12 Compensation and Working Conditions Summer 2000

MARC KRONSON

Employee Costs and

Risks in 401(k) Plans

The rapid growth of employer-sponsored 401(k) plans

has been facilitated, in part, by the many advantages

offered to participants. However, employees also may

encounter many costs and risks in attempting to maximize

their account balances over the course of participating in

a plan.

Marc Kronson is an economist in the Division of Compensation Data Analysis and

Planning, Bureau of Labor Statistics.

Telephone: (202) 691-6201

E-mail: Kronson_M@bls.gov

Among the most important investment decisions made bymany American workers is

whether to contribute toward retirement

through a 401(k) plan. According to

the nonprofit Employee Benefit Research Institute, 55 million U.S. workers are enrolled in 401(k) plans totaling $1.5 trillion, with an average

account balance of almost $50,000.1

These plans offer employees a number of opportunities, including tax advantages, company matches to employee contributions, portability, and

loans and withdrawals from account

balances. At the same time, experts in

pension issues have identified certain

costs and risks that employees face

when participating in employer-sponsored 401(k) retirement plans.

Costs occur when employees’ pretax contributions, company matching

contributions, or account growth are

delayed because of participation or eligibility requirements. They also occur when employees do not contribute

enough to receive maximum matching

company contributions or when account loans or withdrawal options are

exercised. In addition, they occur when

record-keeping costs are high. Investment risk—including market, inflation,

interest rate, and credit risks—may be

higher than average because of a lack

of investment education and experience. The consulting firm, Ernst and

Young, considers employee investment

education a must in dealing with prolonged stock market declines.2 Another

risk involves the lack of investment diversification. A House Democratic Committee analysis noted that 401(k) plans

are not held to the same type of diversification requirements as are traditional

defined benefit pension plans.3 In addition, the form of distribution of account balances can create or extend

risks for 401(k) plan retirees. This article reviews the features of 401(k)

plans, the inherent costs and investment risks associated with such plans,

and the incentives used to encourage

employee contributions.

401(k) plans

Section 401(k) was added to the Internal Revenue Code in 1978, enabling

employees to place a portion of their

before-tax salaries into employer-sponsored retirement savings plans. A

401(k) plan is a type of defined contribution retirement plan whereby employees contribute their own money to

the plan and usually determine how the

funds are invested.4 Employee contributions may be matched by the employer. Under defined contribution

plans, the employee bears the investment risk. Favorable investment results

increase future benefits, while poor re-
 Compensation and Working Conditions Summer 2000 13

401(k) Plans

sults reduce benefits. (In contrast,

employer-sponsored defined benefit

pension plans are those in which the

company makes contributions, and a

predetermined formula—usually tied to

the employee’s earnings or length of

service, or both—establishes the retirement benefit. Therefore, in a defined

benefit plan, the employer accepts the

risk of providing the participant’s future benefits.)

Features of 401(k) plans

Tax deferred status. Investment earnings from 401(k) plans are not subject

to Federal income taxes until the funds

are withdrawn from the account.5 Generally, employees’ contributions also

are made on a pretax basis, thereby reducing their current income tax. The

tax deferral status of 401(k) accounts

facilitates faster growth of the account

balance.6 The advantage of tax-deferred growth in a 401(k) plan is shown

in the accompanying chart. At a 10-

percent rate of return, a tax-deferred

investment of $1,000 over 30 years

would return more than twice as much

as a taxable investment.

Employer matching funds. Some employers provide matching contributions

as an employee benefit and as an incentive to encourage their employees

to participate.7 The employer contributes a certain amount to the participant’s account (usually between 25

cents and $1) for each dollar the employee contributes, up to a specified

limit. Data from the Bureau’s 1997 Employee Benefits Survey (EBS) of medium and large private establishments

showed that, in plans with specified

employer matching rates, 42 percent of

participants had their contributions of

less than 6 percent of earnings (typically 3 to 5 percent) matched by employers. Another 48 percent were in

plans in which the employer matched 6

percent of earnings. The most common rate of employer match (applicable

to 47 percent of participants) was 50

cents for each dollar contributed by the

employee. Other common employer

matching rates were either less than 50

cents for each employee dollar contribution (23 percent of participants) or

dollar for dollar of employee contribution (15 percent of participants).

Investment choices. Most participants

in 401(k) plans can choose, within certain limits, how to invest their own contributions. According to the EBS, 86

percent of employees participating in

401(k) plans in 1997 were permitted

some choice in their investments. Investment options included company

stock, common stock funds, guaranteed investment contracts, government

securities (such as U.S. Treasury bills

and U.S. savings bonds), money market funds, and corporate bonds. The

number of choices in these plans varied from 2 to 10 or more, with the most

common being 4 choices (21 percent of

participants). Employees usually are

allowed to split their contributions

among the various options—typically

in multiples of 10 or 25 percent. For

example, a participant may choose to

invest 50 percent in company stock and

50 percent in government securities.

Also, plans often permit participants

to change their investment choices

periodically, most commonly four times

per year. In 1997, 65 percent of 401(k)

plan participants also were permitted a

choice of investments for their employer’s contributions. In most cases,

however, employees had less of a

choice in how employer contributions

were invested than they did in how their

own contributions were invested.

Where no choice was allowed, the plan

typically specified that the matching contribution be invested in company stock.

Portability. If the participant changes

employers, plan funds can be rolled

over or transferred into an Individual

Retirement Account (IRA) or another

employer’s qualified retirement plan.

The participant is not liable for income

taxes due to the transfer; taxes still

are deferred.

Loans and withdrawals. Many plans

allow participants to access their account balances before retirement. Generally, loans on 401(k) accounts are

paid back with interest (at a fixed rate

determined at the time of the loan)

through after-tax payroll deductions.

Data from the 1997 EBS show that 51

percent of 401(k) participants were eligible for loans from their plans. In addition, 33 percent of 401(k) plan participants were able to take penalty-free

hardship withdrawals for the death or

illness of a family member, educational

expenses, sudden uninsured losses, or

the need to prevent eviction from the

employee’s primary residence. If funds

are withdrawn, they are taxable in the

year of receipt, although hardship provisions allow the participant to avoid

any penalties that might otherwise be

imposed because funds were received

$0

$5,000

$10,000

$15,000

$20,000

6% 8% 10%

Rate of return

Tax deferred

Taxable

CHART. Value of a taxable and a tax-deferred $1,000 investment after 30 years

Value of investment

(Dollars)

Tax-deferred investment

20,000

15,000

10,000

5,000

0

6 8 10

Taxable investment

8 10

Rate of return (percent)

6

SOURCE: American Express
14 Compensation and Working Conditions Summer 2000

prior to retirement age.

Distribution options. At retirement,

401(k) plans commonly (91 percent in

1997) allow for a lump-sum payment.

Many participants can choose from

among a lump sum and other options,

such as a lifetime annuity or installments over a specified period.

Costs and investment risks

Besides the advantages offered by participation in a 401(k) plan, employees

also may encounter certain costs and

investment risks. Eligibility requirements,

discretionary employee contributions,

and matching company funds all can

cause an employee to incur costs. In

addition, investment risks, diversification or lack thereof, high record-keeping costs, the exercise of loan and withdrawal options, and fund distribution

choices all can affect the level of an

employee’s retirement benefits.

Eligibility requirements. Minimum

service requirements frequently are

imposed on new participants in 401(k)

plans. In 1997, 76 percent of full-time

employees in medium and large private

establishments participating in 401(k)

plans had a minimum service requirement (for 53 percent, this requirement

was 1 year of service). Plans with minimum service requirements impose a

cost on workers by delaying the accrual of benefits. For example, investing $300 per month for 30 years with a

6-percent compounded annual return

would result in an account balance of

$301,355. However, a 1-year minimum

service requirement would reduce the

number of years to 29 and the final account balance to $280,362.

Maximizing discretionary employee

contributions and the employer match.

Another potential cost occurs with

401(k) retirement plans when the participant does not make sufficient discretionary contributions to achieve the

maximum employer matching contribution. Furthermore, because 401(k) plans

typically are only partially funded by

the employer, the discretionary savings

of participants should be maximized to

better fund the employee’s retirement.

For example, if a participant contributes

$200 per month into a plan with a 50-

percent employer matching contribution, the account would total $301,355

after 30 years, assuming a 6-percent

compounded annual rate of return. If,

on the other hand, the employee contribution is $100 per month with the

same 50-percent employer match, the

value of the account would be $150,677.

Investment risk. Investment of 401(k)

funds, like all other investments, involves financial risk in order to achieve

returns. Generally, the more risk associated with a particular investment, the

greater its potential for higher returns.

The possibility that an investment will

return less than expected is referred to

as investment risk. The most common

forms of investment risk are market, inflation, interest rate, and credit risk:

• Market risk generally can be defined as the possibility that decreases in the market price of an

investment will result in a loss of

principal for an investor. There

are market risks on the macro

level, such as the ups and downs

associated with the stock market.

On a micro level, market risk is

present if employer stock is used

to fund a 401(k) account. The

value of the account may fluctuate in response to the financial prospects of the employer.

• The rising cost of goods and services over time can pose an inflation risk to 401(k) investors.

Although investments with fixed

or guaranteed interest rates, such

as bonds or certificates of deposit, provide protection from

market risk, such investments are

subject to inflation risk because

the fixed rate may not keep pace

with rising prices over time.

• Interest rate risk can occur when

an increase in the general level

of interest rates causes the value

of existing investments to fall.

Usually the risk applies to bonds

and other debt-type instruments,

the prices of which move contrary to interest rates. As interest rates rise, bond prices tend

to drop.

• Credit risk, also know as default

risk, is the possibility that the issuer of a bond or other debt-type

instrument will not be able to complete its contractual obligations.8

To manage the financial risks inherent in 401(k) investments, employers

have accelerated investment education efforts. Hewitt Associates, a human resource consulting firm, found

that 86 percent of surveyed employers

either have programs to educate employees in 401(k) investing, or are planning to implement such a program in

the coming year.9 IOMA’s report on

managing 401(k) plans predicts that

employers will use an upsurge in 401(k)

plan technology to inform and educate

participants with personalized services

and features.10 Personalized rates of

return establish participants’ level of

risk tolerance, and then suggest what

portion of their accounts should be invested in specific funds such as

growth, value fixed income, or other

retirement options.11

According to Hewitt Associates, 20

percent of employers are now using the

Internet to educate employees and establish and maintain 401(k) plans. 12

Products such as Fidelity’s web-based

e-401(k) program for firms with fewer

than 50 employees offer multiple mutual fund options, along with comprehensive low-cost record-keeping services to employers. One service firm

has recently introduced a business-tobusiness web service allowing employers with 401(k) plans to collect bids,

without being charged, from up to 15

service providers of their choice.

Within 5 business days of using the

service, the employer receives price

quote summaries comparing bids from

the first 10 providers to respond. Moreover, new software products are being
 Compensation and Working Conditions Summer 2000 15

401(k) Plans

developed to allow small businesses

to administer a 401(k) plan in-house.

Employers also are using various

other methods to educate 401(k) investors. Personalized features gaining acceptance are: (1) Automatic account

rebalancing, which maintains each

participant’s asset allocations in line

with his or her original portfolio design; and, (2) self-directed brokerage

accounts. In addition, more companies are offering individual and group

financial planning seminars. Hewitt

Associates found that, in 1997, almost

twice as many employers offered oneon-one planning (41 percent) as had

done so in 1995 (21 percent). Seminars

also are becoming a more common way

for employers to educate plan participants (85 percent in 1997 versus 77

percent in 1995).13 One large pharmaceutical firm, for example, offers 401(k)

participants investment advice from

Ernst & Young through the company

cafeteria plan.14

Diversification choices. According to

a 1999 survey by the consulting firm

Towers Perrin, “39 percent of 401(k)

participants are unaware of how their

plan assets are allocated.”15 One consequence of this passive account management is a lack of diversification in

401(k) plan investments. Investment

diversification is important because it

helps offset the risks unique to one

type of investment by simultaneously

spreading account funds among other

types of investments. For example, the

greater risk and volatility associated

with investment in a stock fund can be

minimized by also placing money in less

risky money market or bond funds.

To achieve a well-diversified 401(k)

portfolio requires account flexibility

and an adequate number of investment

choices. Employees may not always

have sufficient investment options or

the ability to transfer funds among investment offerings. Increasingly, employers are responding to the lack of

diversification of 401(k) assets by offering more investment options and

greater power for employees to move

funds between accounts. According

to Hewitt Associates, 401(k) participants had an average of 8 investment

options to choose from in 1997, up from

6.3 in 1995 and 4.5 in 1993.16 Employees also have more opportunities to

transfer 401(k) money between accounts. Hewitt reports that, in 1997, 64

percent of 401(k) participants were allowed to transfer existing balances

among investment funds on a daily

basis, up from 41 percent in 1995.

High record-keeping costs. Most

401(k) plans are subject to record-keeping and administrative costs. These

charges can run as much as $75 annually per account. The Wall Street Journal reports that 401(k) investment fees

paid by employees ranged from 0.53

to 2.56 percent of plan assets. Assuming annual returns of 10 percent, the

higher cost plans produce a cost by

reducing total expected returns by up

to 25 percent.17

Withdrawal and loan options. Participants in 401(k) plans may be allowed

to withdraw all or a portion of their account funds prior to normal payout

(usually at retirement). Besides the

costs imposed by early withdrawals, tax

penalties are imposed if the withdrawal

is not for hardship purposes. Thus,

the employee typically is liable for income taxes on the amount withdrawn,

plus a tax penalty. In the case of a hardship withdrawal, the withdrawn amount

is taxable, but no penalty is assessed.

Many 401(k) plans have loan provisions allowing employees to avoid

tax penalties by borrowing from their

accounts, with interest, for a specified

period. However, as with taxable withdrawals, loans taken against 401(k) balances result in the cost of lost appreciation of the account balance. To illustrate, taking a $5,000 loan on a

401(k) balance of $10,000 with an annual compounded return of 6 percent

results in a reduction in the total account balance from $57,435 to $28,717

after 30 years (assuming that the loan

is not repaid).

Distribution choices. Depending

upon the distribution method selected,

401(k) participants may incur the risk

of negative tax consequences. At retirement, employees usually can request that their 401(k) funds be paid

out in the form of a lump sum, a lifetime annuity, or installments over a

specified period. Choosing a lumpsum distribution would require the

employee to pay taxes on the entire

sum as if it were income for that particular year. Receiving a lifetime annuity or installments would spread the

income tax owed over a period of years,

thus reducing the impact of the tax consequences. Choosing a lump-sum distribution also may result in the participant exhausting his or her 401(k) funds

early in retirement. An annuity or installments would distribute payments

over the retiree’s lifetime.

Summary

The rapid growth of employer-sponsored 401(k) retirement plans has, in

part, been facilitated by the many advantageous features offered to participants. Tax advantages, portability, the

availability of loans and withdrawals

and the choice of distribution options

have encouraged employee enrollment

in 401(k) plans. However, employees

also encounter various investment risks

and costs in their attempt to maximize

account balances. Ultimately, it is

mainly the employee who is responsible

for minimizing the investment risks and

costs associated with employer-sponsored 401(k) retirement plans.
16 Compensation and Working Conditions Summer 2000

1

 “Average 401(k) Balance Grew 26% From

1996-1998,” Employee Benefit Research Institute News Release, Jan. 20, 2000, pp. 1-3. 2

 William J. Arnone, Personal Financial

Planning: The 401(k) Time Bomb, on the

Internet at http://www.bcsolutionsmag.com/

401TIMEB.htm (visited Oct. 21, 1999). 3

 U. S. House Democratic Leadership, “Pension Security: How Safe are 401(k) Plans”? on

the Internet at http://www.house.gov/democrats/401k.htm/ (visited Oct. 21, 1999). 4

 The Bureau’s Employee Benefits Survey

classifies defined contribution retirement plans

into savings and thrift plans, deferred profitsharing plans, money purchase pension plans,

employee stock ownership plans, and stock

bonus plans. A frequently encountered feature of some defined contribution plans is a

401(k) cash or deferred arrangement allowing

participants to choose between receiving currently taxable income or deferring taxation

by placing the money in a retirement account.

The plans usually take the form of either salary reduction or deferrals of profit-sharing allocations. Salary reduction plans allow employees to contribute a part of their pretax

earnings to a retirement plan, and defer income taxes on those contributions and their

earnings until distribution. Savings and thrift

plans are the most common salary reduction

vehicle. Deferrals of profit sharing give employees the choice of receiving an employer’s

profit-sharing contribution immediately in

cash, or deferring the contribution and postponing taxation until distribution; such arrangements are not common. 5

 This is usually also true for State and

local taxes. 6

 “Benefits of a 401(k) Plan–The Advantages of Tax-Deferred Growth,” American Express Retirement Services, Jan. 19,

2000, on the Internet at http://www10.

americanexpress.com/sif/cda/page/

0,1641,1255,00.asp (visited Mar. 3, 2000). 7

 This article frames the discussion of

employee risk in 401(k) plans in terms of the

private sector. However, these plans also are

offered to Federal, State, and local government employees. 8

 Definition of risks is taken from “Types

of Investment Risk,” Klaers & Associates,

Mar. 2, 2000, pp. 1-3, on the Internet at

http://users.inetech.com/ka/docs/

investmentrisk.html (visited Mar. 5, 2000).

09

 “Hewitt 401(k) Survey Shows Employers are Offering More Investment Options,

Plus Education to Help Employees Save for

Retirement,” Hewitt Newstand, Feb. 12, 1998,

pp. 1-3. 10 “What the Year 2000 Will Mean For

401(k) Plan Sponsors,” IOMA’s Report on

Managing 401(k) Plans, February 2000,

p. 4. IOMA is a monthly publication of

the Institute of Management and Administration, Inc. 11 Ibid., pp. 4-5.

12 “Hewitt 401(k) Survey,” pp. 1-3. 13 Ibid., p. 3.

14 “What The Year 2000 Will Mean,” p. 7.

15 Towers Perrin, “Your 401(k) Plan,” July

14, 1999, on the Internet at http://

abcnews.go.com/sections/business/

Finance/401kplans980714.html (visited

Mar. 7, 2000). 16 “Hewitt 401(k) Survey,” pp. 1-2. 17 The Wall Street Journal as cited by John

P. Greany in “Are You Getting the Shaft in

Your 401(k)?” The Retire Early Home Page,

July 1, 1999, on the Internet at http://

www.geocities.com/WallStreet/8257/

shaft2.html (visited Mar. 10, 2000).

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