Retirement plans have long been used by employers to attract new talent. For years, defined benefit plans (i.e. pension plans) were in vogue. These plans were great for employees, because they offered them a guaranteed monthly payment at retirement - the payment was typically determined by a combination of your average or final salary, years of service with the company, and age. Because the pension payment was based on a set formula rather than market or investment performance, savers had the luxury of taking a more passive role in their retirement planning.
Around 1980, section 401(k) was added to the tax code, paving the way to allow employees to contribute a portion of their salaries on a pre-tax basis to qualified plans. Shortly after the addition of this provision, several companies, including Johnson & Johnson and Honeywell, began adding 401(k) plans as supplements to existing pension plans. Over time, employers began doing away with pension plans in favor of 401(k) plans, which typically are more cost-efficient for companies to offer.
With guaranteed monthly payments from pensions out and 401(k)s in, it's become extremely important for this generation of savers to take a more active role in their road to retirement and that starts with taking stock of your 401(k) plan. And with excessive fees rampant throughout the retirement investment industry, the average American has to be extra careful that he's not being bilked.
Here's seven ways to tell if you have a good 401(k) plan:
1. Eligibility - The best 401(k) plans allow employees to contribute and receive employer contributions immediately. Unfortunately, less generous plans could make employees wait up to one year before being eligible to contribute their own funds and two years before receiving employer contributions.
In Vanguard's "How America Saves 2015" report, an analysis of Vanguard's defined contribution data for 2014, the company found that 58% of plans offer employees immediate eligibility to make their own contributions. But that leaves a large number of plans that require some waiting period before being eligible to contribute.
2. Employer Contribution - Employers can make matching and non-matching contributions on behalf of employees. The employer match contribution is generally based on a percentage of monies you contribute to your 401(k) plan in a given year. The formula can vary based on the plan and in 2014, Vanguard administered more than 225 distinct match formulas.
What matters is how much actual money those match formulas translate to you. In addition to matching contributions, employers can also make non-matching contributions for employees.
Overall, 94% of Vanguard plans offer some type of employer contributions, with 46% of plans offering only a matching contribution, 37% of plans offering both a matching and non-matching contribution and 11% of plans offering only a non-matching contribution.
3. Employer Matching Contribution Timing - Aside from the actual amount of the matching contribution you'll receive, what's also important is when you'll receive that money from your employer. The sooner you receive matching contributions, the more time you have for those contributions to be invested and potentially grow.
The most generous plans dispense matching contributions each pay period. The least generous plans require employees to be with the company through the end of the year in order to receive matching contributions. As a result, for employees who contribute to their 401(k) plans early in the year but switch jobs mid-year, they could end up not receiving any matching contribution for that year.
Generally, non-matching contributions are distributed annually.
Jeff Jones, founder of Cypress Financial Planning in Woodbury, N.J., serves a diverse client base with a wide range of employers. Most commonly, he has seen employers deposit a matching contribution concurrent with the employee's salary deferrals. The most generous is a local public university that requires all employees to contribute 5% of salary into a 401(a) (government equivalent to private company 401(k)), and matches this with an 8% contribution.
4. Vesting Schedule - Unfortunately, just because an employer contribution is deposited into your account, doesn't mean you'll actually be able to keep it. The least generous 401(k) plans require employer contributions to be vested over a period of time - either 100% vesting after three years or gradual vesting over two to six years (i.e. 20% vesting per year). In the case of 100% vesting after three years, if an employee left a company after two years, he'd have to forfeit his employer contributions.
The most generous 401(k) plans allow employees to be vested immediately in any employer contributions.
5. Contribution Types - Most plans allow employees to make contributions to their 401(k) plans on a pre-tax basis - employees contribute money to their 401(k) plans that hasn't been taxed. The best plans not only offer pre-tax contributions, but also allow for Roth and after-tax contributions.
While the majority of people may want to contribute pre-tax dollars to lower their current taxable income, some may want the option to make Roth contributions, to get taxed today for the benefit of having withdrawals be free from taxes.
"If you have the option for a Roth contribution, I recommend this for most clients as it is a great way to create long-term tax strategies in your retirement plan," said Brittney Castro, founder of financial planning firm Financially Wise Women. "With Roth 401(k) contributions, you sacrifice the tax deduction in the year of the contribution, but have the ability to withdraw this money tax-free, after 59 1/2, which can definitely help provide more tax savings in the future."
Of the plans Vanguard administers, 56% of them offer a Roth contribution option and 14% of participants given this option take advantage of it.
While after-tax contributions are taxed upfront and upon withdrawal, they do grow tax-free and could allow for some interesting tax diversification strategies. Just 18% of Vanguard plans offer after-tax contributions, and only 7% of participants with this option actually utilize it.
6. Investment Options and Fees - Once you've contributed money to your 401(k) plan and received your employer's contribution, another important component is what your options are within the plan to invest those monies.
The best plans have a variety of index and actively managed funds available across asset classes with low expense ratios. The least attractive plans have few investment options with high fees.
Jones of Cypress Financial Planning also likes to see a low-cost suite of target-date funds within a 401(k). For an employee that isn't as experienced of an investor, or isn't getting professional guidance, putting 100% of your 401(k) balance into a well-run target-date fund aligned with your expected retirement date is a sound strategy.
7. Bonus Features - Some other attractive features of 401(k)s are in-plan distributions, automatic enrollment and rollovers. In-plan distributions allow you to remove certain monies from the plan while you're still working at the company. Automatic enrollment ensures a higher employee participation rate since employees are automatically enrolled in the plan rather than having to take action to enroll. Lastly, accepting rollovers could benefit employees in a couple of ways. First, it allows them to have most, if not all, of their retirement monies in one place, which makes ongoing management easier. In addition, if employees work at larger companies, they may be able to benefit from lower expense ratios within 401(k) plans - allowing them to save money over time.
So How's Your 401(k)?
So, what are you waiting for? Take a look at your current 401(k) plan features, and see how your plan stacks up vs. other plans. When you look for your next job, be sure to consider the competitiveness of the retirement benefits offered by your new employer compared with your existing employer. In the end, it's a material portion of your overall compensation package, and as we've seen, retirement plans can vary widely in how generous they actually are.