Are Employer-Sponsored DC Plans the Best Retirement Savings Vehicles?

Started with the passage of the Revenue Act of 1978, employer-sponsored 401(k) plans have been celebrated among those in the retirement industry for their tax advantages. However, in an op-ed for Bloomberg, Aaron Brown, a former managing director and head of financial market research at AQR Capital Management, contends that the four factors on which the tax advantages of a 401(k) depend have changed dramatically since 1980, to the detriment of 401(k)s. He argues that the tax incentive to save in 401(k)s is diminished.

Brown also suggests in his op-ed that fees eat into 401(k) participants’ returns. And there have been an increasing number of excessive fee lawsuits, against both 401(k) and 403(b) plans, that argue just that.

In addition, a working paper issued by the Pension Research Council of The Wharton School at the University of Pennsylvania found that investment returns in the coming decades may continue to fall. One researcher the paper cited, who looked into the effects of past European pandemics, predicted that after-effects from the coronavirus outbreak will persist for roughly 40 years.

A 2018 report by the Stanford Center on Longevity found that if workers expect to retire by age 65, they must aim to allocate 10% to 17% of their salary to a retirement account annually, beginning at 25 years old. As the average employer match stretched to 4.7% last year, according to Fidelity, that leaves anywhere between 5% to 12% for the employee to cover. Effects of the coronavirus pandemic have revealed the precarious financial situation many employees are in and calls into question whether this amount of savings is feasible for them.

Provisions in the Coronavirus Aid, Relief and Economic Security (CARES) Act grant employees access to their defined contribution (DC) plan accounts to address financial needs. Many say this shows employees need to build emergency savings before saving for retirement.

The employer match, if provided, is a great value to DC plan participants. However, during the 2008/2009 financial crisis and the coronavirus pandemic, some plan sponsors reduced or cut their matching contributions due to their own financial troubles.

Still There’s Current and Potential Value in DC Plans

Steve Vernon, a consulting research scholar in the Financial Security Division at the Stanford Center on Longevity says 401(k) and 403(b) plans are still important, if not for their payroll deduction basis, then for many of the features included in these plans. Accessibility to investment advice, recordkeepers and financial wellness education are likely included in most employer-sponsored plans, but not in other retirement savings vehicles, such as individual retirement accounts (IRAs).

IRAs allow participants to fund their retirement on their own accord, providing a tailored solution for those looking to manage their own accounts. Participants can shop around for investment funds and decide fee options. While they provide a soluble alternative for sophisticated individuals, IRAs are a complex tool for the average investor, Vernon says. “An individual will need to shop on their own, and, while that’s not a bad problem, a lot of people don’t know how to shop financially,” he says. Additionally, while 401(k)s are automatically deduced from a paycheck, those with an IRA have to write and send monthly checks to their account.

Robyn Credico, defined contribution consulting leader, North America, Willis Towers Watson, says contribution levels are higher in employer-sponsored plans, such as 401(k)s and 403(b)s, than in IRAs. While limits on traditional and Roth IRAs are capped at $6,000, 401(k) and 403(b) limits are $19,500. “You can actually save more in a 401(k) or a 403(b) than in an IRA,” Credico says.

In its report, “Is your defined contribution plan ready for 2020 and beyond?” Willis Towers Watson notes that DC plan sponsors can address the problem of emergency savings within their plans. “For example, employers can set up after-tax accounts or in-plan Roth sidecar accounts that employees can use to fund emergency savings up to a target threshold (e.g., three months of salary). Employees can then withdraw after-tax dollars to address financial emergencies instead of taking a loan or hardship withdrawal, both of which come with associated repayment requirements and/or unfavorable tax ramifications,” the report says.

The report also suggests that plan sponsors can examine their DC plan investment options and increase diversification to make plan investments work harder and smarter for participants. In addition, it says, “the need for plan sponsors to offer appropriate and flexible spend-down solutions for retirees is now more important than ever.” Willis Towers Watson encourages plan sponsors to look at available retirement income solutions that can help participants balance income needs with growth potential.

On the subject of tax advantages, Vernon recommends employers look at health savings accounts (HSAs) as retirement savings vehicles. If an employer has a high-deductible health plan (HDHP), its employees can contribute to an HSA.

“That actually has better tax advantages than a [DC plan] account, because the money that you put in isn’t taxed, and the money you take out is not taxed. If you’re an employee that is eligible to contribute to an HSA, what you do is contribute to the DC plan first [up to the amount] the employer matches,” he recommends. “Once you max out on those savings, then you switch over to an HSA.”