Client Service December 6, 2018

When Auto-Roth Accounts Make More Sense

Janus Henderson research suggests the vast majority of auto-enrollment programs fund only pre-tax accounts; this is despite the fact that for younger, lower-income employees, funding a Roth account may be a more appropriate long-term option.

Reported by

Automatic retirement plan features have put significant numbers of employees in the U.S. on a path towards retirement readiness, but employers could still do a lot more to overcome participant inertia.

This is according to a new white paper published by Janus Henderson, “Defined Contribution Redefined.” According to Janus Henderson researchers, since the enactment of the Pension Protection Act of 2006 (PPA), automatic features have become common within defined contribution (DC) plans such as 401(k)s, 403(b)s and 457s. In particular, the main trio of automatic features—auto-enrollment, auto-escalation and automatically diversified qualified default investment alternatives (QDIAs)—have helped increase DC assets from $3.0 trillion in 2007 to $5.3 trillion in 2017.

Never miss a story — sign up for PLANADVISER newsletters to keep up on the latest retirement plan adviser news.

“Now that these automatic and default features have gained widespread acceptance, it may be time to consider additional steps to further enhance participant retirement preparedness,” the white paper says.

Most plans with auto-enrollment offer it to new hires (94.5%), while approximately one-quarter (25.4%) have auto-enrolled existing employees either as a one-time sweep or periodic sweep. According to the white paper, anecdotal evidence suggests the vast majority of auto-enrollment programs fund only pre-tax accounts. This is despite the fact that for younger, lower-income employees, funding a Roth account may be a more appropriate long-term option.

“While contributions are made with after-tax dollars, the earnings can potentially accumulate tax free for many years. Further, younger, lower-paid employees are likely in a lower tax bracket, so the tax advantages of pre-tax deferrals are muted,” the white paper says.

Janus Henderson researchers consider a theoretical 25-year-old in a 20% effective federal tax bracket.

“Contributions of $2,500 a year for 10 years will grow to $32,951, assuming a 6% annual rate of return. If no additional contributions are made, the balance will grow to $189,253 by the time the investor reaches age 65,” the white paper says. ‘Distributions from a Roth will be tax free, while distributions from a tax-deferred account will result in an after-tax distribution of $151,403. In this case, the Roth provides a more valuable retirement benefit, even after accounting for the annual $5,000 tax savings over 10 years ($2,500 x 20% = $500/year).”

According to Janus Henderson researchers, another innovative strategy that employers should consider is linking automatic escalation to retirement income replacement projections. Citing a previous Callan survey, the white paper says approximately 70% of all nongovernmental plans offer auto-escalation, up from 48% in 2014. Further, the number of plans that use an opt-out approach also grew from 52.8% in 2014 to 70.8% in 2017.

“The vast majority of plans automatically increase deferrals by 1% per year (86%), with a median cap of 15% of compensation,” the white paper says. “About half of companies selected their cap because it was likely to be most palatable to participants or limit opt-outs, while one-third felt it would maximize the likelihood participants reach their retirement goals.”

While automatically increasing deferrals annually should help participants accumulate larger balances at retirement, a uniform 1% approach may not help some participants adequately replace their pre-retirement income, Janus Henderson researchers warn.

“For example, older employees have fewer years to accumulate savings. If these employees do not have substantial account balances, they may require both a higher starting deferral rate and more aggressive annual increases to meet their retirement goals,” the white paper says. “Even younger employees may fall short unless prompted by their employer to increase deferrals at a faster rate.”

When it comes to automatic investments, while most plans use target-date funds as their default, 75.2% offer a managed account option. In these cases, the vast majority (92.6%) offer it as an opt-in feature whereby participants must proactively elect to use the feature similar to any other investment decision.

“According to Callan, only 13.3% of sponsors pay for the managed account fee, with the majority assessing the costs directly to the participant or shared by the sponsor and participant,” the white paper says. “Given the sensitivity to the additional cost of a managed account, it is understandable why many sponsors have elected to use a target-date fund as their plan’s default option.”

As the white paper points out, Morningstar and others posit that in some cases, the higher fee associated with managed accounts may be justified, particularly for older participants with significant balances.

“A hybrid or dynamic solution is suggested whereby younger participants are defaulted into the plan’s target-date fund but later defaults participants into the managed account solution upon reaching a specified age,” the white paper says. “Choosing an appropriate age would depend upon each plan’s unique participant characteristics.”

The paper notes that few DC providers currently offer the ability to facilitate a dynamic QDIA approach; however, the marketplace will likely evolve to meet future plan sponsor demand, according to Janus Henderson researchers.

Compliance December 6, 2018

IRS Offers Relief for 403(b) Plans Excluding Certain Part-Time Employees

Under the once-in-always-in exclusion condition, for a 403(b) plan that excludes part-time employees from making elective deferrals, once an employee is eligible to make elective deferrals, the employee may not be excluded from making elective deferrals in any later exclusion year on the basis that the employee is a part-time employee.

Reported by

The IRS has issued Notice 2018-95, which provides transition relief from the “once-in-always-in” (OIAI) condition for excluding part-time employees from 403(b) plan eligibility under Section 1.403(b)-5(b)(4)(iii)(B) of the Treasury Regulations. 

Under the OIAI exclusion condition, for a 403(b) plan that excludes part-time employees from making elective deferrals, once an employee is eligible to make elective deferrals, the employee may not be excluded from making elective deferrals in any later exclusion year on the basis that the employee is a part-time employee.

Never miss a story — sign up for PLANADVISER newsletters to keep up on the latest retirement plan adviser news.

The IRS explained that when it announced the opening of document submissions for its 403(b) pre-approved plan program, it issued a List of Required Modifications (LRM) which included the OIAI condition. However, commenters requested transition relief with respect to the OIAI condition, stating that many employers were not aware that the part-time exclusion included that condition.

Commenters noted that the OIAI condition was not specifically highlighted in writing until the 2015 LRMs were issued, and that, even then, the LRMs were directed at drafters of pre-approved plans and not adopting employers or sponsors of individually designed plans. As a result, the commenters argued, many 403(b) plan sponsors did not follow the OIAI condition.

So, the Treasury Department and the IRS are providing transition relief from the OIAI condition, including relief regarding plan operations for a transition period referred to as the “Relief Period,” relief regarding plan language, and a fresh-start opportunity after the Relief Period ends. The Relief Period begins with taxable years beginning after December 31, 2008, (the general effective date for the 403(b) regulations). For plans with exclusion years based on plan years, the Relief Period ends for all employees on the last day of the last exclusion year that ends before December 31, 2019.  For plans with exclusion years based on employee anniversary years, the Relief Period ends, with respect to any employee, on the last day of that employee’s last exclusion year that ends before December 31, 2019.

During the Relief Period, a plan will not be treated as failing to satisfy the conditions of the part-time exclusion merely because the plan was not operated in compliance with the OIAI condition. 

The Notice offers examples of the relief provided. 403(b) plan sponsors have until March 31, 2020, to adopt a pre-approved plan document and to make sure their plan has been operating in accordance with the plan terms.

«