Making the Most of Your Match

Arnerich Massena, Inc. April 2012 Contributors: Scott Dunbar, JD; Vincent Galindo; Jillian Perkins; Jacob O Shaughnessy, CFA

Table of Contents Introduction... page 3 How are employers currently making matching contributions?... page 3 Matching effects... page 5 Participation Contribution rates Employee satisfaction Retirement outcomes Designing a match program... page 8 Matches are making a comeback... page 10 Endnotes... page 11 Arnerich Massena, Inc. 2

Making the Most of Your Match The financial crisis of 2008 saw company matching contributions eliminated for scores of American workers. By 2009, 11.2 percent of plans had suspended their company match. But the match is making a comeback; only 2.1 percent of employers were continuing their match suspension in 2010. (PSCA, 2010, 2011) Now, more than 93 percent of companies make some sort of contribution to employees retirement savings, and nearly 40 percent use a matching formula in order to do so. An employer match has a clear value to employees, but how do employers maximize that value? Match amounts, match formulas, and vesting schedules vary widely across plans. The match formula may affect safe harbor, participation, non-discrimination testing, contribution rates, automatic features, employee retention, and, perhaps most importantly, retirement outcomes. We ll take a look at some of the options and how they re currently used, and then explore the ways that you and your employees can reap the greatest benefit from a match. How are employers currently making matching contributions? The Profit Sharing/401(k) Council Annual Survey of Profit Sharing and 401(k) Plans provides a useful overview of how companies are currently contributing to employees retirement plans. 65 percent of plans that offer a match provide a fixed match, while 35 percent offer a graded match (including safe harbor and service-based matches). (PSCA, 2011) Table 1 on the following page illustrates the rates of use of different matching formulas in plans with fixed and discretionary matches. Current vesting schedules are implemented as follows: Vesting Schedule Percentage of Plans Immediate full vesting 37.3% 2-Year Cliff Vesting 5.5% 3-Year Cliff Vesting 11.3% 3-Year Graduated Vesting 3.8% 4-Year Graduated Vesting 1.8% 5-Year Graduated Vesting 19.7% 6-Year Graduated Vesting 16.7% Other 4.0% Source: PSCA, 2011 Arnerich Massena, Inc. 3

Table 1: Matching formulas used in plans with fixed and discretionary matches Cents matched per $1.00 Percentage of Plans Less than $0.25 per $1.00 1.5% $0.25 per $1.00 14.2% on the first 4% 2.7% on the first 5% 0.3% on the first 6% 6.2% More than $0.25 and less than $0.50 per $1.00 3.6% $0.50 per $1.00 47.5% on the first 3% 7.1% on the first 4% 5.6% on the first 5% 3.9% on the first 6% 26.1% on the first 7-8% 2.1% on the first 10% 0.6% other 2.1% More than $0.50 and less than $1.00 per $1.00 4.2% $1.00 per $1.00 27.9% on the first 2% 2.1% on the first 3% 4.7% on the first 4% 7.1% on the first 5% 3.9% on the first 6% 7.7% other 2.4% More than $1.00 per $1.00 1.2% Note: 4.0 percent of companies match up to a specified dollar amount rather than a percentage of pay. Source: PSCA, 2011 Arnerich Massena, Inc. 4

Matching effects In order to make decisions about how to structure a company match, it is valuable to evaluate its impact on different aspects of a plan. Participation It has been suggested that, outside of individual factors such as age and income, an employer match is one of the two most important determinants of whether an employee will participate in their plan (the other being, according to this study, access to money via a loan feature). (Munnell, Sunden, Taylor, 2002) However, some studies have shown that with regular, opt-in participation, the effect of having an employer match is fairly small. While most researchers seem to agree that a company match increases participation, different studies have shown varying degrees of effect. In plans that utilize automatic enrollment, it has been shown that the auto-enrollment feature has a dramatic impact on participation rates. Since most auto-enrollment plans offer a company match, it is difficult to determine its impact on participation, but one study found that reducing or eliminating the match reduced participation by about 1.8 to 3.8 percentage points for each percentage point decrease in the maximum match. [This] leads us to conclude that automatic enrollment participation rates are positively related to match generosity, but the magnitude of this effect is modest. (Beshears, Choi, Laibson, Madrian, 2007) Ironically, some forms of employer contributions, such as maintaining a separate defined benefit plan or providing profit sharing contributions can be a disincentive to participation in a defined contribution plan. Employees may feel as if they are already building up enough of a nest egg through employer-provided funds and that there is thus less need to save for retirement on their own. Contribution rates Depending on the match design, participation rates of non-highly compensated employees increase by 5 to 15 percentage points as the result of a match, a meaningful though modest incentive effect. In the typical plan, about 60% of nonhighly compensated employees would join their retirement savings plan regardless of the match; 10% would participate due to the match; and nearly 30% of non-highly compensated employees fail to join regardless of the match, despite the fact that the match offers a return premium on their contributions. - Utkus, 2005 Employer matching contributions have been shown to affect participants contribution rates, but varying amounts and structures of matches impact deferral rates differently. A match will typically incentivize a large proportion of employees to save enough to capture the match. However, there are two pitfalls. One is that Arnerich Massena, Inc. 5

many employees will save only enough to capture the match. In this case, the match serves as a disincentive for employees to increase their savings rate beyond the level of the match. Compare two plans: one offers $1.00 for each dollar up to 3% of pay, and the other provides $0.50 for each dollar up to 6% of pay. Both plans offer the same maximum match available, but the first one only provides employees incentive to save 3% of their salary, whereas in the other, employees must save at least 6% of their salary to capture the full match. And indeed, plans with the second structure will typically find a higher rate of contribution among non-highly compensated employees. However, even in the second plan, a large number of employees will not increase their contribution rates higher than 6%. The second pitfall is in providing an extremely generous match. This has the same impact as providing a defined benefit plan or profit sharing contributions; employees feel that their retirement is already taken care of and there s no need to boost their own savings rates above the rate necessary to receive the match. Larger matches have indeed been found to negatively affect employee deferral rates. (Munnell, Sunden, 2003) One method the industry has developed to counter this is automatic deferral increases. Not only does it override participant inertia, but it also gives employees a different frame of reference from which to view their retirement savings. Consider a plan that auto-enrolls participants at 2% of their salary and provides matching contributions on the first 5% of their salary. The implication participants might draw from this is that 5% is the optimal amount to save, and therefore maintain a 5% deferral rate (it never even occurring to them to save more). By implementing automatic deferral increases (in which participants deferral rates automatically increase each year by a set amount, typically 1% to 2 %) up to 10%, you are not only giving participant inertia an opportunity to work to a higher degree, but even if participants opt out before they reach 10%, they are making that decision in a different context. The 10% maximum implicitly suggests that 10% is the optimal deferral rate, and automatically becomes a goal in the mind of participants. Employee satisfaction One of the main reasons plan sponsors institute employer-matching contributions to a retirement plan is to attract and retain personnel. As the number of defined benefit plans dwindles, the defined contribution plan has become the primary source of retirement savings for American workers. Many workers recognize and appreciate the value of a defined contribution plan and accompanying matching contributions. [This] study provides evidence that the large positive association between employee tenure and 401(k) participation is because stayers tend to be savers. Firms that offer a defined contribution plan, and particularly firms that offer matching contributions, are more likely to attract employees who are savers. - Even, Macpherson, 2004 Those employees are, in turn, more likely to stay with an employer, whereas nonsavers are often those less likely to be long-term employees. (Even, Macpherson, 2004) Given the penalties and restrictions involved in retrieving their savings early (and the potential loss of non-vested matching contributions), employees who don t plan on staying will typically not view a defined contribution plan as having the same value as would an employee looking to the long term. Thus, by offering a defined contribution plan with an appropriate matching feature, employers can help weed out short-term employees and increase employee tenure. Arnerich Massena, Inc. 6

Retirement outcomes While many plans gauge success based primarily on participation rates, the ultimate end-game of all retirement plans is to provide adequate retirement income for participants.thus the question is: how does a match affect retirement income replacement? How much does it improve retirement outcomes for participants? In Chart 1 below, three scenarios are represented. In the first, the employee contributes 3% of salary to a plan with no matching contributions. In the second, a match of $1.00 per $1.00 on the first 3% of salary is provided, incentivizing the employee to save 3% and resulting in a 6% total contribution. In the third scenario, the match is structured to provide $0.50 per dollar on the first 6% saved, resulting in a 9% total contribution. The chart tracks the growth of the accounts over 35 years at a 5% and 7% annualized return. Clearly, the additional savings a match provides increases participants nest eggs, but by adding a match and incentivizing a higher savings rate, the difference in outcome is substantial: at a 7% return, from about $172,000 after 35 years with no match, to almost $350,000 with a 3% dollar-for-dollar match, to more than $500,000 with a tiered 3% match that encourages 6% employee savings. This does not take into account any growth in the participants salaries, which would even further magnify the benefits of the matches. Chart 1: Growth of accounts over 35 years 9% contribution 7% rate of return 5% rate of return $516,627 6% contribution 7% rate of return 5% rate of return 3% contribution 7% rate of return 5% rate of return $344,418 $334,194 $222,796 $172,209 $111,398 For illustrative purposes only. Assumes $40,000 fixed annual salary, 5 and7% annualized returns 35 years Arnerich Massena, Inc. 7

Designing a match program No single, most efficient match structure exists that works for everyone. You will want to consider a number of variables, and identify clearly what you would like to accomplish by offering matching contributions. For instance, your goals may include: Attain safe harbor from discrimination testing Attain safe harbor for automatic enrollment Increase participation in the plan Incentivize employees to save more Provide employees with an additional source of retirement savings Improve employee retirement outcomes Attract individuals to employment with your organization Improve or maintain employee tenure Provide compensation in a deferred form to maximize tax benefits Simply share your organization s success with employees If your priority is attaining safe harbor status, either for non-discrimination testing or automatic enrollment, your primary concerns may be meeting the requirements and cost. These will likely drive how your match program is structured. However, you may want to take into consideration how, within those constraints, you can accomplish some of these other goals. Small adjustments to the structure of a match can achieve significant effects. To incentivize employee saving and improve retirement outcomes, consider a tiered match. For instance, instead of offering a dollar-for-dollar match up to 3%, offer a $0.50-per-dollar match up to 6%. Some employers use multiple tiers, such as offering $0.50 per dollar up to 3%, and $0.25 per dollar between 3% and 9%. While any match is likely to help attract employees, different structures may affect the types of employees you attract. A generous match with immediate vesting, for instance, will be attractive to everyone. But a graded match with a longer vesting schedule may help to draw in candidates who are looking for a more long-term employment option. Arnerich Massena, Inc. 8

Safe Harbor Match In order to attain safe harbor from ADP* testing, you can either make a non-elective contribution equal to at least 3% of compensation to all eligible employees, or you can provide employer matching contributions that meet the following requirements: The safe harbor portion of any matching contributions must be immediately 100% vested and be ineligible for hardship distributions and in-service withdrawals prior to age 59 1/2. A basic match must match 100% of employee salary deferral up to 3% of compensation and 50% of employee deferral from 3% to 5% of compensation. Employers may use a different formula or provide a higher match, but it must be at least equal to the basic formula, and the rate cannot increase as an employee s rate of elective deferrals increase (for instance, you could match 150% of elective deferrals up to 3%, but not 50% of deferrals up to 6% and 100% for elective deferrals greater than 6%). To meet ACP* safe harbor requirements, you must meet the following additional requirements: Matching contributions cannot be based on employee elective deferrals in excess of 6%. Other discretionary matching contributions cannot exceed 4% of an employee s compensation. To attain safe harbor for automatic enrollment, keep in mind that you must provide for automatic escalation of employee deferrals from a minimum of 3% in the first year to 4% in the second year, 5% in the third year, and 6% for all later years up to a maximum of 10% in any given year. *ADP and ACP testing refer to Actual Deferral Percentage /Actual Contribution Percentage tests required by the IRS for qualified plans annually to ensure that all employees are benefitting equally from the plan (i.e. that the plan does not discriminate in favor of highly compensated employees). To encourage participation in the plan, nothing seems to work as well as implementing automatic enrollment. With or without automatic enrollment, however, a match can provide some incentive to increase participation. If this is your primary goal, you might consider keeping the match more generous at the lower levels of deferral rates (i.e. a dollar-for-dollar match), rather than introducing a graded match, which could be intimidating for participants just starting out. Communication and education are essential to a successful match program, no matter what the goal or structure. If employees are not told and reminded of the value of the match, it will have little impact on their retention or satisfaction, and any incentive potential is not maximized. It is important to develop a strong Arnerich Massena, Inc. 9

communication program that incorporates a variety of methods to demonstrate how the match is helping employees reach their retirement savings goals. Use projections to illustrate the long-term value of the match, and to encourage employees to save more themselves. If you do not incorporate automatic deferral increases, your education program is a great tool to establish the context of saving for participants. Rather than focusing on a 3% or 5% deferral rate, show projections that also illlustrate a 10% or 12% deferral rate, primarily so that participants don t stop at 5% because anything higher is outside their awareness. Matches are making a comeback As employer matches are reintroduced to the American workforce, employees will begin to see this benefit as an important part of their retirement savings plan. With tax incentives, providing a match may not be as costly as you think. If you haven t already, begin researching the costs and consider the potential benefits of introducing a match to your retirement plan. Most importantly, make sure that you maximize the value for both the plan sponsor and the participant. Arnerich Massena, Inc. 10

Endnotes: Beshears, John; Choi, James J.; Laibson, David; Madrian, Brigitte C.: The Impact of Employer Matching on Savings Plan Participation Under Automatic Enrollment, National Bureau of Economic Research Working Paper 13352 Even, William E.; Macpherson, David A.: Determinants and Effects of Employer Matching Contributions in 401(k) Plans, Miami University Department of Economics and Florida State University Department of Economics, May 2004 Lincoln Financial Group: Detailed information on safe harbor contributions to 401(k) plans, May, 2009 Munnell, Alicia H; Sunden, Annika: Suspending the Employer 401(k) Match, Center for Retirement Research at Boston College, June 2003, Number 12 Munnell, Alicia H.; Sunden, Annika; Taylor, Catherine: What Determines 401(k) Participation and Contributions?, Social Security Administration Perspectives Profit Sharing/401(k) Council of America (PSCA): 53rd Annual Survey Reflecting 2009 Plan Experience 2010 Profit Sharing/401(k) Council of America (PSCA): 54th Annual Survey Reflecting 2010 Plan Experience 2011 Utkus, Stephen P.: 401(k) Plan Design: Match, Loan, and Investment Menu Effects, Vanguard Center for Retirement Research, Vol. 21, December 2005 2012 Arnerich Massena, Inc. All rights reserved. This material is provided for informational purposes only to clients and prospective clients of Arnerich Massena, Inc. It is drawn from third-party sources believed reliable but not independently verified or guaranteed by Arnerich Massena. We do not represent that it is accurate or complete, and it should not be relied on as such. It does not constitute investment advice, which would need to take into account a client s particular investment objectives, financial situation, and needs. Opinions expressed are our current opinions as of the date appearing on this material. Past performance does not guarantee future results. Investments and strategies discussed herein may not be suitable for all readers, and you should consult with a legal, tax, or accounting professional before acting upon any information or analysis contained herein. The information, ideas, and context expressed herein are confidential, proprietary, expressly copyrighted and may not be sold, reproduced, republished, or distributed in any way without Arnerich Massena s prior written consent. Arnerich Massena, Inc. 11