The 401(k) plan turned forty this year. Today, the 401(k) plan remains very popular with large employers and is essentially viewed as a helpful way for retaining employees, as well as providing them with a tax efficient way to save for retirement.
However, many small to mid-size businesses have been reluctant to establish 401(k) plans for their employees. According to the August 31, 2018 White House Executive Order, in 2017, approximately 89 percent of workers at private-sector establishments with 500 or more workers were offered a retirement plan, compared to only 53 percent for workers at private-sector establishments with fewer than 100 workers. And the numbers were more glaring for younger people. The Pew Charitable Trusts found that 41 percent of millennials didn’t have access to an employer-sponsored retirement plan.
So why have more small and mid-size businesses have been slow to establish 401(k) plans? The Trump Administration believes it has an answer. An executive order signed by President Trump in Charlotte, North Carolina on August 31, 2018 instructed the Labor Department to craft guidance that would relax existing restrictions on Open Multiple Employer Plans (“MEP”) and allow groups of small employers to pool workers into one 401(k) plan, permitting them to lower investment, record keeping, and administration fees. In addition, MEPs also discharge employers of reporting requirements to the Labor Department, and allow MEP providers to share employers’ fiduciary requirements under ERISA.
MEPs are not a new concept. According to Morningstar research, MEPs cover around 4.5 million retirement savers. However, MEP’s popularity among employers have been limited by existing regulations, specifically the commonality requirement and “one bad apple” rule. Established under the Obama Administration, employers are required to share commonality, or a nexus, such as membership in a trade group, in order to be eligible to be part of an MEP. In addition, the so-called “one bad apple” rule subjects MEPs to disqualification if one participating employer fails to meet administrative requirements.
On August 31, 2018, the White House published the Executive Order on Strengthening Retirement Security in America. The order’s goal is to expand access to MEPs for small businesses by reducing administrative costs of retirement plan establishment and maintenance, which the White House believes will encourage more plan formation by small businesses. The order requested the Department of Labor to examine policies to remove or revise the commonality requirement and the “one-bad-apple” rule. Although new MEP rules should reduce plan investment costs and administration fees, it will not tackle the biggest obstacle stopping many small businesses from adopting a 401(k) plan – the cost of safe harbor contributions.
One of the more popular types of 401(k) plans for small businesses is the safe harbor 401(k) plan. A safe harbor 401(k) is a way to structure a plan that automatically passes the non-discrimination test or avoids it altogether, which could limit the amount the owners or highly compensated employees can contribute to the plan. A safe harbor plan essentially requires the employer to make contributions to each eligible employee based on a set percentage of salary. The minimum safe harbor employer contribution is generally 3%. The contribution is deductible to the employer but could have a direct impact on the employer’s cash flow. Alternatively, an employer is not required to elect a safe harbor option and can rely on passing the annual plan nondiscrimination tests involving deferral and contribution percentages.
While the adoption of an MEP by a small business can lower investment and administration related costs due to economies of scale, the savings are generally underwhelming when a business owner considers the costs of satisfying the plan safe harbor rules. One reason for this is that 401(k) plan mutual fund investment costs have been decreasing significantly since 2000. According to ICO.org, in 2000, 401(k) plan participants incurred an average expense ratio of 0.77 percent for investing in equity mutual funds. By 2017, that figure had fallen to 0.45 percent, a 42 percent decline.
Joining an MEP program could still further reduce employee investment fees, which is an attractive feature, however, from the perspective of the business owner who is the one in charge of deciding whether the business will establish a 401(k) plan, the economic cost of satisfying the safe harbor contribution rules continue to be the real roadblock.
For example, let’s take ABC, LLC, a software consulting company, with nine employees and an average salary of $50,000. Let’s further assume that ABC offered its employees a safe harbor 401(k) plan non-elective contribution of 3%. ABC would be required to make annual safe harbor contributions of approximately $13,500 (3 percent of $50,000 salary). Yes, the safe harbor contribution is tax deductible, but it does have a direct impact on company cash flow. Whereas, adopting an MEP will likely reduce third-party administration/ recordkeeping (“TPA”) fees, which typically range between $1200-$2500 annually for a small business, far less than the cost of satisfying the safe harbor plan rules.
Therefore, if the Trump Administration really wants to encourage more small businesses to adopt 401(k) plans, which is a noble and important public policy initiative, it would be better served finding ways in which small businesses can offer 401(k) plan benefits to their employees without the high economic costs of satisfying the safe harbor rules.
I have spoken to thousands of small business owners through my career in the retirement industry, and the common issue stopping many small business owners from adopting 401(k) plans for their employees is not the costs of investments or TPA fees, but the economic cost of satisfying the minimum 3% safe harbor contribution requirement. Unless the Labor Department comes up with a plan for reducing or eliminating the costs of satisfying the safe harbor rules, I don’t believe any new or revised MEP regulations will significantly increase the number of small businesses establishing 401(k) plans for their employees.