Plan Design: In-Plan Roth Conversion

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

The In-Plan Roth Conversion provision is a plan feature introduced by the American Taxpayer Relief Act (ATRA) in January, 2013 that permits participants to convert pre-tax balances that are vested to after-tax Roth balances within the plan.  Expanding in-plan Roth contributions may prove to be a powerful tool for plan participants and a welcome enhancement to plan sponsors' retirement offerings.

IRS Notice 2013-74 dramatically increases participants' ability to convert pre-tax savings into after-tax Roth retirement savings by expanding the pool of eligible assets. 

Pre-Tax

Traditional DC plans such as 401(k), 403(b) and government 457(b) plans allow participants to make pre-tax deferrals to their plan.  These contributions reduce their current tax liability but ultimately, the withdrawals taken during retirement are taxed at regular income tax rates. 

After-Tax

With Roth versions of 401(k), 403(b) and 457(b) plans, participants contribute after-tax amounts that will be taxed in the year of their contribution, however,  withdrawals  will be tax-free.  In-Plan Roth rollovers enable participants to convert pre-tax retirement amounts into an after-tax account (Roth), paying taxes in the year of the conversion.

New IRS Guidance

On December 11, 2013 the IRS issued Notice 2013-74 which expands  the previously limited in-plan Roth conversion option to all vested amounts under eligible plans.  The new rule also allows amounts that are not yet eligible for distribution.

Plan sponsors are not required to offer in-plan Roth conversions to their participants.  Plan sponsors may limit the types of vested pre-tax contributions  to be converted (employer/employee), may  designate the frequency of elective conversions and may choose to discontinue the conversion program, as long as it is done in an equitable manner.

In-Plan Roth Conversion Process

A participant can make an in-plan Roth conversion by transferring assets from a non-Roth account into a designated Roth account within their retirement plan.   The amount transferred from pre-tax to after-tax becomes taxable in the year of the conversion. 

The participant is paying taxes up-front on its converted balances so that in the qualified distributions taken by the participant during retirement may not be taxed.   Essentially, the participant is paying taxes today to avoid paying taxes in the future.  According to the tax law, both the cumulative contributions and any accumulated earnings are both tax-free when withdrawn by the participant in a qualified distribution.  In order to qualify for tax-free status, among other criteria, the assets must be held in the Roth account for at least five years prior to distribution.

Eligible Pre-Tax Amounts

Prior to the new regulations, the only amounts in a pre-tax retirement plan that were eligible for Roth conversion were amounts that were otherwise distributable under tax law.  The new expansion of eligible amounts now covers all vested assets within a pre-tax plan including those that were previously excluded from conversion.

The Notice clarifies that plan sponsors may decide and restrict the types of vested contributions eligible for conversion within their own plan.  The frequency of conversions is also left to the discretion of the plan sponsor.  The plan sponsor must ensure, however, that any restrictions that are implemented do not  disproportionately favor highly compensated employee.

Tax Considerations

The guidance specifically identifies in-plan Roth conversion amounts as not being subject to income tax withholding.  This means that when a participant converts a pre-tax amount to an after-tax Roth amount, the income tax withholding for the year will be insufficient to cover their annual tax liability.  The conversion will trigger an increase in tax liability and the Notice warns that employees who choose to partake in the in-plan Roth conversion either increase their withholding rates or make estimated tax payments to cover the additional income tax liability

Administrative Considerations

Despite characterizing Roth conversions as in-plan "rollovers" from non-Roth to Roth accounts, the new law does not require plan administrators to provide Code section 402(f) notices regarding the tax implications of rollover distributions to participants who choose the make in-plan Roth conversions of non-distributable amounts.

Distribution Restrictions

Any amounts with specific distribution restrictions that are selected for conversion from pre-tax to after-tax Roth amounts will retain those same restrictions after the completion of the conversion.  The IRS suggests that for the simplicity of recordkeeping purposes, plan sponsors simply exclude those amounts with distribution restrictions from the amounts eligible for conversion.  Again, the Notice leaves the determination of eligible assets entirely up to the plan sponsor.  This would eliminate the need to track different converted amounts with different distribution restrictions, dramatically simplifying recordkeeping.

Qualified Roth Distributions

Several requirements must be met for Roth distributions to be considered qualified and therefore tax-free.  Primary among these criteria is the five-year period for qualification.  A qualified distribution must come from a Roth account made more than five taxable years after the first year the participant contributed to the Roth account.  In order to calculate the five-year period, the IRS has stated that if an in-plan Roth conversion is a participant’s first contribution to a Roth account in the plan, the five-taxable-year period begins on the first day of the taxable year in which the in-plan Roth conversion was made.

Converted Excess Contributions and Deferrals

In some cases, contributions and deferrals may later be determined to be in excess of limits.  Excess contributions may occur under the Internal Revenue Code (IRC) nondiscrimination rules.  Excess deferrals may occur under the IRC individual deferral limit.  If any converted amounts are  determined to be in excess, those amounts must be distributed from the Roth account.  This includes amounts that were previously designated non-distributable at the time of the in-plan Roth conversion.

Amending the Plan Document

In order to offer in-plan Roth conversions plan sponsors must amend their plan document before the end of the first calendar year in which they choose to add the feature.  For safe harbor plans with mid-calendar year-ends, the IRS allows for such plans to implement in-plan Roth conversions immediately. 

Conclusion

The Internal Revenue Service (IRS) recently issued guidance on the new legislation that could significantly expand the use of in-plan Roth rollovers in defined contribution (DC) plans.  Plan sponsors have the opportunity to offer expanded in-plan Roth conversions and should seriously evaluate the feature in light of their plan demographics, income levels and tax brackets before deciding to add this feature.

QDIAs Offer Fiduciary Protection

Barbara E. Williams, CFA

Managing Director

Bridgebay Financial, Inc.

www.bridgebay.com

The Pension Protection Act (PPA) of 2006 introduced the qualified default investment alternative (QDIA) as a safe harbor investment. The final QDIA regulation issued in October 2007 was followed by a DOL fact sheet and Field Assistance Bulletin (FAB) No. 2008-03 in April 2008.

At that time the DOL issued regulations to guide plan sponsors in the selection of appropriate default investments for the employer defined contribution plan.  QDIAs generally apply to any participant that is enrolled in the retirement plan and has not made an investment choice or has not made an “affirmative investment” selection.  QDIAs are most frequently used to default employees under automatic enrollment. 

The DOL designated the types of investments that qualify as QDIAs which include age-based asset allocation funds (target-date funds), risk-based asset allocation funds, managed accounts and balanced funds. The DOL regulation did not include stable value funds, GICs and money market funds as QDIAs.

Since the DOL’s QDIA regulation, most plan sponsors have designated a QDIA for their defined contribution plan’s automatic enrollment default investment.  Target-date funds have become the most popular QDIA choice by plan sponsors. 

Target Date Retirement Funds - Tips for ERISA Plan Fiduciaries

In February, 2013 the Department of Labor’s EBSA released a fiduciary guidance for plan sponsors to establish a process for evaluating, selecting, and monitoring target-date funds. QDIA options should be evaluated for  transparency, overall performance, risk management, fees and participant understanding. 

The publication highlights that plan fiduciaries should: 

1.  Establish a process to compare and select TDFs against peer groups and benchmarks

2.  Develop a periodic review process to ensure performance and soundness

3.  Understand the glide path, asset classes and underlying investments  

4.  Evaluate expenses for reasonableness

5.  Consider custom or non-proprietary TDFs as alternatives  

6.  Develop effective employee communications specific to TDFs

7.  Use independent, third party resources to evaluate TDFs

8.  Document the decision making process

Safe Harbor Conditions for QDIAs 

The QDIA regulation offers a safe harbor for plan sponsors seeking legal protection from fiduciary liability for enrolled participants that do not make an investment selection.  The QDIA regulation, however, still requires that fiduciaries prudently select and monitor QDIAs. 

Plan sponsors must meet certain conditions in order to benefit from safe harbor protections:

•        Participant balances must be invested in the plan’s designated QDIA

•        Participants must have been given an opportunity to make an investment decision and decided not to make a selection

•        Participants must be notified in advance of the initial QDIA investment, followed by annual notifications

•        The notice should include an investment prospectus

•        Participants must be able to change out of their QDIA investment, at least quarterly or comparable, into other investments in the plan

•        Participants must be able to opt-out of the plan and/or the QDIA without incurring high fees or penalties 

ERISA Section 404(c) Safe Harbor

•        Compliance with ERISA Section 404(c) may relieve plan fiduciaries of liability for investment losses from a participant that exercises control over assets in their account.  The plan must offer a broad range of investment choices and the participant must be able to exercise control in their accounts.  

•        Default investments that qualify as QDIAs can also provide plan sponsor protection under ERISA Section 404(c).  Under this safe harbor, the plan sponsor is not liable for investment losses by the participant as long as the plan sponsor has made the appropriate QDIA notifications, provided opportunity for opt-out, and conducted a due diligence in the selection and monitoring of the QDIA for the plan.  

•        Plan sponsors select a QDIA so that they may have a fiduciary safe harbor when they default participants to the investment option and use auto-enrollment to increase plan participation. 

•        Plan sponsors tend to select a QDIA in conjunction with automatic enrollment when their participants do not make their own investment selection.  

•        The QDIA affords fiduciary protection to the plan sponsor in the designation of a default option, however, the fiduciary is still responsible for the investments' due diligence, understanding, selecting, monitoring the funds and fees of the QDIA investments. 

Conclusion

Surprisingly, given the safe harbor available to plan fiduciaries by including a QDIA in the plan and relying on the 404(c) safe harbor, there are still some plan sponsors that have not updated their plans and are inadvertently foregoing the safe harbor protections available to them.  Amazingly, there are still plan sponsors that may not be aware of the advantages and fiduciary relief offered by using QDIAs.  There is still a strong need for fiduciary education for plan sponsors. 

Plan sponsors that were prompt to adopt a QDIA for their plans are now re-evaluating the QDIA they had originally selected to ensure that the choice is still appropriate for the plan.  A QDIA review entails the same level of investment due diligence applied to other investment choices in the plan's fund line-up.

Investment Oversight Best Practices

Nicholas Zaiko

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

The employer-sponsored defined contribution (DC) plan now represents the primary retirement savings vehicle for most employees.  The increased size, complexity and recent 401(k) plan litigation, demands greater scrutiny of the plan's investment options in addition to enhanced administrative oversight.  These issues are not limited to the 401(k) plans but also 403(b) plans that are under ERISA and DoL.   

Revisiting the Oversight Role

The increased significance of the role of the DC plan now demands additional expert focus on the investment options offered to the participants.  The oversight structure should also adapt to consider the changing relationship between the plan sponsor and the service provider as assets in the DC plan grow.  Additional services may be required as the plan grows and the service providers' ability to deliver those services in a cost-effective way must be evaluated.  Failing to achieve enhanced services or reduced fees as a DC plan grows may result in an unintentional fiduciary breach on behalf of the plan sponsor as recent litigation has shown.  The sponsor may also fail to meet its fiduciary duty to participants if the participation rates, investment selection and education programs are not closely monitored and maintained.

Investment Oversight

The most effective way to increase investment oversight is to include members of the treasury or finance departments in the plan oversight committee.  This is an evolving trend that is spreading throughout the DC market.  Since traditional pension plans or defined benefit (DB) plans directly impact the financial statements, the CFO or Treasurer are typically heavily involved in both the administration and investments in those plans.  In contrast, the DC plan has had minimal impact on the employer's income statement and has historically been overlooked by the treasury group.  Recent litigation on fees and fiduciary breaches have demonstrated that DC plans can have an adverse monetary impact the employer's finances.    Employing the same robust oversight historically reserved for the DB plan to the DC plan will greatly enhance fiduciary compliance and minimize risk.  

As plan assets grow, plan sponsors may consider retaining the services of an independent, retirement plan consultant that has the benefit of working with many different plan providers, investment funds/managers and plan sponsors.  Many bundled 401(k) plans have relied on the affiliated investment consultant provided by the recordkeeper that is an employee of the recordkeeper's parent organization.  Periodically, a plan sponsor should seek a deep-dive review of the investment recommendations by an independent third-party advisor to ensure that the investment line-up is best in class with reasonable fees.

The expertise of a retirement plan advisor will assist the plan sponsor in ensuring that plan fees and services are competitive with other plan providers.  An independent consultant can also point out any deficiencies in the administration of and the investments in the plan. 

The Plan Committee

Plan sponsors should pay close attention to the size and composition of their investment committee.  The cornerstone of an effective committee is ensuring that all members represent experts in their particular field of focus.  The best committees are well rounded, drawing from several different departments.  Each member should focus on a particular area of the plan which aligns with their particular expertise and take the lead in major decisions.  For example, the ERISA attorney should have greater direct input and authority on providing fiduciary and compliance advice.  Similarly, the Treasury professional should focus on the investments, leaving legal compliance issues to the ERISA attorney.  The administrative requirements of the plan should be provided by the benefits manager and Human Resources representative.  Additionally, an advocate for the participants and employees should also provide input to the committee.  Well defined roles and segregation of duties is crucial for an efficient and effective oversight committee.

The committee should be sufficiently small as to avoid getting bogged down in procedure and scheduling conflicts and allow sufficient time for proper oversight by each member.  Exceedingly large committees may have problems assembling enough members at any one meeting in order to establish a quorum and thus inadvertently delay crucial plan decisions. 

Investment vs. Administrative Decisions

Investment and administrative timelines tend to differ dramatically and can often conflict.  Many challenges arise when trying to fit investment decisions into administrative timelines.  The conflict may become so great, that investment decisions end up being made based on administrative pressures rather than investment priorities.  These types of decisions can potentially represent breaches of the plan sponsor's fiduciary duty to the plan participants.  For example, leaving an underperforming fund in the plan because of administrative restrictions after the committee has decided to remove or replace the fund may open the door to fiduciary liability.  On the flipside, the plan investment policy should not be written in such a way as to rigidly trigger automatic action regarding a fund.  The policy should reflect a structure of monitoring that involves the evaluation of numerous important factors.  Any action taken regarding a fund should be reviewed and documented by the committee.

Investment Review Process

A well-designed and methodical investment review and search process is the hallmark of the top institutional DC plans.  Any changes made to the plan should be done so in a well thought out approach which takes into account investment considerations.  While administrative considerations are omnipresent, they should simply inform but never interfere with critical investment decisions.  There are some steps that can be taken to reduce administrative burdens such as utilizing a multi-manager framework and using asset class specific funds.  This makes it significantly easier to simply replace an underperforming fund with a similar fund with better performance.  The best plan sponsors also have an established search process in case a fund change is required at any time, rather than relying on a pre-determined periodic review.  This allows the committee to act swiftly in the case of an unexpected event.  Though periodic review is important, searches should be conducted in response to external events and not simply be restricted by the calendar.

Conclusion

Now rivaling the traditional pension or defined benefit (DB) market in scale, DC plans have taken center stage in employees' retirement future.  As such, professional, expert scrutiny of the investments offered to plan participants is becoming increasingly important.  The plan committee composition and size are crucial to providing diligent and effective oversight in order to protect against fiduciary risk.  Engaging the broad knowledge and specific expertise of an independent investment consultant to share the burden of co-fiduciary status affords the sponsor further protection and market insight.   A detailed and methodical review and search methodology, coupled with a comprehensive pattern of documentation is the one of the best ways to fulfill the sponsor's fiduciary duties to the plan participants.

Implement an Education Strategy

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

The best way to implement an effective education strategy is to create an Education Policy Statement that establishes an overriding framework for deploying and measuring the effectiveness of participant communications.  The process of formally documenting the strategy in a policy statement helps ensure that the program will be focused, effective, and quantifiable. 

By establishing specific goals in the policy, educational campaigns can be more easily assessed and positive results measured against identified criteria.  The process of creating the policy turns nebulous notions of improving participant financial literacy into specific, discrete goals that can be used to guide the educational efforts of the program.

An Education Strategy guides the development of ongoing participant communications and education.  The strategy focuses on specific demographics or employee segments that need targeted education and messaging.  The strategy should identify specific types of desired results and include a calendar for delivering the education, milestones and how the program’s success will be measured.

Getting Started

An Education Strategy can document the objectives of the education program, content of the educational meetings, webinars, seminars, topics to be covered, and feedback or survey results.  There are several plan statistics that can be helpful in identifying areas for improved participant communications which include participation rates, average deferral rates, asset allocation among funds, and average participant balances.  All of this data can be provided by the recordkeeper and sliced by age, income group or geographic location.   Different savings patterns can be further evaluated by employee salary levels, divisional location, experience level and age.  These statistics, supplemented with employee surveys, can be utilized to identify certain populations of employees that face similar challenges in retirement plan savings. 

Once some of the challenges have been recognized, relevant goals, objectives, action plans and an education program can be developed to achieve stated goals. 

Employee Surveys

A well designed employee questionnaire or survey can be instrumental in identifying misconceptions about the retirement plan, employee benefits and areas of interest to employees.  The results of this survey may highlight areas for increased participant communication and educational needs. 

Plan sponsors can also benefit from industry data available through the recordkeeper and plan advisor that compares the plan to peer groups with similar workforces.  These industry surveys and benchmarking studies can be helpful in designing the plan and the communications program to enhance participant satisfaction and employee retention.

Setting Goals

Different measures of success can be used to establish specific goals.  Some typical milestones include increasing participation levels among a specific demographic, growing balances among certain salary levels, increasing contributions for participants stuck at a low percentage, broadening overall savings, improving asset allocation for participants in one undiversified fund, or improving personal returns.

Determining the Goals

The Education Strategy should focus on the issues or communications gaps that must be addressed.  Not participating in the retirement plan, inadequate deferral rates or excessive loan taking can all be areas for further education.  Employee groups to be targeted with specific educational topics can be prioritized in the annual education plan. 

The communications objectives should be stated to provide a clear message in the educational campaign.  Document the education campaigns to be delivered for the year by topic, targeted group, frequency, and delivery method.  Establishing an annual communications calendar that highlights the specific schedule for the various educational programs is critical for a well-orchestrated program that is measurable and repeatable. 

Finally, define the annual goals and objectives and how they will be evaluated and measured.  This is an opportunity to define the key metrics to be used to monitor the plan’s effectiveness and identify areas for modification. 

Means of Delivering Education Program

The methods by which the education will be delivered is an integral part of the strategy and planning process.  The use of in-person small group sessions, webinars, seminars, online tools, and participant feedback should be part of the annual plan.

The sequence of educational topics for the general audience as well as more targeted communications for specific employee demographics is important.  Certain topics may address the unique financial wellness and planning for women while other topics may be more relevant to young parents or recent graduates or new hires.  The topics should be segmented by stages in life and unique needs.

Topics to Be Presented

The education strategy should have a process for the review of all educational materials to be presented to the participants to screen for sales pitches or other services that would be a conflict of interest.  The annual plan should include a list of presentation materials that have been reviewed by the plan sponsor in advance for relevance and educational value. 

Measure Milestones and Education Success

Metrics for measuring the success of specific educational campaigns should be established in advance and should be used to evaluate the factors that contributed to the session’s success or help explain why the program missed the mark with participants.  Later sessions can be modified to absorb the feedback from participants.  By setting expectations in advance, results can be measured to determine the effectiveness of the program and set standards for future improvements. 

The effectiveness of a program can be measured by changes in participation rates, deferral rates, fund changes, or increased usage of service provider services following an educational program.  Follow up may also include a participant survey which can provide actionable information. 

Educational programs should be developmental and sequential.  They should target different participant groups by topic and interest.  Simply providing introductory and enrollment meetings does not educate participants nor do they gain financial literacy.  Educational plans should provide a foundation upon which to progressively build the participants’ knowledge of financial topics that are relevant to them.