The end of the year – or the beginning, for some – is an optimal time for organization-wide or department-specific strategic planning.
When 2021 wraps, plan fiduciaries will encounter an opportune time to closely review their plans’ target date funds (TDFs). The review requires special consideration. TDFs are not oranges to be compared to the apples that make up the plan’s core funds list.
As we enter the home stretch for 2021, plan sponsors are beginning to encounter the typical questions that arise near the end of each calendar year. This month’s newsletter is intended to help you to be prepared for those questions.
As we set out to prepare this month’s newsletter, we first encountered a strange feeling: it seemed that the retirement landscape had entered a momentary standstill.
A qualified plan sponsor’s decision to make the Roth contribution feature available to its employees is no longer an emerging trend. The Roth contribution availability has emerged, solidified its presence, and appears to be here to stay. Many would include it among plan sponsor best practices. Some consider it a competitive arrow within the talent acquisition quiver. Yet, despite its wide acceptance and significant appeal, not all sponsors have embraced Roth contributions.
This White Paper, written by Matthew Eickman, J.D., AIF®, national retirement practice leader, will review Congress’s steps to permit Roth contributions and explore the various reasons plan sponsors and participants are well-served to take advantage of the Roth opportunity.
Better Understanding the “Mega Backdoor Roth” Concept: FAQ’s
Retirement plan lingo typically isn’t the most exciting. Terms like “EPCRS”, “ACP”, “ADP”, “QACA”, “EACA”, “402(g) limit”, “415 limit”, etc. don’t make for the best headlines.
Writers and commentators have found a term they like, though, in “Mega Backdoor Roth”. When they throw the term into a headline and introduce a story with the ability to save $58,000 into a 401(k) plan and avoid taxes in the future, we have an intriguing concept on our hands. Yet they frequently overstate its simplicity and fail to address nuances that merit additional attention. Let’s take a look at some FAQs that will help plan sponsors to navigate the processes of considering the necessary plan amendment and communicating with participants.
Q: What steps would be involved in the “Mega Backdoor Roth” possibility?
A: As a starting point, the plan must allow for old-fashioned “after-tax contributions”. These are not Roth contributions; the Tax Code permitted this type of after-tax contributions long before Roth contributions became available.
Next, a participant must elect to convert after-tax contributions to Roth dollars. This could occur through an “in-plan Roth conversion” if the plan’s terms permit such a conversion. In this case, the dollars would remain in the plan. In the alternative, to the extent the plan were to permit an “in-service distribution”, the participant could elect a distribution and rollover the proceeds to an outside Roth IRA.
Following that participant action, the Tax Code would treat the dollars like other Roth amounts, including a later tax-free distribution of the principal amount and earnings (provided that the distribution otherwise met the requirements for a “qualified” distribution).
Q: Could a participant contribute an unlimited amount of after-tax contributions?
A: No. The Tax Code generally limits the total amount that may be contributed to a participant’s 401(k) or 403(b) plan in any given year. For 2021, the limit is $58,000. The following formula answers this question: Annual total contribution limit – sum of all other contributions made to the plan (pre-tax deferrals, Roth contributions, and all employer contributions) = limit on after-tax contributions. (Note that the annual limit increases for participants who make catch-up contributions after maximizing their traditional pre-tax or Roth contributions. In 2021, the limit is $64,500 for those participants.) As discussed below, the limit could be further reduced for a highly compensated employee (HCE) if the plan were to fail the applicable nondiscrimination test.
Q: My CFO read about this in the Wall Street Journal and has asked us to make it possible. Is it really a no-brainer?
A: No. It’s not a no-brainer. It’s also not a slam dunk or a home run. If it works (more on this below), though, it is pretty cool.
Consider the high percentage of employees’ retirement savings that is sitting a pre-tax bucket, awaiting taxation at the time of distribution. The Mega Backdoor Roth structure would provide a pathway toward shifting that percentage lower and permitting more retirement dollars that will be exempt from taxation when distributed. In overly simplistic terms, a Roth 401(k) structure may permit a participant to save around 3x the amount he or she could contribute to a Roth IRA in any given year; a Mega Backdoor Roth structure takes that to an entirely different level, by potentially permitting a participant to save between 2x and 3x the amount that could be contributed under a typical Roth 401(k) structure. In addition, the plan contributions are not subject to the adjusted gross income (AGI) limits that prevent many high earners from directly contributing to a Roth IRA.
The potential advantages make the concept worth exploring. Of course, the potential surprises trigger the need to dive deeper into the details.
Q: What issues should we consider before making Mega Backdoor Roth available?
A: The biggest potential issue relates to the plan’s nondiscrimination testing. An employee’s after-tax contributions are treated as employer contributions for testing purposes and subject to the Average Contribution Percentage (ACP) test. This testing will be required without regard to whether the plan is a safe harbor plan. If only HCEs make after-tax contributions, failure is quite likely – particularly if the plan does not include an employer contribution.
Plan sponsors should also consider whether the after-tax contributions will be subject to a matching contribution. Any plan amendment and participant communication should clearly address the organization’s preferred approach.
Finally, if a plan liberally permits in-service distributions that would be used to accomplish the Mega Backdoor Roth conversion into external Roth IRAs, this could result in significant plan asset outflows. Some employers don’t worry about this. Others take pride in retaining retirement assets in the plan, in part because larger assets provide greater pricing efficiencies for the entire workforce.
Q: Given the combination of potential advantages and disadvantages, what are employers doing to make it work?
A: The most critical test will be to ask the recordkeeper to perform some stress testing in advance of making plan design changes. We recently participated in this exercise with Prudential, which did an incredible job of simulating various potential after-tax contribution usage rates and was able to project the likely outcomes under various scenarios. The stress testing could suggest there will not be testing issues. It also could suggest that potential limits (such as a dollar or percentage ceiling) on after-tax contributions would greatly increase the likelihood of passing the test.
Others are thinking about ways to feature after-tax contributions as an option that participants may appreciate for a variety of purposes. The Mega Backdoor Roth concept most commonly involves HCEs. Yet after-tax contributions are also gaining traction as an attractive emergency savings option, particularly for non-HCEs. QPA’s Rob Massa blogged about this “old idea to solve a modern problem” in July.
These are complex issues. It may make sense to introduce the building blocks over a series of plan amendments. Start with Roth contributions, later add the traditional in-plan Roth conversion option that allows the conversion of pre-tax amounts in the plan, and then follow with the Mega Backdoor Roth concept. If a plan sponsor is not inclined to take that gradual approach, communication is paramount. Depending on the stress test results, a plan sponsor may need to very proactively encourage non-HCEs to use after-tax contributions.
We welcome these conversations. We understand many in human resources or benefits departments face a tough scenario when an executive or otherwise-influential employee presents the Mega Backdoor Roth as a sure thing or, even worse, suggests that the absence of that feature is cause for judging the plan as a poor employee benefit. As is frequently the case in life, the answer is somewhere in the middle. Progressive employers take the time to listen to employee demand, discuss the possibilities with the plan consultant, and explore avenues to bring new features to participants that will be a net positive. The Mega Backdoor Roth could work. Or it could not. We’ll see.
United States Supreme Court to Hear Excessive Fee Case
We have experienced a fair amount of retirement plan litigation over the last decade. The litigation pace picked up during the COVID-19 pandemic and shows no signs of slowing down. That pace could accelerate, in fact, if the United States Supreme Court rules that plaintiffs can proceed in the Hughes v. Northwestern University suit. Although the Court will not hear oral arguments until October at the earliest, it is important for plan fiduciaries to be aware of its potential implications.
The Complaint. The nation’s most prominent ERISA litigation firm filed suit on behalf of participants in Northwestern University’s defined contribution plans. The complaint included many of the allegations common among recent retirement plan expense lawsuits, including: (i) excessive recordkeeping fees; (ii) the failure to benchmark the recordkeeping fees; and (iii) the use of expensive share classes when cheaper share classes of the plans’ investment options were also available.
Motion to Dismiss. The next part is critical: we’re not even to the point in the litigation process when the trial court would decide whether those allegations were valid. The trial court granted the defendants’ motion to dismiss, and the Seventh Circuit Court of Appeals upheld the dismissal. The plaintiffs asked the United States Supreme Court to hear their argument that the lower courts erred in dismissing the case. This request relies upon precedent in other Federal circuits that would have allowed the plaintiffs’ case to proceed to discovery.
Supreme Court Takes the Case. Before responding to that request, the Court asked the Solicitor’s Office to provide the Department of Labor’s (DOL’s) position regarding the split in the federal circuit courts and the significance of the issues. The Solicitor’s Office filed a brief reflecting its clear belief that plaintiffs should be allowed to pursue their claims and that “the question of what ERISA requires of plan fiduciaries to control expenses is important to millions of employees throughout the Nation whose retirement assets are invested in ERISA-governed plans.” The Court “granted certiorari” – thereby agreeing to receive arguments from both parties – because of the split in federal circuits’ approach and the significance of the issue.
Why Does This Case Matter? Well, it is certainly important to the plaintiffs and defendants involved in the lawsuit. But more broadly, it’s important because the most pivotal point in these large lawsuits is whether a plaintiff can survive a motion to dismiss. If it survives the motion, the looming threat of discovery is much more likely to motivate settlement negotiations. If plaintiffs cannot survive that motion, the case falls apart, and the dream of a settlement or courtroom victory goes up in smoke.
The Court is likely to establish the clearest set of principles dictating what is – and what is not – sufficient for plaintiffs to survive a motion to dismiss in a retirement plan fee lawsuit. The Court will not offer an opinion on the plaintiffs’ claims; it will simply determine whether they receive their day in court to present those claims.
What Should Fiduciaries Do Now? It would be reasonable for fiduciaries to decide not to wait for the Court’s opinion, which likely will not arrive until 2022. If the Court supports the plaintiffs’ perspective, plaintiffs will be able to move forward. Even if it does not, the DOL has shared its opinion on this type of fact pattern, and it’s quite clear the DOL is sympathetic with plan participants.
As we look around the country, the last decade of litigation has paid dividends for many plan participants. Yet many others continue to participate in plans with recordkeeping services that have not been benchmarked and/or investment options that are more expensive than they need be. Taking into account the Court’s upcoming consideration of these issues and the DOL’s position, we anticipate many plan fiduciaries will ramp up their due diligence efforts during the back half of this year. As always, those efforts shouldn’t focus too heavily on the cheapest option, but they should be on the lookout for value. Participants and fiduciaries will benefit as a result.
Lessons from 401(k) Litigation During the Pandemic
In many ways, the world came to a halt when the COVID-19 pandemic hit. Retirement plan sponsors and fiduciaries should be aware that this certainly was not the case for plaintiffs’ firms. In the context of retirement plan litigation, in fact, they only picked up the pace.
After we saw roughly 50 class action retirement fee lawsuits filed in each of 2016, 2017, and 2018, that number fell off dramatically to around 20 in 2019. One might have expected that fall-off to continue during the pandemic. To the contrary, though, we saw nearly 100 suits filed in 2020 alone.
As always, we don’t consider fear to be the primary reason to pay attention to retirement plan fee litigation. Those plaintiffs’ complaints present opportunities for other plan sponsors and fiduciaries to understand trends and evolving expectations for reasonableness. Without regard to the ultimate outcome of the many (many) lawsuits initiated over the last several months, we can learn a lot of lessons by digging into the trends and allegations. During tomorrow’s Fiduciary 15 webinar, we’ll dive deeper into lawsuits fitting into three broad categories.
Revenue Sharing Is Still an Issue. It is a bit surprising to see that many plan sponsors – particularly those sponsoring larger plans – continue to rely on expensive investment options to generate revenue sharing that offsets plan expenses. Here is the basic pattern of allegations in those lawsuits:
1. Plan committee used more expensive versions of investment options when a cheaper version was available.
2. This resulted in excessive gross investment expenses.
3. Plan committee members have a fiduciary responsibility to seek cheaper versions (i.e., share class, CIT, and/or separate account) of any investment option made available.
4. They failed to meet that responsibility because they wanted to generate revenue sharing.
5. But they also failed to meet the responsibility to benchmark the recordkeeping expenses.
6. If they had benchmarked the recordkeeping expenses, they’d have discovered that the revenue sharing approach resulted in excessive recordkeeper fees.
7. Thus, even though a portion of the allegedly excessive investment fees were used to offset recordkeeping expenses, the total cost of the plan was unreasonable.
What do we learn from this? Committees should ensure that the plan is indeed using the cheapest or most efficient version of the investment options made available to participants. They also should be aware of the fee arrangement for the recordkeeper and monitor the total fees the recordkeeper receives.
There’s a Growing Target on Target Date Funds. The plaintiffs’ firms have really honed in on target date funds (TDFs). From a pure numbers perspective, this makes a lot of sense. With increasing frequency, plans have been using automatic enrollment and selecting TDFs as the plan’s default investment option. This means that a larger portion of plan assets are invested in TDFs, which in turn presents a more appealing prize for plaintiffs’ firms.
When plan fiduciaries establish TDFs as the default investment, they frequently rely on the Department of Labor’s safe harbor for a “Qualified Default Investment Alternative” or QDIA. That safe harbor treatment can provide a false sense of security, though, because plan fiduciaries end up paying less attention to the TDFs than to a plan’s core funds menu. The accelerating string of TDF lawsuits attack various aspects of plan’s TDFs:
* Expensive share class (with a cheaper share class or CIT version available)
* Proprietary fund usage (without supporting due diligence)
* Poor performance
* Using more expensive active TDFs instead of cheaper passive TDFs
What do we learn from this? Prudent fiduciaries will give more attention to their plan’s TDFs. It is time to ramp up the committee’s understanding of a plan’s particular TDFs, why they were chosen, and whether they remain the most reasonable option for the plan’s participants. If you’re a QPA client, please ask about our firm’s new “Target Date Deep Dive” capabilities, which will help you to take a closer look at your TDFs and to complete a checklist reflecting the DOL’s expectations.
Data Is at Greater Risk Than Ever Before. This probably doesn’t surprise anyone. We live through electronic data. Our retirement plan data is accessed electronically on a frequent basis and data is more frequently moving in electronic form with more remote workers.
The recent lawsuits target a couple of distinct data-related risks: (1) identity and account theft; and (2) recordkeepers using plan data to cross-sell. The DOL has provided a package of tips and best practices intended to help with the cybersecurity risks. That package will help plan fiduciaries and participants to manage those risks. Federal courts have not provided the same help with respect to cross-selling, however, as they’ve generally supported recordkeepers’ ability to use plan data for a variety of business purposes. This means that plan fiduciaries will have to become more diligent.
Closing Thoughts. There is a lot happening on the litigation front – far more than we can address in one short monthly newsletter. Our Fiduciary 15 webinar will provide you with more examples and best practices. Please take 15 minutes to join us and don’t hesitate to reach out if you have any additional questions.
Much of the talk about financial security tends to focus on long-term investing and accumulating sufficient wealth to retire comfortably. But the pandemic has shown us that when a current financial crisis must be navigated, simply having a well-funded retirement account can offer little consolation.
If an individual has been laid off or seen their hours reduced at work due to the far-reaching economic effects of COVID-19, they may suffer immediate and severe anxiety no matter the size of their retirement nest egg. Additionally, the pandemic uncovered that many Americans lack a basic understanding of their expenses and corresponding cash-flow needs.
The clear message to employers? If employees are to achieve true financial wellness, they must have more than just a solid long-term plan. Adequate savings to draw from in an emergency are just as important, as well as the knowledge and confidence to handle adverse economic issues as they arise.
The importance of financial wellness programs for the employer & employee
Financial wellness is critical because, without it, employees can become preoccupied with money burdens. The greatest source of stress across the country is financial, significantly outpacing any other category. The logical extension of that is if employees feel financially stressed and preoccupied with money concerns, they’re going to be less focused on work and therefore less productive and efficient. As a result, the productivity of the organization is driven down and profitability suffers.
On the flip side, financially fit employees are more relaxed, comfortable, and confident. They’re mentally and physically healthier, which means they show up for work more often, are better motivated and contribute to a greater extent, benefiting their employer from a bottom-line perspective.
As I stated earlier, when promoting a financial wellness program, offering a 401(k) plan alone is not enough. Yes, it’s a great first step since it can greatly benefit employees when they eventually retire, but it doesn’t go far enough because it only addresses the long-term planning aspects of a person’s overall financial picture. It does not address the short- and intermediate-term planning that should also be emphasized. A financial wellness program should cover all aspects of an individual’s financial goals.
What should the curriculum look like?
Traditionally, much of the education offered by employers about their 401(k) plans could be considered modular, with topics addressed independently and little attention paid to their interrelation. A legitimate financial wellness program is more likely to be a comprehensive curriculum, where employees learn how the company retirement plan works, but also how it fits into their overall financial picture and how to achieve financial goals that come up before retirement.
Regardless of the format or content of the program, employers should ensure they include a strong emphasis on budgeting. This would entail employees taking a hard look at their income and expenses, and being taught how to better handle money, including ways to save that instill more comfort and confidence.
Employees would also benefit from education about investment options beyond the company 401(k) plan, such as the use of a 529 plan to save toward college education for their children. Employers should consider delving into family protection, including short- and long-term disability coverage and whether a life insurance policy might make sense.
For older employees who are closer to retirement, education around Social Security is key. This could include details about the ages of eligibility to receive partial and full Social Security benefits, as well as how much reliance should be placed on these funds. When you pull all of that education together, it becomes a much more comprehensive assessment of an employee’s financial picture than merely a number that rests in a 401(k) or 403(b) account.
Financial wellness is here to stay
A much more widespread and genuine motivation has now emerged among employers. Many truly want to foster and facilitate financial wellness rather than just implement a program that can be touted in an employee handbook or recruitment brochure. The bottom line is that companies are directly and adversely impacted when their employees aren’t financially well. The drastic impact of the pandemic has ensured that the level of employer commitment to financial wellness will increase significantly.
Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a Registered Investment Adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”).
Open Enrollment As we talk to plan participants this fall, it’s apparent that they’re awash with uncertainty. Throughout the last couple of months – before, during, and after the election – the markets have been trying to tell participants that they shouldn’t be as…