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Most people don't want to work until the day they die, even if they are healthy enough to do so. For many Americans, the tax code offers companies the ability to create 401(k) plans that allow participants to save a portion of their compensation in a tax-deferred environment. Participants have a higher chance of reaching their realistic retirement goals as compared to employees of companies that do not offer a 401(k) plan. However, according to Time, 1-in-3 Americans don’t have anything saved for retirement.
The staple of corporate-sponsored retirement savings is 401(k) plans. Another option – state-run retirement plans – offers some advantages, but faces some daunting obstacles that hinders their widespread acceptance.
Benefits of federally supported retirement plans
More than 78% of all full-time workers have access to a 401(k) plan, and more than half of that percentage routinely contributes a portion of their earnings into these accounts. Of these households, almost three-quarters earn less than $100,000 per year. These statistics demonstrate that the majority of workers with access to a 401(k) plan actually use it for retirement savings, regardless of the level of their annual income and if the tax advantages of doing so are weighted toward low-to-moderate-income households.
Additionally, there is evidence that millennials who have access to a 401(k) plan are saving more than previous generations. So, the issue of not saving enough for retirement is a generational one that is beginning to correct itself.
In the meantime, however, a large part of the population needs a retirement plan.
Gaps within America's retirement-savings system
Despite the proven benefits of employer-sponsored retirement accounts, there are still millions of short-service and/or part-time American workers who either do not have access to one or don't elect to use it if they do have access. The workers without an employer-sponsored account can open an individual retirement account (IRA) on their own, but statistics indicate that less than 5% of these workers actually take that step.
State-based plans as an option?
To fill these gaps, some states are considering offering state-run retirement plans that are similar to 401(k)-type plans except that they are not subject to the Employee Retirement Income Security Act of 1974 (ERISA). While not being subject to ERISA eliminates many of the annual compliance and government filing requirements that apply to 401(k) plans, it also eliminates many of the legal protections that participants enjoy with an ERISA-covered 401(k) plan.
The state-run plans would essentially require employers to offer their employees the ability to defer a portion of their compensation – similar to 401(k) plans. There are no eligibility requirements for employees to participate in the plan, and these plans would not require the company to engage service providers, such as an investment advisor, to create an investment menu and perform employee communications.
One of the primary challenges with state-run programs, however, is that they are already being sold as lower-cost, easier to manage options than traditional 401(k) plans when the reality is that this might not be the case when reviewing the service providers. Some of the early proposals discussed the “all-in” cost per participant may in fact be higher than what is available via a private sector 401(k) plan – even for small employers (when excluding an investment-advisor component).
There are several other factors that come into play. One is the historic underfunding of state-run public employee pension plans. For example, Illinois is currently owes its public employees $100 million more than it has saved, and California is behind by more than $175 million. And those are two of the states leading the charge to state-run plans. Another is the number of state governments that are involved in budget disputes and allegations of corruption. Although the state-run 401(k) funds are via tax deferrals from participants, participants will fear that state governments will use monies from one area to pay another.
Employers who adopt state-run plans may be simply trading one set of rules for another. Although complex in many ways, 401(k) plans are subject to a single set of rules that apply nationally, regardless of which cities or states a company does business. With a state-run plan, on the other hand, an employer would be subject to different sets of rules in each state where it has employees, and different sets of rules may conflict with one another. With several large U.S. cities also looking to provide retirement plans, the tangled web of rules gets even more complex.
Another major difference is that 401(k) plans can offer profit sharing and company-match contributions. A company match increases participation rates. Traditional 401(k) plans will always have the advantage of plan-design flexibility, and the tax advantages will always go to the owners of small companies. Generally, the benefits to the owner(s) via their deferrals and company contributions, let alone the deductions for the company contributions are typically worth the nominal plan administration fees.
With the DOL fiduciary rule, participants will continue to benefit from the competitive marketplace via lower fees that are all fully disclosed. Furthermore, if service is not delivered as promised, the plan sponsor can switch service providers (including their investment advisor). Government-run plans will have a competitive bidding process, but once in place it is rare the players are changed. The incentive to perform without competition rarely results in service excellence and competitive fees. Indeed, there are plenty of instances when a government “competitive bidding process” has resulted in the job being awarded based on political considerations.
Finally, sponsors of and participants in 401(k) plans typically have access to an investment advisor. This individual is a professional who can, at minimum, educate participants on how to save, thereby allowing them to reach their realistic retirement goals.
Additionally, the proposed state-run plans would not enjoy the protections built into ERISA-covered plans like 401(k) plans. Those protections require that accounts be held in a trust that is shielded from creditors and legal judgements. There are substantial penalties if an employer takes money out of a plan. The system has numerous checks and balances to ensure those rules are enforced and that those who violate those rules are held accountable. A USA Today article at the end of 2015 indicated that only three states achieved a grade above “D” in a recent “State Integrity Investigation.” That means 47 states were graded at either a D or an F. Is that who should be in charge of managing the retirement savings of American workers?
Many of the state proposals include a mandate that all employers in their state adopt the state-run plan if they do not already offer retirement plan of some sort. That mandate may be a silver lining. When employers realize they can have a more flexible plan that offers greater tax advantages with better service and a lower cost, they will likely opt to start a 401(k) plan or even a SEP or a SIMPLE rather than adopt the state plan. For those in the retirement-plan industry, every employed worker having the chance to participate in a 401(k)-type plan is a major step in the right direction.
One possible solution: auto enroll IRA plans
One solution appears to be gaining momentum, potentially with the new presidential administration: auto-entroll IRA plans. This solution is similar to the state-based plans and has the potential to be portable if the federal government gets involved.
One issue with the auto-enroll solution is that the automatic portion of the plan design. ERISA creates a national rule that allows automatic withholding for 401(k) contributions and overrides state laws. So, those differences need to be resolved either at the federal level or consistently across the states.
Assuming it is resolved, two other important items must be addressed. The first is the ability to allow plan sponsors to easily “graduate” to a 401(k) plan – including permissible rollovers from the auto IRA plan to the 401(k) plan. There should be no restriction permitting these monies to rollover.
The other issue is the creation of a free-market solution, by eliminating a single-provider government-mandated solution so that there is a competitive menu of service providers that all meet certain standards set by the states. A company that opts for an auto-enroll IRA will be able to select a service provider based on their key criteria, one of which may be a solution with a local or regional investment advisor.
One final solution to make 401(k) plans easier to implement for new companies is to offer a temporary “safe-harbor-type” 401(k) solution. This would allow companies that start a 401(k) with automatic enrollment to be exempt from the actual-deferral percentage (ADP) and top-heavy tests for the first three or four years the plan is in place.
To wrap up, the best option for retirement savers is to have investment advisors and private-sector businesses serving the marketplace. The best solution to our current 401(k) gap is to focus on areas that are lacking, by making 401(k) plans easier to implement, especially in small companies and startups, rather than trying to fix something that already works for a majority of the population.
Keith Clark is a co-founder of DWC ERISA Consultants, a firm dedicated to providing third party plan administration, compliance and consulting services for qualified retirement plans, helping businesses and investment advisors across the country navigate today's complex regulatory environment. For more information, visit dwcconsultants.com.
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