Redefining Defined Contributions

Proposed tax changes to retirement savings could put a cap on employer and employee contributions to qualified defined-contribution plans and, experts say, HR professionals would be wise to quickly revisit their retirement-plan designs.

Monday, October 3, 2011
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Faced with a still-flailing economy and wavering confidence in their job security, millions of U.S. workers are already losing sleep over their financial futures. Proposed changes to reduce current-law tax limits for savings in retirement plans could give them another reason to toss and turn at night -- and is cause for HR leaders to re-examine the design of their organizations' 401(k) plans.

There are several proposals on the table, including reports from the Fiscal Commission and Bipartisan Policy Center, recommending a return to pre-1986 caps on both the amount and percentage of total employer and employee contributions to a qualified defined-contribution plan at $20,000, or 20 percent of compensation, whichever is lower.

If the proposed "20/20 caps" are imposed, which they could be as early as 2012, workers at both ends of the income spectrum figure to be hit the hardest, says Jack VanDerhei, Employee Benefit Research Institute research director, who testified at a Sept. 15 Senate Finance Committee hearing on the proposals.

EBRI, a nonpartisan, nonprofit group based in Washington, has conducted preliminary research on the potential impact of the 20/20 caps, and is planning a follow-up study to explore the likely effect of these constraints on retirement-plan sponsor behavior, and to estimate the extent to which fewer employers would be willing to offer qualified defined-contribution plans, VanDerhei says.

Based on its preliminary research, workers with the highest incomes would, as expected, generally be the most affected if federal tax limits in 401(k)-type plans were lowered, he says. 

"The finding that the highest-income quartile within each age quartile experiences the largest average percentage reduction [from the 20/20 caps] is no surprise," VanDerhei says, "given the increased likelihood that workers in this cohort either currently exceed the $20,000 indexed limit when their contributions are combined with employer contributions or are predicted to do so in the future."

The more startling effect of the caps being imposed could be the impact on large numbers of the lowest-income workers, he adds.

"For each age cohort other than the oldest one, the lowest-income quartile has the second-highest average percentage reduction," he says. "Although this may be due to several considerations, it is almost always a result of their current or expected future contributions exceeding 20 percent of compensation, when combined with employer contributions."

Workers in both high- and low-income groups report they would reduce contributions or stop saving in their work-based retirement plan entirely if the current exclusion of worker contributions for retirement-savings plans were ended, he says.

For instance, if the current exclusion of worker contributions for retirement-savings plans were ended in 2012 and replaced with flat-rate tax credits, as proposed by Brookings Institution Fellow William Gale, the average reductions in 401(k) accounts at Social Security normal retirement age would range from a low of 11 percent for workers currently aged 26 to 35 in the highest income groups, to a high of 24 percent for workers in that age range in the lowest income group, VanDerhei says.

The most immediate impact on rank-and-file employees would likely be the elimination of defined-contribution plans, says Gary Kushner, president and CEO of Kushner & Co., a Washington-based firm specializing in HR strategy and employee-benefits consulting and administration.

Small- to mid-sized companies and their employees would feel the brunt of the blow, Kushner says.

"For those employers, the time and expense of design and compliance with retirement-plan legislation and regulation, coupled with even more onerous changes already in the pipeline and the relatively meaningless overall contributions to a solid retirement income ... would likely cause small business owners to throw up their hands in resignation, terminate their plans and simply pay the current tax on a distribution to themselves.

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"If such a draconian cap was put in place," he says, "it would be the rank-and-file employees who would lose the most."

Still, larger companies would share in that loss, albeit on a lesser scale, Kushner adds.

Large employers and their HR leaders would still "have issues in such a hostile legislative environment," he says, "but not to the same extent as smaller to mid-sized ones, since choosing to offer and then maintain a qualified plan is less driven" by the needs of highly compensated employees and more by recruitment and retention needs.

"However, at some point, a significantly reduced benefit will be deemed to be more work than it's worth, even in a larger organization," Kushner says.

For smaller employers, the loss of tax incentives on the employer contribution may indeed cause them to reduce their contribution, or not offer one at all, agrees Robyn Credico, North American defined-contribution practice leader at New York-based Towers Watson.

The possibility of the $20,000 cap becoming a reality will force HR professionals to rethink 401(k) plans, and should motivate HR leaders to continue efforts to "change savings behavior" among the workforce, Credico says.

"In a time when people are living longer and have to rely on their defined-contribution plans as a primary source of retirement income, [employers] need to encourage people to save more and ... help them in this process," she says.

And, time is of the essence for organizations and the HR professionals charged with designing their organization's 401(k) plans, Credico says.

"Employers will need to revisit plan design very quickly if limits are to apply in 2012," she says. "Systems will need to be changed, plan documents and communication materials amended, and those impacted by this limit [must be] educated on the need to save on their own or on an after-tax basis if the plan permits and can pass testing."


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