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Tread carefully when rolling over—or keeping—401(k) fund balances for departing employees.
Employers who sponsor 401(k) retirement plans are facing complex issues as they increasingly deal with departing and retiring employees who have vested balances in their accounts. While the decision about what to do with the money lies in employees’ hands, plan sponsors must make some decisions about how to handle these accounts.
Too often, younger workers ask employers to cash out their 401(k) balances. A study conducted last year by Hewitt Associates, the Lincolnshire, Ill.-based benefits consultant, found that 68 percent of workers aged 20 to 59 who are enrolled in 401(k) plans opt to take cash when they change jobs.
"People don’t have the fortitude to leave it alone," says Robert Wuelfing, administrator of the Society of Professional Administrators and Recordkeepers, an association of investment managers in Simsbury, Conn.
Of course, employees get heavily penalized for cashing out. Federal law mandates that 20 percent of the amount must be withheld for income tax purposes, and another 10 percent in federal excise taxes will be chopped off if the employee takes the cash prior to reaching age 59½.
Ideally, employees will choose one of the other options for their long-term nest egg: leave the money where it is; roll it over into an Individual Retirement Account (IRA) on a long-term basis; roll it over into an IRA on an interim basis prior to rolling over to a new employer’s plan; or transfer the funds directly into the new employer’s plan.
$5,000 a Typical Cutoff
Employers have no legal obligation to maintain accounts with a vested balance of less than $5,000, although a few do. Most employers use this threshold, specifying in plan documents that amounts less than $5,000 will be moved out of the plan.
With these low balances, "There is a strong bias toward distribution," says Fred Reish, managing partner with Reish & Luftman in Los Angeles, which has a client base including both plan sponsors and financial institutions providing 401(k) services. "It is more of a burden to keep the former employee’s money than not." Many employers make the distribution process as easy as possible as a subtle way to encourage a transfer out of the employer’s plan, says Reish
Many clients of benefits and retirement consultant Matthew Hutcheson of Portland, Ore., "clean up" their plans prior to year-end by distributing all terminated participant balances less than $5,000. "Rolling over small balances can be burdensome, so most plans simply distribute as soon as the plan will allow."
Regardless of the amount of the balance, Hutcheson advises giving each participant a 402(f) notice upon termination. A 402(f) notice spells out employees’ options for handling a 401(k) disbursement.
Another Cleanup Option
Employers have another road they can take to close out small accounts, a distribution option blessed last year by the Internal Revenue Service. Revenue Ruling 2000-36 clarifies that employers can structure their plans so account balances of less than $5,000 can be shifted automatically into an IRA if the separating employee fails to express a preference for a cash distribution or a rollover.
Experts say it is not clear how many employers will choose this route. "I think the IRS made the right choice," Hutcheson says, because the ruling sets up a preference for savings over cashout. But he questions what the market response will be. Hutcheson predicts that large companies with a lot of small accounts to close out could have a hard time finding a high-quality investment manager to take on what could turn out to be high-maintenance, low-return IRA accounts. Mid-sized companies with an established relationship with a financial institution or insurance broker may find a warmer reception.
What about plan sponsors who have lost track of a former employee? The revenue ruling provides "a roadmap of how to do it right," says Sherwin Kaplan, a benefits lawyer with Piper Marbury Rudnick & Wolfe in Washington, D.C. The employer must make a serious attempt to find the former employee and get an indication of his or her wishes for disposition of the funds within a reasonable period of time, Kaplan says. If this effort fails to yield an indication of preference from the former employee, the employer should choose "a middle-of-the-road, plain vanilla" investment fund. The process laid out in the ruling and its accompanying footnote makes clear that "this is what you have to do to protect yourself against a mad participant."
Money Can Stay Put
For balances of $5,000 and above, employers must give departing employees or retirees the option to maintain their account if they choose. Departing employees may choose to leave their money with a former employer for many reasons. They might just want time to think over their next step. Their new employer plan might not have a 401(k) plan, or might have one with less attractive investment options or waiting periods that delay eligibility.
From the employer perspective, hanging onto the funds of departed employees raises some potential problems, particularly in terms of communication obligations.
The Employee Retirement Income Security Act (ERISA) sets minimum requirements for communicating with plan participants whether or not they are still with a company. These include distribution of summary plan descriptions and annual reports, and notification of changes in the plan. In addition, some employers schedule informal events, such as brown-bag lunches, to explain plan changes and investment options and give participants an opportunity to ask questions.
"Most employers do more than the minimum," says Kaplan, an ERISA expert and former Department of Labor official. Noting that it clearly is harder to communicate with people who are no longer with the company, Kaplan says "There is no hard-and-fast rule, but the guiding principle has to be that the employer was acting in the interest of the greatest possible number of participants." If there is a difference in the communication with former employees, plan sponsors should take care to document the justification, such as its expense.
Even careful companies run into problems. Reish cites an employer client who decided to switch investment providers. During this process, there is a "blackout period" during which current investments are effectively frozen prior to liquidation and shifting of funds to the new provider. "They thought they had communicated with all their ex-employees during that time, but they hadn’t," Reish says. During that period, the stock market started to slide. The result was a disgruntled former employee who claimed he was locked out of a chance to unload some of his investments due to a blackout period of which he had not been made aware.
A Trend Toward Standing Pat
Despite the complications, David Wray, president of the Chicago-based Profit Sharing/401(k) Council of America (PSCA), says he sees a shift in attitudes about maintaining former employees’ accounts.
"Companies have begun to be more interested in keeping the money in the plans," he says, driven in part by money managers who realize there are financial benefits to keeping participants in the plan, even if their accounts are small. With new technology that simplifies administrative systems and allows for electronic communication, it is not always a significant amount of additional expense and work to maintain small-balance accounts, says Wray. "It’s a recognition of the way systems are managed now—it isn’t necessarily in everybody’s best interest to cash out."
He notes that while many studies have looked at data on rollovers and cashouts, there is limited research on how many former employees keep their money with their old employers’ plans because the data is hard to gather. He cites a recent study by LIMRA International, a Windsor, Conn.-based investment marketing and research firm, that found about 25 percent of "job changers" and 22 percent of retirees surveyed planned to leave their money in their old plans. The study was based on a survey of 1,763 employees, primarily over the age of 30, who were eligible for a lump-sum payment from their employers’ retirement plans.
Another influence prompting employees to stand pat with their 401(k) accounts is the quality of ancillary services, such as investment education and advice. "Many plans do an outstanding job of providing education and advice to their employees, and the employees have become comfortable with that," Reish says. Employees also may be comfortable with benefits information delivery systems that are run through an intranet or the Internet and are "self-serve."
Wray says PSCA is pressing federal regulators to approve an administrative rule change that would allow plans to impose a small charge on former employees to cover the costs of administering their accounts. "Employers do not want to use company money to pay for people who have terminated," he observes. "You don’t want to charge your current workforce to carry those people."
Other Options: IRA or Rollover
Employees who choose to move their funds have three other options: transfer from the former employer’s plan to an IRA; transfer from the former employer’s plan to a "conduit" IRA, which serves as a temporary holding place for a rollover until the participant becomes eligible for another qualified plan; or transfer from the former employer’s plan directly to a new employer’s plan. Employers should make clear to plan participants that if they do not want to be subject to withholding taxes and penalties, the rollover money should not pass through their hands or be payable to them, Hutcheson notes.
For the same reasons, employers should be careful handling rollovers of balances into another employer’s plan, benefits experts advise. Hutcheson says, "Before a plan distributes funds per a participant’s request for transfer or rollover, it is always a good idea to make sure the receiving plan is eligible to receive the funds and that they are also willing to receive them."
Employers are under no legal obligation to accept rollovers, although the vast majority of them do, eventually if not immediately, experts say.
Wray notes that a recent PSCA study found almost 95 percent of surveyed employers accept rollovers. He says the situation is the result of recent regulatory reforms that simplify the rollover process, as well as the influence of a push from employees. "What drives it is what you need to do in the workplace to get the people you need," he says.
Similarly, many employers now allow for immediate, or at least rapid, enrollment in their 401(k) plans, a relatively new development. "With a mobile workforce today and with unemployment as low as it is, most plans are allowing immediate enrollment," says Reish. Another PSCA study released in December found that 52 percent of 348 sampled companies have a waiting period for 401(k) enrollment of only 90 days, 37 percent of them one month or less. Both percentages are up significantly from 1998. Quick eligibility makes a rapid rollover possible as well.
Even if an employer is willing to accept the rollover funds, HR departments should ascertain the eligibility of plans to receive a rollover. Hutcheson notes that a 401(k) disbursement can be rolled over into an IRA or comparable 401(k) plan, but cannot be rolled over into a different type of plan. For example, the funds cannot be rolled over if the new employer’s plan is a 403(b) plan, a retirement plan offered by non-profits and educational institutions. For the receiving plan, the best way to ensure compatibility is to request a copy of the distributing plan’s determination letter, Hutcheson says. If the letter is unavailable, he advises employers to request a written statement from legal counsel or a plan fiduciary stating that the plans are compatible.
Rollover mistakes rarely prompt serious legal problems, "but it becomes an administrative nightmare for the HR people, because they are a lightning rod for criticism," he notes. "Little mistakes like that can really erode one’s credibility."
Some aspects of the process would be simplified under legislation that Congress is expected to take another look at this year. Last year, the House voted 401-25 to approve a pension reform bill that included provisions that would allow employees to shift retirement fund balances among various types of defined contribution plans without restrictions. The Senate did not take up the proposal, which includes numerous other changes in pension law, but proponents plan to press ahead.
Hutcheson says it’s not clear if the legislation will be taken up soon. But he notes the portability provisions have a fair amount of general support because they would make it easier for a mobile workforce to build retirement savings and avoid "leakage" of assets. "There’s a significant push to make all of these plans compatible, so that no matter where you come from, you can move your money around," he says.
Charlotte Garvey is a freelance writer, based in the Washington, D.C., area, who reports on business and environmental issues.
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