On December 20, 2019, the President signed the Further Consolidated Appropriations Act, 2020 into law. This year-end spending package included the most extensive retirement plan legislation in over a decade - the Setting Every Community Up for Retirement Enhancement (SECURE) Act. After the SECURE Act was passed by the House, I judged the bill a mixed bag of good, bad, and ugly – the good representing welcome reform, the bad representing undue complexity, and the ugly representing handouts to the financial industry. That view has not changed now that the bill is law.
Below is a summary of the major SECURE Act provisions applicable to 401(k) plans. My analysis of each change – as well as its effective date – is included.
Small Business Tax Credits
Before the SECURE Act, a small business (up to 100 employees) could claim a tax credit equal to 50% of their retirement plan startup costs, up to a $500 limit. Now, the limit is the greater of (1) $500 or (2) the lesser of (a) $250 multiplied by the number of non-highly compensated employees eligible for plan participation or (b) $5,000. This credit is available for up to three years
Small businesses can earn an additional $500 tax credit by adding an automatic enrollment feature to a new or existing 401(k) plan. The credit is available for each of the first three years the feature is effective.
According to a recent Pew study, the top reason why small businesses do not sponsor a 401(k) plan today is cost. The SECURE Act’s higher tax credits should help address that concern. That said, I would have preferred a perennial tax credit. An ongoing credit should not only incentivize more long-term plan sponsorship, but also the payment of 401(k) administration fees from a corporate account instead of plan assets – which automatically increases the investment returns of plan participants.
Both credits are effective for tax years beginning after December 31, 2019.
The deadline for employers to establish a new 401(k) plan is extended from the last day of the tax year until the due date of the year’s tax return (including extensions).
I like this change a lot. It gives employers additional time to allocate a year-end profit sharing (nonelective) contribution to their employees.
Change is effective for tax years beginning after December 31, 2019.
Safe Harbor 401(k) Plans
The following changes apply to safe harbor 401(k) plans that employ a nonelective contribution (not a match):
Eliminates the annual safe harbor notice requirement
Permits a 401(k) plan to add a 3% safe harbor nonelective contribution at any time up to 30 days before the close of the plan year.
Permits a 401(k) plan to add a safe harbor nonelective contribution after the 30th day before the close of the plan year when 1) the amendment to adopt safe harbor 401(k) status is made by the end of the following plan year (the deadline for distributing ADP/ACP corrective refunds) and 2) the nonelective contribution is at least 4%.
All of these changes are welcome. They will simplify safe harbor plan administration and improve the retirement readiness of more workers.
All changes are effective for plan years beginning after December 31, 2019.
QACA Automatic Enrollment
The default contribution limit for a Qualified Automatic Contribution Arrangement (QACA) safe harbor 401(k) plan is increased from 10% to 15% following a participant’s first year of plan participation – the 10% limit still applies for the first year of participation.
A higher default limit could help all QACA plan participants save more – not just the defaulted ones. Many participants view a default contribution rate as a de facto recommendation. While no game-changer, this change should increase some 401(k) participant deferral rates
This change is effective for plan years beginning after December 31, 2019.
The following changes apply to 401(k) distributions:
- The age at which 401(k) plan participants must start taking Required Minimum Distributions (RMDs) is increased from 70½ to 72. RMDs for non-5% owners can still be postponed until the year the participant terminates employment if later. This change is effective for participants who turn 70½ after December 31, 2019.
- Before the SECURE Act, an individual (i.e., human being) 401(k) beneficiary could “stretch” distributions from an inherited account over the course of their lifetime. Now, only an “eligible designated beneficiary” – a surviving spouse, a minor child, a disabled person, a chronically ill person, or any person not more than 10 years younger than the employee – can do so. Other 401(k) beneficiaries must fully liquidate their account within 10 years of the decedent’s death. These new rules generally apply with respect to participants who die after December 31, 2019.
- Penalty‑free distributions of up to $5,000 for expenses related to the birth or adoption of a child are now allowed. The adopted child must be either under age 18 or “physically or mentally incapable of self‑” These special distributions can be repaid. This change is effective for distributions after December 31, 2019.
I have mixed feelings about these changes. I think the RMD change is overdue because individuals are retiring later and living longer. The “stretch” distribution change is kind of a raw deal for 401(k) participants that pumped money into their account to increase the inheritance of non-spouse heirs. The new child distribution option could be attractive to new parents, but it would make plan administration more complicated for employers.
Benefit statements must include a lifetime income estimate that illustrates the monthly payments that plan participants could expect to receive in retirement based on their account balance. This estimate must be provided at least annually and regardless of whether the plan includes an annuity distribution option.
Another change I like a lot. 401(k) participants should target monthly income, not an account balance, when saving for retirement. Otherwise, they could easily underestimate the cost of a retirement that could last decades. An estimate should help 401(k) participants better target the account balance they’ll need to afford the income they want in retirement.
This change won’t take effect until one year after the DOL has issued interim final rules, model disclosures, and specified assumptions.
Long-term, Part-time Employees
Employers must now allow long-term, part-time employees – defined as employees that complete at least 500 hours of service annually for three consecutive years – to make 401(k) salary deferrals. This group can be excluded from employer contribution allocations without adversely affecting plan testing. Previously, employers could keep out part-time workers that never completed more than 1,000 hours of service in a year.
While I fully support more liberal 401(k) eligibility requirements, this provision will be difficult to administer properly – not to mention, even 3 years is too long to keep part-time employees out in my view. I think a better alternative is allowing all employees to make 401(k) salary deferrals immediately.
This change is effective for plan years beginning after December 31, 2020. Hours of service before 2021 do not count.
Pooled Employer Plans
The SECURE Act created Pooled Employer Plans (PEPs) – a form of “open” Multiple Employer 401(k) Plan (MEP) that any employer can join. MEP supporters claim PEPs will offer two key advantages over traditional single-employer 401(k) plans – lower fees for retirement savers and unequaled liability protection for employers. In truth, PEPs are unlikely to deliver either.
- Economies of scale - By gathering the 401(k) assets of multiple employers, Supporters claim MEPs can offer lower fees and higher quality services to small employers with few 401(k) assets due to "economies of scale." The problem? Index funds and technology have made high-quality 401(k) investments and administration services accessible to employers of any size for very low fees. These low-cost 401(k) plans can cost much less than a MEP. Don’t believe me? Shop around.
- Reduced fiduciary liability - Employers must meet certain fiduciary responsibilities to protect the interests of their 401(k) plan participants. When employers join a MEP, they delegate many (if not all) of their fiduciary responsibilities to the MEP provider - a Pooled Plan Provider (PPP) in the case of a PEP. This delegation can sound like an easy way for employers to reduce their fiduciary liability until you understand that 401(k) fiduciary responsibilities include a duty to “monitor” plan service providers – to ensure they’re doing a competent job for reasonable fees.
In general, a MEP provider is more difficult to monitor than other 401(k) providers due to the administration-related fiduciary responsibilities they are delegated. Their discretionary power makes MEPs more prone to conflicts of interest or downright abuse. A recent GAO study noted DOL concerns about “the potential for inadequate employer oversight of the MEP is greater because employers have passed along so much responsibility to the entity controlling the MEP. Labor officials noted that potential abuses might include layering of fees, misuse of the assets, or falsification of benefit statements.”
In my view, it’s a lot less risky for employers to meet administration-related 401(k) fiduciary responsibilities themselves than to delegate them. A qualified 401(k) provider will do most of the heavy-lifting and guide employers in doing their part. Employers can use a simple checklist to manage their responsibilities.
So why the support for these complex and opaque plans in Washington? Money. For years, the financial services industry has lobbied Congress hard for “open” MEPs. Due to the fiduciary power delegated to the PPP, a PEP can be a profitable dumping ground for overpriced investments and superfluous services that employers tend to reject as the lead fiduciary of their 401(k) plan today.
This change is effective for plan years after December 31, 2020.
Lifetime Income Investments
The following changes apply to in-plan lifetime income investments (i.e., annuities):
- The SECURE Act creates a new fiduciary safe harbor for employers that want to add annuities to their 401(k) plan. Employers will be deemed to have satisfied its fiduciary requirements with respect to the financial capability of the annuity provider if the fiduciary receives certain representations from the provider as to its status under and satisfaction of state insurance laws. Employers that meet the safe harbor would be shielded from fiduciary liability with respect to participant losses in the event of the annuity provider is unable to pay promised benefits. This change took effect when the SECURE Act become law.
- If an employer decides to eliminate an annuity option from their 401(k) plan, the SECURE Act permits investors to transfer their annuity to another plan or IRA. This change is effective for plan years beginning after December 31, 2019.
I don’t like the new fiduciary safe harbor because it doesn’t go far enough. It only protects employers from an annuity provider that can’t afford to pay promised benefits. Employers can still be liable for selecting in-plan annuities with excessive fees – which can be difficult to avoid given the complexity of these investments.
No question the SECURE Act’s new annuity “portability” provision will help investors avoid the brutal surrender charges and other fees that often accompany an annuity’s liquidation. That said, so what. An annuity will likely underperform a diversified, risk-adjusted, portfolio of index funds - my baseline portfolio for 401(k) participants - over decades of investment. Due to the power of compound interest, these lost earnings can really add up - possibly forcing a 401(k) participant to work years longer than necessary to afford their target income in retirement.
The IRS penalty for filing a Form 5500 late is increased from $25 to $250 per day. The maximum penalty is increased from $15,000 to $150,000.
The 10x increase is draconian, but the IRS usually waives this penalty when employers correct a late Form 5500 problem using the DOL’s Delinquent Filer Voluntary Compliance Program.
This change is effective for Form 5500s with a filing deadline after December 31, 2019.
Participant loans can no longer be distributed from a 401(k) account through credit cards or similar arrangements.
I’m happy about this change. When a worker leaves their job, they often leave behind an outstanding 401(k) loan balance – which triggers a 401(k) distribution. By taking a pre-retirement 401(k) distribution, workers can delay their future retirement by years – maybe even making one impossible - due to the power of compound interest. This outcome is why 401(k) account “leakage” is considered such a big problem today. Making 401(k) loans are as convenient to take as swiping a credit card exacerbates this problem.
This change took effect when the SECURE Act became law.
That’s A LOT of Change!
No doubt about it. The SECURE Act made a lot of 401(k) plan changes – some good, some bad and some ugly.
However, with some basic education, 401(k) sponsors and participants can take advantage of the good changes, while avoiding the ones that benefit the financial industry more than 401(k) participants.