The term 401 (k) plan was taken from the Internal Revenue Code of 1978, in particular Section 401 (a) which defines qualified plan trusts and its respective rules for qualifications. A 401 (k) plan is savings plan for retirement which is being funded through the contributions of employees as well as the employer’s supplementary contributions. The contributions of the 401 (k) plan is acquired from the pre-tax salary. Until the funds are withdrawn, they remain tax-free. With these advantages, companies have availed of the said plans for their employees.
As mentioned earlier, one of the advantages of 401 (k) plans is that the contributions from the employees can be acquired through his/her pre-tax money. This set-up evidently reduces the tax generated from the employee’s pay check. Another advantage of the plan is that until withdrawal, the contributions of employers including any growth in capital grow tax-free. With the additional contributions of employers, the plan also serves as an added benefit to the employees apart from its regular compensation. The employee also possess more control of their investments since the plan provides them options as to where to direct future contributions and savings. In the event that the employee changes jobs, he/she is allowed to transfer the contributions from the plan of its former company to his/her new company plan.
Another gain from the 401 (k) plan is that the plan being a personal investment program is actually protected under pension laws (ERISA). This protection consists of added protection of funds from attachments by creditors and other individuals.
While the 401 (k) plan shows a number of benefits, the said plan also possess several disadvantages. Among these weaknesses include difficulties in accessing the savings from the 401 (k) plan for individuals below the age of59 � years old. Another disadvantage is that, similar to other pension plans, the 401 (k) plan is not insured by the Pension Benefit Guaranty Corporation (PBGC). Another important note is that the contributions of the employer are not vested immediately and usually takes a number of years which are often in two schedules. The first schedule is a three-year cliff plan in which 1005 shall be acquired after 3 years. Another schedule offers a 6-year graded plan which allows 20% yearly acquisition from the 2nd year until the 6th year.
There are a variety of investment options for individuals with 401 (k) plan which are mostly mutual funds. The said funds often consists of bond funds with different maturities such as short, intermediate or long term, money market funds as well as a variety of stock funds. Other plans permit investments in US Series EE Savings Bond and company stocks among others. In such plans, the employee is provided with options to decide on the manner of investing savings and is permitted to modifying details such as where the current savings will be invested.
While the 401 (k) plan rules and regulations often vary depending on the company’s preferred plan, there are standard regulations that apply to all 401 (k) plans. Among these regulations include rules in contributions. As previously mentioned, employees are given the choice of whether to providing all or a part of their contributions from their pre-tax gross income. This measure reduces the amount of tax deducted from employee’s pay check and defers in until the employee has taken the pre-tax fund from the plan. Employee contributions remain tax free and must be deposited immediately each month.
The IRS specifically imposes rules that on before-tax as well as after-tax contributions. The pre-tax deductions are limited to a fixed dollar figure which is also subject to change for each year. For the after-tax contributions, the funds are generated from the net pay of the employee. This set-up also facilitates the convenient and easier withdrawal of funds since this will no longer be within the IRS rule which is only imposed on pre-tax contributions.
The before-tax contributions of an employee us limited by the IRS. The imposed limit for 2009 is $ 16,500 which reflects the employee’s maximum amount that can be provided to his 401 (k) plan from his/her pre-tax earnings. In cases wherein the employee contributed beyond the pre-tax limit, he/she must communicate with his/her employer. The excess contribution can be refunded or reconsidered as an after-tax contribution.
Regulations are also imposed for employees receiving high compensation to prevent companies from exploiting such circumstances. Highly compensated employees (with income beyond $ 111, 000) may not be permitted to save at the maximum rates. Applying the regulations for such employees often vary on the company since the companies can also identify and decide that the top 20% of the workforce will be considered as highly compensated.
Another set of regulations dictates limitations on annual contributions for each year. The amount varies annually with the 2009 limit set at $ 195, 000. Additional limitations were set by the IRS such as the defined contribution plans’ total amount to the lesser 100% of compensations yearly, which, in the year 2009 amounts to $ 49, 000.
Another advantage of the 401 (k) plan is that it permits a person to limited and access to savings without any penalties below the age of 59 such as applying for a loan from the plan. A person can pay back the loan in regular terms often through payroll deductions which is also another form of returning or paying back the principal and interest to the plan.
There are several benefits and disadvantages of obtaining a loan from the 401 (k) plan. A loan from the plan is more convenient since there are no credit checks and long process of approval. The loan will also be subjected to low interest rates and the person shall technically pay the interest to his/her own plan and not the bank. A clear disadvantage of acquiring a loan is that the since the funds are loaned out, its value will not increase. The loan may also be subjected to fees. In instances wherein an employee transfers jobs, the loan must be immediately paid back.
Since the onset of recession, a significant number of companies have reduced their counterpart contributions for their employee’s 401 (k) plans as a means of reducing cutting costs. There were more than 170 firms in 2008 who have declared measures of reducing or suspending match contributions as a measure of cost-cutting. Cost-cutting through 401 (k) plans have been applied several companies during early years of the decade but the number is increasing. Reductions and suspensions are becoming more prevalent particularly in large companies.
A survey organized Watson Wyatt reflected recent changes to HR programs. Based on the survey, 52 % of the companies who have responded admitted they have laid off employees. 42% have imposed salary fees or pay reduction strategies and 12 % of the companies have suspended or reduced their matching contributions.
While other companies have opted to cancel matching contributions, some companies have chosen suspend the matches and review the company’s performance before continuing with the contributions. General Motors have reduced their contributions to 60 cents for every dollar of employee contribution which is up to 6% of salary. Delphi Automative Systems have indefinitely suspended its contributions as part of the cost-reduction program. Delphi has provided 70 cents for each dollar contributed by its employees.
Frontier airlines have also declared its suspension of matching contributions for the plan. Dollar Thrifty Automotive Group (DTG), Fedex, Charles Schwab Corporation, and Cushman & Wakefield real estate firm were among the companies who have ceased the offering of matching contributions.
A number of companies are also resorting to tie-matching contributions to the performance of the company which became part of company policy to provide incentives depending on their worker’s performance.
According to a survey conducted by the Principal Financial Group, the company’s matching contributions have assisted in making 401 (k) plans the second most valued benefit of the employees aside from healthcare. The companies have been forced to review such benefits particularly the retirement plans to be able to reduce the company costs without laying off workers.
There are a number of factors that cause a company’s reduction of 401 (k) plan match – liquidity, size/industry of the firm, profitability and nature of its pension arrangement. There are two aspects of liquidity that was studied – Quick Ratio and Failure to Transmit. Quick ratio is the ratio of cash, marketable assets, cash equivalents and accounts receivable to current liabilities. This variable gauges the company’s ability to discharge of its current liabilities. During the economic low, companies challenged by a financial crisis may have difficulties in rolling over their debt. Such companies will resort to all measures that will reduce their market exposure. It is expected that when the quick ratio is larger, the company is less likely to suspend its match.
Another variable in liquidity is the failure to transmit. Delaying the contribution transfer to the plan is a safety measure for companies which reflect the low possibility of suspending matches.
Another cause for reduction or cancellation of employers’ match contribution is their need to preserve profitability. There are also variables to consider when discussing the profitability of a company. Gross Margin measures the profitability of the firm. This is the ratio of annual gross profit against the cost of sold goods. If this variable remains the company’s motivation, it would reflect that the higher the ratio, the lesser chance of the company suspending its match.
The company’s pension arrangements may also affect the possibility of match suspension. For firms with defined benefit plan has a high probability of suspending the match because the employees already have protection for the pension.
Another aspect for consideration is the employer contribution. The size or amount of employer contribution is gauged by the ratio of the employer contributions against the number of employee and employer contributions. It is perceived that when the employer contributions are large, there will be a higher financial burden, thus the higher possibility of suspending the match.
Another reason for the match suspension is the firm’s characteristics as well as the nature of the industry. For large firms, which consist of 2,000 employees or more, the larger the companies, the higher the expenses incurred for 401 (k) contributions. Such companies have a higher possibility of match suspension during a financial crisis. For manufacturing companies, the global competition has increasing weakened the operations of such companies and as such will be more vulnerable to the financial crisis. The said companies are likely to suspend their 401 (k) match contributions.
Based on the gathered financial data from Standard & Poor’s 2009 Compustat, employers are identifying constraints in liquidity as the main cause of 401 (k) match suspensions. Companies possessing short-term assets relative to liabilities have the low probability of suspending their match. Failure to transmit contributions of employees also provide statistical significance. Companies who are willing to compromise on their accounting by delaying employee contributions and refusing to transmit such contributions to the 401 (k) plan have low probability of facing liquidity constraints that can lead to suspension of the match. Large firms and manufacturing companies have high probability of suspending their 401 (k) match.
For this year, a number of companies have been restoring contributions to their employee’s retirement plans after being forced to suspend their contributions during the crisis. In a study conducted by the largest provider of retirement plans in the workplace, Fidelity Investments, 44 percent of their clients who have cancelled the contributions have reinstated the plan. These reinstatements were perceived to be good indicators of the company’s confidence in their fiscal future.
The 401 (k) retirement plan provides protection for workers in their age of retirement. While the reduction/suspension of employers’ match contributions were a disappointing consequence of the recession, a number of companies have opted to reduce or suspend the contributions rather than opt to reduce their workforce. The recent reinstatements of high profile companies of their 401 (k) match contributions reflect the willingness to continue compensating and providing benefits for their workers.
Reference:
Carreiro, R., Nieters, E., & Olson, D. (2009). Retirement Plans 401 (k) plan. Northeastern University. Retrieved 7 May 2010 at http://invest-faq.com/articles/ret-plan-401k.html
Munnel, A. & Quinby, L. (2010). Why did some Employers Suspend their 401 (k) Match? Boston College. Center for Retirement Research. Retrieved 7 May 2010 at http://crr.bc.edu/images/stories/Briefs/ib_10-2.pdf
Walsh, M. & McGeehan, P. (2003). Schwab Joins Others Ending Contributions To 401(k)’s. The New York Times. Retrieved 7 May 2010 at http://www.nytimes.com/2003/03 /14/business/schwab-joins-others-ending-contributions-to-401-k-s.html?pagewanted=1
Watson Wyatt. (2009). Economic Crisis Prompts Many Companies To Suspend Contributions To Employee Savings Plans. Insider. Retrieved 7 May 2010 at http://www.watsonwyatt. com/us/pubs/insider/showarticle.asp?articleid=21034