Energize Your Workforce with a 401(k)

02/28/07

HR people report that more and more twenty-two-year-old recruits are asking knowledgeable questions about 401(k) pension plans. Having a 401(k) is no longer a “nice to offer” benefit for some companies—it’s becoming a “must” item in the benefits package.

Yet the most recent government figures show that less than half of all small businesses have a pension plan of any kind. If you’re one of the non-haves, you’re missing out. Employers say that pension plans can have a big impact on your ability to recruit and retain employees, improve morale and productivity, and enhance loyalty. Plus, they can provide tax advantages for both employees and employers.

Enter the 401(k)
Thirty years ago, most pension plans were so-called “defined benefit” plans that guaranteed retirees a certain amount of money each month. Only 19 percent of the workforce is now covered by a defined benefit plan, while 50 percent is now covered by a “defined contribution” plan—one in which employees and/or employers pay into an investment account that grows tax-free over time.

And the most commonly defined contribution plan is the 401(k)—named for the section of the IRS code that permits defined contribution plans with specific characteristics.

Not Rocket Science
Despite a reputation to the contrary, 401(k) s aren’t that difficult to comprehend. There is complexity in the details, but these details can be handled easily by financial professionals.

Is it time for you to add a 401(k) to your benefits package? Taking a look at some of the features will help you make an informed decision:

Who can participate? Employees can either be eligible upon the date of their hiring, or you can require them to wait up to a year. You can also require them to be at least twenty-one years old Having them wait a year could be an advantage, according to 401(k) expert and attorney John H. W. Cole, co-author of The Pension Answer Book—Forms & Worksheets. “In the plans I design, I prefer to make employees wait a year. It cuts down on administrative costs, and it ensures short-term employees don’t participate.”

You can also limit participation to white-collar workers or those in certain departments, for instance, but don’t forget that doing so may harm morale among those you exclude.

Who contributes? 401(k) s offer great flexibility in how you fund the plan. Typically, employees contribute part of their paychecks on a regular basis. Employers can also contribute, either by matching employee contributions, offering profit sharing, or both. In that regard, says Cole, 401(k) s are really “profit-sharing plans with additional bells and whistles.”

How much can you contribute? Employees can contribute up to $10,500. Employers often match contributions, but employer contributions aren’t mandatory. Cole says that in about half the plans he sets up, employers don’t match contributions. Among those that do, matches vary from 25 to 100 percent of the employee’s contribution.

The IRS limits contributions in a number of ways. For instance, an employer can deduct, as a business expense, no more than 15 percent of the total yearly payroll. And you can’t contribute more than 25 percent of any one employee’s yearly salary.

Other limitations kick in if the plan is considered “top heavy,” or if highly compensated employees skew the contribution rate.

Tax benefits. These are among the best things about 401(k) s. Neither employee nor employer contributions are taxed at the federal or state level and investment earnings grow tax free until funds are disbursed (like an IRA).

Vesting. Vesting is the amount of time it takes employees to gain full, legal possession of the funds in the 401(k) account even if they leave for another job.

Employee contributions are fully vested immediately, because the funds come out of their own paychecks.

Employers can grant immediate vesting of their contributions, or they can provide vesting schedules. In most situations, these come in two forms:

Five-year “cliff” vesting. The employee gains possession of 100 percent of the funds after five years.

Graded vesting. The plan vests on a three-to-seven year schedule. In a five-year graded vesting schedule, for instance, employees would own an additional 20 percent each year until they hit 100 percent in year five.

How you choose to vest depends on employee expectations, says John Cole. “Professionals and managers, for instance, look upon 401(k) s as immediate compensation. They expect immediate vesting. Manufacturing employees, on the other hand, view pensions as add-on benefits. In that case, I suggest a vesting schedule. It discourages people from quitting just to get the money.”

Who controls investments? An employer can choose to invest the funds wherever it wants to. But this may create a liability problem if, for instance, investments lose value over time. That’s why most plans allow for employee choice. “Usually the choice is limited to a group of mutual funds,” says Cole. “That reduces administrative costs and liability.”

Loans. Another nice feature of 401(k) s is the employee’s potential ability to draw on the funds. Half of Cole’s plans permit loans. But he says there can be a problem with employees not paying back loans. “In my plans, I make sure loans are paid back through payroll deduction.”

Plan design. As the previous two sections show, the 401(k) details can get cumbersome. That’s why it’s always a good idea to have a professional design a plan specific to your organization’s needs. You can do this a couple of different ways.

First, you can hire an attorney or consultant. This option ensures that a 401(k) reflects your specific, unique needs in terms of contribution rates, vesting, loan provisions, etc. It’s a custom job that should be submitted to the IRS for approval.

The other choice is to have a brokerage house, mutual fund company, or insurance firm set up what’s called a “prototype” plan. Such one-size-fits-all plans are already approved by the IRS but limit your options and limit where the money can be invested.

The second option may seem more desirable, because many choices are already made for you, making it simpler to understand. And it may be cheaper at least on the surface. John Cole: “If you’re an owner and want the plan to cover just yourself, use a prototype plan. But if you have two or more employees, a good plan designer can save you money even in the first year.”

Designing a plan using an attorney or consultant like Cole will cost you $1,800 to $2,500. On the low end, a prototype plan like Fidelity’s e401—an Internet-only 401(k)—costs $750-$1,000 to set up. But remember: It will be nothing more than a basic, plain vanilla 401(k)—and may end up costing you more as time goes on.

Plan administration. Recordkeeping and administrative responsibilities for 401(k) s can be burdensome. You could take care of these responsibilities yourself but, Cole says, “I don’t think it’s cost effective. And if you make a mistake it can be financially painful. Unless you’re trained in this area, you shouldn’t do it.”

Fortunately, many companies exist to do nothing more than administer your plan. They’ll file form 5500 with the IRS, allocate earnings and expenses, prepare annual accounting and statements for participants, and do the appropriate returns.

The yearly cost to administer plans runs $1,200 on up, in addition to a “headcount” fee ranging from $20 to $50 for each participant.

Avoid Mistakes
There are lots of details regarding 401(k) s not mentioned here. Seek out an advisor who can walk you through the process and provide a plan that fits your needs.

John Cole says the biggest mistake he sees are companies not getting good advice in the beginning. “They may depend on a vendor for advice who’s steering them into plans he gets a commission for. Such people don’t often pay attention to detail.”

However you approach the job of setting up a 401(k), get references and pursue a couple of options before signing on with a plan designer or administrator.

Also, Cole advises, “Don’t wait until December to set up a plan. It’s a bad month to get anything done. Have some lead time to educate yourself and employees.”