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Is Your Retirement Savings Potential Limited by a Poor Plan Design?

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You might be surprised at the difference a few thousand dollars can make in your 401(k) account, when it has years to grow. Let's say you make the maximum contribution of $17,500 and because you are over 50, you are also eligible to make a catch-up contribution of $5,500. That brings your total contribution for this year to $23,000. Compare that with a total contribution this year of $16,000. After 15 years of growth, the difference between the two contributions would add up to nearly $20,000 (assuming an average 7 percent annual return).

In a different scenario, let's say you are 40, therefore ineligible for the catch-up contribution. In addition, because of discrimination testing constraints, you are limited to $10,000 in tax-deferred savings this year (as opposed to the usual $17,500 maximum). Under these circumstances you would end up with $41,000 less at age 65 than you would if you made the maximum contribution. Multiply these shortfalls by many years of diminished tax-deferred savings, and you'll begin to see the numbers are significant.

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Of course, you can still make up the shortfall (or, for that matter, set aside as much as you can afford) in a taxable account, but you'll pay more for the privilege. The amount of the premium is your tax rate. So, for example, if you are in the 28 percent tax bracket, setting aside $7,500 for retirement on an after-tax basis would cost you $9,600. Add state income taxes, and the toll is higher. (This analysis does not factor in any assumptions about the tax rates you will face at retirement, however. If you think you might be paying higher taxes then, accumulating some after-tax retirement savings isn't a bad idea.)

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Why Do You Fail?

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So what might be causing your 401(k) plan to flunk the annual discrimination tests? One big factor could be low participation rates among non-highly compensated employees, caused by a delay in participation eligibility. According to Vanguard's most recent "How America Saves" survey, 45 percent of 401(k) plans do not allow employees to participate in the plan right away. Most of these employers have a one-year waiting period from the time they join the company.

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All employees eligible to participate in the plan, including those who will become eligible after a one-year exclusion period, are lumped in with active participants in performing discrimination tests whether they participate or not. The two basic tests which must be passed are:

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• The "Actual Deferral Percentage" which compares the average salary deferral (as a percentage of pre-tax compensation) of highly-compensated employees and non-highly compensated employees, and

• The "Actual Contribution Percentage" which compares the matching contributions of the same two groups.

Obviously, if there is zero contribution from the non-highly compensated employees, the group's average is pulled down.

Delaying eligibility can have a particularly adverse impact on new, young employees who have not previously participated in a 401(k). Having never experienced the benefits of plan participation, these employees are less likely to enroll when the opportunity does open up. Inertia plays a big role. Also, these employees will already have become accustomed to the size of their paychecks, and be less inclined to do anything to reduce it.

Auto-Enrollment Growing

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While there has been little change in recent years in the proportion of employers that maintain a one-year eligibility exclusion period, the Vanguard survey does show growth in the adoption of 401(k) auto-enrollment. About one-third of plans had that feature last year, compared to 24 percent in 2009.

Of those employers who auto-enroll, about half of them auto-enroll both new employees and all other non-participants. This forces hold-outs to affirmatively disenroll if they want no part of the plan. Last year, among employers who enroll employees in plan participation by default, roughly 69 percent of those plans also automatically raise the employee's deferral amount one notch each year, usually 1 percent.

Vanguard's survey data paints an interesting picture contrasting average deferral rates of auto-enrolled plans and those that do not auto-enroll. Overall, the average deferral rate of employees in auto-enroll plans is about 4.9 percent, while employees in voluntary-enroll plans average about 7.5 percent.*

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» However, when the participant data is examined by account size, average deferral percentages among workers with at least $10,000 in their 401(k) accounts were higher for the auto-enrolled category.

In any case, Vanguard believes average deferral rates can be raised. Vanguard suggests that low "quit rates," that is, employees who undo auto-enrollment, suggest that employers using auto-enrollment could raise the initial deferral rate well above the typical 3 percent level without losing many participants.If your plan is failing the discrimination tests and therefore limiting your deferrals and those of other highly- compensated employees, the bottom line is this: You might be able to improve your testing track record by dropping eligibility delay provisions and getting aggressive with auto-enrollment defaults.

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