollars can make in
your 401(k) account, when it has years to grow. Let's say you make the
maximum contribution of $17,500 and because you are over 50, you are also
eligible to make a catch-up contribution of $5,500. That brings your total
contribution for this year to $23,000. Compare that with a total contribution
this year of $16,000. After 15 years of growth, the difference between the
two contributions would add up to nearly $20,000 (assuming an average 7
percent annual return).
In a different scenario, let's say you are 40, therefore ineligible for the catch-
up contribution. In addition, because of discrimination testing constraints,
you are limited to $10,000 in tax-deferred savings this year (as opposed to
the usual $17,500 maximum). Under these circumstances you would end up
with $41,000 less at age 65 than you would if you made the maximum
contribution. Multiply these shortfalls by many years of diminished tax-
deferred savings, and you'll begin to see the numbers are significant.

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Of course, you can still make up the shortfall (or, for that matter, set aside as
much as you can afford) in a taxable account, but you'll pay more for the
privilege. The amount of the premium is your tax rate. So, for example, if you
are in the 28 percent tax bracket, setting aside $7,500 for retirement on an
after-tax basis would cost you $9,600. Add state income taxes, and the toll is
higher. (This analysis does not factor in any assumptions about the tax rates
you will face at retirement, however. If you think you might be paying higher
taxes then, accumulating some after-tax retirement savings isn't a bad idea.)

Why Do You Fail?

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So what might be causing your 401(k) plan to flunk the annual discrimination
tests? One big factor could be low participation rates among non-highly
compensated employees, caused by a delay in participation eligibility.
According to Vanguard's most recent "How America Saves" survey, 45 percent
of 401(k) plans do not allow employees to participate in the plan right away.
Most of these employers have a one-year waiting period from the time they
join the company.
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All employees eligible to participate in the plan, including those who will
become eligible after a one-year exclusion period, are lumped in with active
participants in performing discrimination tests whether they participate or
not. The two basic tests which must be passed are:

The "Actual Deferral Percentage" which compares the average salary

deferral (as a percentage of pre-tax compensation) of highly-
compensated employees and non-highly compensated employees, and
The "Actual Contribution Percentage" which compares the matching
contributions of the same two groups.
Obviously, if there is zero contribution from the non-highly compensated
employees, the group's average is pulled down.
Delaying eligibility can have a particularly adverse impact on new, young
employees who have not previously participated in a 401(k). Having never
experienced the benefits of plan participation, these employees are less likely
to enroll when the opportunity does open up. Inertia plays a big role. Also,
these employees will already have become accustomed to the size of their
paychecks, and be less inclined to do anything to reduce it.
Auto-Enrollment Growing
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While there has been little change in recent years in the proportion of
employers that maintain a one-year eligibility exclusion period, the Vanguard
survey does show growth in the adoption of 401(k) auto-enrollment. About
one-third of plans had that feature last year, compared to 24 percent in 2009.
Of those employers who auto-enroll, about half of them auto-enroll both
new employees and all other non-participants. This forces hold-outs to
affirmatively disenroll if they want no part of the plan. Last year, among
employers who enroll employees in plan participation by default, roughly 69
percent of those plans also automatically raise the employee's deferral
amount one notch each year, usually 1 percent.
Vanguard's survey data paints an interesting picture contrasting average
deferral rates of auto-enrolled plans and those that do not auto-enroll.
Overall, the average deferral rate of employees in auto-enroll plans is about
4.9 percent, while employees in voluntary-enroll plans average about 7.5
percent.*
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However, when the participant data is examined by account size, average
deferral percentages among workers with at least $10,000 in their 401(k)
accounts were higher for the auto-enrolled category.
In any case, Vanguard believes average deferral rates can be raised. Vanguard
suggests that low "quit rates," that is, employees who undo auto-enrollment,
suggest that employers using auto-enrollment could raise the initial deferral
rate well above the typical 3 percent level without losing many participants.
If your plan is failing the discrimination
tests and therefore limiting your
deferrals and those of other highly-
compensated employees, the bottom
line is this: You might be able to
improve your testing track record by
dropping eligibility delay provisions
and getting aggressive with auto-
enrollment defaults.
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