Roth Option Viewed as Another Avenue for Diversification

Experts say sponsors should offer a Roth option so that participants can diversify their tax situation in retirement.

For retirement plan advisers and sponsors that have not considered offering a Roth option for a 401(k) or 403(b) plan, a recent finding from the Plan Sponsor Council of America (PSCA) should give them pause. In 2016, 63.1% of plans offered a Roth, more than double the 30.3% of plans that did so in 2007.

Experts say that Roth options represent another way that participants can diversify their savings, in this case via taxes. They also say that they make the most sense for younger workers who are in lower tax brackets.  Paying taxes today before putting their savings into a retirement account so that they can then withdraw the savings tax-free in retirement is a powerful way to “turbo charge” savings, says Gregg Levinson, senior retirement consultant with Willis Towers Watson in Philadelphia.

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“In the retirement industry, we focus greatly on the diversification of investments in a participant’s account,” says John Geli, president of retirement solutions at DST in New York. “Such diversification allows a participant to weather the ups and downs of the market. Similarly, diversifying the tax impact of your qualified plan account allows an individual to be prepared regardless of what their personal tax situation ends up being upon retirement.”

Many workers are aware of the Roth option, says Gary Weir, vice president, retirement solutions at Frenkel Benefits, an EPIC Company, based in New York. “The few times an employer has started a new plan and not offered a Roth contribution, one of the first questions we get from employees is if they can contribute on a Roth basis,” Weir says. “Qualified retirement plans often add Roth provisions to increase the flexibility and attractiveness of the plan to all workers and to appeal to younger workers or those in a lower tax bracket, for whom the prospect of long-term tax-free gains are more attractive than current tax savings.”

Amy Oullette, head of operations at Betterment for Business in New York, agrees that the Roth option may make the most sense for younger workers, who have a longer period of time to amass earnings on their savings.

Conversely, “if a participant expects that Social Security will be their primary source of income in retirement, they may not derive as much benefit from a Roth account, since they may be in a very low tax bracket,” adds Steve Bogner, managing director at HighTower Treasury Partners in New York.

What sponsors need to know

Zovistoski says there are six steps/points that sponsors need to take or be aware of before offering a Roth option. First, they will need to work with their third party administrator (TPA) to update their plan document to include information about the Roth option. Second, they need to contact their payroll service to ensure they can handle both pre- and post-tax contributions.

Third, they should be aware “that eligible employees can contribute to a traditional retirement plan, a Roth retirement plan or both—but that the combined IRS [Internal Revenue Service] maximum deferral amount is applied to both accounts,” Zovistoski says.

Fourth, should a participant elect to invest in both a traditional and a Roth retirement account, the recordkeeper needs to maintain two separate files on both because they are taxed differently, he says.

Fifth, participants’ “Roth contributions are eligible for employer matches, just like traditional contributions, and like traditional contributions, the employee is immediately 100% vested,” he says.

Sixth, should the plan decide to use automatic enrollment, the default is typically a traditional retirement plan; employees would need to affirmatively elect the Roth option, he says.

In-plan Roth conversions

Few sponsors that offer a Roth option permit in-plan conversions, Weir says. Should a participant decide to convert their savings in a traditional retirement account to a Roth account, they need to be aware that they will be subject to ordinary income tax on whatever that amount is in the year in which they make the conversion, he says. Thus, if a participant has a $300,000 balance but is only earning $50,000 a year, the participant would most likely be unable to pay the taxes on that amount, and it, therefore, makes sense for “the employee to work with their tax adviser to structure their conversions in such a way that the taxable situation can be spread over several years so there is not an adverse tax consequence in any one year,” Weir says.

It is also critical for participants to realize that once they make the conversion, it cannot be reversed, adds Cindy Wilson, financial consultant director, institutional financial services at TIAA in Los Angeles. And, sponsors have the option of allowing either unmatched pre-tax deferrals or matched pre-tax deferrals to be converted, Wilson says.

Once a participant has decided to make a conversion, Zovistoski says, they should go through six steps to ensure that it is done properly. First, they should make sure that the Roth option is, indeed, available at their company. “Second, just because a company offers a Roth option does not mean they also offer in-plan Roth conversions,” he adds. “Half of the plans with Roth do not allow for in-plan conversions.”

Third, just as Weir recommended, the participant needs to be aware that they will be responsible for the taxes on any amount that they decide to convert and, therefore, it often makes the most sense to “spread out the amounts over a period of time to spread out the tax burden,” Zovistoski says.

Fourth, the participant then needs to obtain the forms to conduct the conversion from their human resources department. Fifth, “they need to look at their next quarterly statement or log onto their account online to make sure the conversion was handled properly, and, finally, they need to look for a 1099R form at the end of the year, which will tell them how much” of the money converted from their traditional retirement account is taxable.

Participants in Roth 401(k)s or 403(b)s cannot take a distribution from the account without being subject to the 10% tax on early withdrawals until five years from their first Roth contribution or reaching age 59-1/2, says Jamelle Moody, retirement plan consultant with DWC – The 401(k) Experts in Houston.

Unfortunately, Levinson says, “the challenge with Roth is that it is complicated to explain, which is why I think many people do not use it. We just did our DC [defined contribution] survey, which showed an uptick in sponsors offering the Roth option, but among those who don’t, they say it is too complicated for participants to understand. This has to change. Roth needs to be brought into the mainstream because defined benefit plans are gone, and not enough people are properly prepared for retirement. People need every tool possible,” and the Roth option is one that can really boost savings, he says.

Retirement Programs Must Continue to Evolve to Address Participant Needs

Chuck Coldwell, vice president - national director, Consulting and BOLI Services at Pentegra, believes as an industry, we still have not reached the goal of getting the majority of participants in a good place for retirement—even with auto enroll and escalate.

As it became clear that defined contribution (DC) plan participants were struggling with savings and investing decisions, the use of automatic plan features, encouraged by the Pension Protection Act (PPA), became the new trend in helping participants reach their retirement goals.

The 2017 PLANSPOSOR DC survey found that 42.7% of DC plans overall use automatic enrollment, and 35.4% use automatic deferral escalation. This increases to 65.6% and 67.3%, respectively, for the largest plans. In addition, many DC plans are defaulting participants into target-date funds (TDFs) as a set-it-and-forget-it investment strategy—letting professional managers take control of investment diversification decisions.

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However, as retirement plan sponsors focus on increasing retirement income replacement ratios for participants and new generations enter the workforce, they need to look at enhancing their retirement programs so participant retirement goals are met.

“’Set-it-and-forget-it’ might be the approach that many participants prefer to take when it comes to their retirement plan account, but for employers such an approach can be extremely limiting—or even detrimental. As with most components of a successful business, staying up-to-date on new developments as a means of remaining competitive can make a huge difference,” says Chuck Coldwell, vice president – national director, consulting and BOLI Services at Pentegra, who is based in Katonah, New York.

Coldwell believes as an industry, we still have not reached the goal of getting the majority of participants in a good place for retirement—even with auto enroll and escalate, there is a long way to go to get the majority of participants into these types of plan design. “DC plans are not first on people’s minds. Getting them to save what they need to is still a huge challenge. Automated features will help without a doubt to build better account balances, but employees still have responsibilities for decisions about how much to save and how to invest,” he says.

Joel Lieb, director of SEI Defined Contribution Advisory in Oaks, Pennsylvania, adds that meeting the needs of younger and new generation participants is especially important. “The simple truth of the matter is that younger folks do not have the same set of resources as older employees, who have generated real and sustainable retirement income through pension plans. Younger workers, we all know, are having to rely almost exclusively on defined contribution plans, and that will be the case moving forward,” he says. “I mention this well-known background because today we are stepping back and asking, what can we do to help plan sponsors make their defined contribution plans just as effective at creating retirement wealth as have been DB [defined benefit] plans? How can we help employees get into a position where they can retire when they want to, and not be forced into the situation of trying to work past the traditional retirement age, because of poor planning?”

Targeted communications and financial wellness

Coldwell says he is a firm believer in education. “Education has to be more than in-person because that can’t happen as frequently as needed. We push out education rather than waiting for participants to seek it. There is still a challenge of making sure they read it, but I still think it is the best method, and it has to be consistent.

An Insights article from Sibson Consulting states that, “A pivotal factor in helping employees improve their retirement readiness is opening the channels of communication and customizing the messages. To have a meaningful impact, plan-related communication must be actionable and personalized. Except in rare instances, one-size-fits-all is a misnomer; it should be one-size-fits-few. Communication should also be easy to understand and delivered on a regular basis, beginning well before retirement age. Further, the impact of the communication must be measurable, so the results can be monitored.”

Doron Scharf, senior vice president with Sibson Consulting in New York City, says one of things Sibson does is a survey to find out what drives behaviors of participants. This helps with targeted communications. Jonathan Price, Sibson Consulting vice president and consultant in New York City, adds that communications should be provided about the retirement plan, but capturing participant behaviors and intentions—understanding them—will apply to not only retirement plan communications, but overall financial wellness education.

For younger workers, one way to make these conversation more concrete is to use the framework of “Health, Education and Retirement,” says Lieb—a concept explored in an SEI paper, “The Next Generation of Retirement Plan Participants.”  Lieb adds, “We know that younger employees, as they get their foot in the door, they face significant student debt burdens and they have to make decisions about starting a family and other challenging topics. We think that DC plan sponsors are in a great position to help these people, especially as we see technology improve and it becomes easier to link all the necessary infrastructure that will help folks both see and manage their holistic financial picture.”

Robb Muse, senior vice president of SEI Trust Company in Oaks, Pennsylvania, says, “One of the chief challenges that we face today as providers and sponsors is that we don’t exactly have a complete picture of individual plan participants. Where the industry is moving, slowly but surely, is towards finding a way to put together a solution that offers a holistic view of the participant lifecycle. Having this visibility will help us better understand how participants evolve, from the time they start with the company to the time they retire. Early on in the savings journey, for example, we know it is more important to look at the debt and other financial burdens the employee is carrying, and analyzing how these factors impact decisions in terms of investing in the plan. As we build a more holistic view of the employee, as the employee ages and the needs evolve, the plan sponsor can help them shift priorities. That’s the kind of evolution we are trying to push forward—building a full picture of what individuals’ life needs are and how we can address them going forward.”

Scharf says employers should convey that the retirement plan is only part of the broad financial wellness of participants. Remind them how important retirement savings is, but address other needs.

Coldwell says tools are also important for educating retirement plan participants. Employers should provide tools for employees, such as calculators, differentiators between Roth and pre-tax (he says the average participant doesn’t understand the benefits of Roth deferrals) and investment concepts. He notes that the Advice Plus software program from Pentegra tells people if they are falling short of retirement goals; they may have to save more but may have to reinvest. And, it actually tells participants what funds to use in their portfolios.

Plan design changes

Sharf says one step beyond automatic enrollment and automatic escalation is automatic re-enrollment. Facing the behavioral concept of participant inertia, making employees choose to opt-out every year increases the opportunity to engage them. In addition to helping employees save at the default deferral rate, re-enrollment can help participants with investment decisions, as they are re-enrolled periodically into a default investment strategy such as TDFs, Coldwell adds.

Robb Muse, senior vice president of SEI Trust Company in Oaks, Pennsylvania, says he pulled data from two plans in which the firm has had great success getting people into the qualified default investment alternatives (QDIAs), and in both of those plans less than 5% of participants did any type of trading in response to recent market drops. “In fact in the one plan, which has something like 80% usage of TDFs, that plan population had less than 1% of active participants do any trading during the month. Another plan that has about 50% of assets in TDFs; they saw less than 4% of participants make trades during February. Looking at those in TDFs solely, the figure drops to 2%,” he notes.

Sibson also suggests DC plan sponsors stretch their match formulas. Jonathan Price, Sibson Consulting vice president and consultant in New York City, suggests that if a plan auto enrolls participants at 6% and matches 100% of 6%, but auto escalates participants to 10%, the plan sponsor may consider stretching the match to 60% of 10% of deferrals to incentivize employees to stay with auto escalation. Doran notes that this does not cost plan sponsors anything additional.

However, Price warns that when considering implementing a stretch match, plan sponsors should consider examining whether a portion of the participant population feels they cannot afford to increase deferrals. In this case, stretching the match could be disenfranchising to employees and could have unintended consequences.

Sibson also suggests DC plan sponsors should consider participants transition from accumulating account balances to generating income. According to the Insights paper, “Offering income options (e.g., lifetime annuities, qualifying longevity annuity contracts (QLACs)), either within or outside of the organization’s retirement plan, can help employees feel comfortable that they will be able to retire when they want.”

In addition to stretching the match and re-enrollment, Pentegra suggests allowing rollovers in plans and ending automatic cash-outs. “Why leave money in a 401(k) account from a previous job—or withdraw it and deal with penalties and taxes—when you can just add it to your current retirement savings vehicle?” Coldwell queries.

He adds that instead of automatic cash-outs, plan sponsors should use automatic rollovers. “Cashed out money is likely to spent on something other than retirement,” Coldwell says. “I understand the need to clean up records and decrease costs, but rather than give money to participants, set up an IRA for them, and in communications, when someone terminates employment, remind them they still have a balance and can possibly roll it over into a new plan or IRA.”

Simplify investments

Muse says helping participants with streamlining and simplifying their investment menus is important, and a big part of this is ensuring investors are routed into age-appropriate and well-diversified QDIAs. However, many participants favor the ability to take a hands-on approach to investing. But, according to SEI’s article, “What these individuals prefer to do without is the research and due diligence of the [many] investment options available on their plan’s menu.”

Muse says helping these individuals build a custom investment portfolio generally involves going down the white label route and exploring the use of collective investment trusts (CITs). He explains that CITs are attractive investment vehicles to use within retirement plans for a variety of reasons. In addition to the cost and pricing benefits associated with CITs, the customized packaging capabilities allow for smoother administration of plan investment lineups, participant communication and plan-specific branding. Likewise, the construction of portfolios as CITs permits the inclusion of smaller, niche managers who may not offer a mutual fund product lineup, which can be especially beneficial in emerging areas, such as environmental, social and governance (ESG) and other socially responsible investments.

SEI explains that white-labeled investments are funds that include several different fund managers within a certain investment strategy. For example, participants can be presented with one Multi-Manager U.S. Large Cap Equity Fund, but it consists of five different types of large-cap equity funds—simplifying the large-cap fund choice for DC plan participants.

Muse says a further spin on this method of menu creation is to take a goals-based approach, where rather than presenting participants with investment options labeled as broad asset classes, goals such as growth, income and stability are highlighted. “Though this type of plan menu design strategy hasn’t gained traction yet in the marketplace, the potential benefits in terms of participant engagement and outcomes are significant,” he says.

“Plan sponsors must understand that they still have a responsibility to their work force to help them plan for retirement in a realistic way,” Lieb concludes.

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