This article originally ran on September 29, 2014.
By Michael A. Webb
Ellie Lowder recently wrote a must-read article on increasing voluntary participation rates in 403(b) plans, for which, in the K-12 segment, it is not unusual to see participation rates in the 18-20% range. Certainly, such participation rates can and should be improved, but the voluntary participation rate in 403(b) plans is not as doom-and-gloom as those who market alternatives to 403(b) plan sponsors (such as 401(k) plans) would like you to believe. In this article, I will attempt to explain why simply comparing 401(k) participation rates to 403(b) participation rates does not tell the whole story when evaluating whether 403(b) participation rates are clearly inferior.
On the face of it, it would appear that voluntary participation rates for 401(k) plans crush those for 403(b) plans. The many studies of voluntary participation rates for 401(k) plans peg such a rate in the 75% range. Though studies of 403(b) plans are far less prevalent, most indicate as participation in the 50-66% range. In it important to note that this is the average participation rate for 403(b) across all market segments; if you drill down to certain market segments you will find lower average participation rates (such as K-14) as well as higher participation rates (such as higher ed).
However, if you dig deeper into the numbers, you will find that a simple comparison of 401(k) participation rates to 403(b) rates paints a completely inaccurate picture of participation disparity between the two plan types. The reasons for this inaccuracy are multifaceted and are described below.
For those of you who recall your fifth-grade math, if two division equations have the same numerator, but a larger denominator, the fraction of the one with the larger denominator will be smaller, resulting in a smaller percentage. This is a key element in examining comparative voluntary participation rates, since with 403(b) plans, the denominator is ALWAYS smaller than it is for 401(k) plans, resulting in a lower fraction/percentage.
Why is this the case? In 403(b) plans, generally ALL employees are eligible to make elective salary deferrals, due to universal availability. In 401(k) plans, certain employees may be excluded from the right to make elective deferrals, such as those who have not satisfied the age and service requirements of the plan. Such exclusions are fairly common, which results in artificially high 401(k) voluntary participation percentages for those individuals who choose to exclude such employees. Furthermore, the employees who are generally excluded from 401(k) plans are those who are generally less likely to make elective deferrals to the plan, exacerbating the issue.
Primary Plan vs. Supplemental Plan
For many 401(k) plan sponsors, the 401(k) is the primary retirement plan of the organization, if not the only retirement plan. Defined benefit pension plans, which once were commonplace among corporations, are relatively rare today. Thus, in many cases, 401(k) plans provide for employer contributions — including matching contributions — which directly provide an incentivize employees to make elective deferrals to the plan.
By contrast, there are entire market segments in 403(b), such a K-12, where the 403(b) is rarely a primary retirement plan, but supplemental to a defined benefit pension plan provided by a state retirement system. In those cases, there are no employer contributions to the 403(b); the 403(b) merely serves as a supplemental voluntary savings vehicle. As logic would dictate (and studies have shown); voluntary participation rates are often far lower in retirement plans that lack employer contributions, especially matching contributions.
In some 403(b) market segments (especially higher education, but increasingly in K-14 as well) employees are required to make a pretax contribution out of their own salary to either a state retirement system or the 401(a) or 403(b) retirement plan of the institution. It is rare to see such mandatory contributions to retirement plans of 401(k) plan sponsors. Such mandatory contributions subtract from the disposable income necessary to be able to make an elective deferral to a 403(b) plan, thus negatively affecting voluntary participation rates.
Conversely, automatic enrollment, through which participants are enrolled at a stated elective deferral percentage unless they opt of automatic enrollment process is far more prevalent in 401(k) plans than 403(b) plans. Such automatic enrollment figures count in voluntary participation percentage, thus again artificially inflating 401(k) participation figures.
The reasons automatic enrollment is far less commonplace in 403(b) plans is due to:
- recordkeeping structures (e.g., multiple providers) that render automatic enrollment impractical,
- the existence of mandatory contribution formulas and
- conflict with certain state laws for 403(b) plans that are not subject to ERISA.
The apparent disparity between 401(k) and 403(b) voluntary participation figures is yet another example where the raw numbers don’t always tell the truth, due to the factors described above as well as other less significant differences (such as salaries, number of vendors, etc.). Taking these factors into account, 403(b) participation rates are indeed far from “awful,” though pockets of extremely low participation rates do occur. Plan sponsors and advisors should work to maximize participation rates wherever possible, since this will only lead to more significant retirement accumulations for participants.
Adviser Practice Pointer: The prudent adviser will not only work to increase 403(b) plan participation rates, but also proactively communicate the differences between 401(k) and 403(b) plan participation rates (as well as other differences between 401(k) and 403(b) plans) so that plan sponsors can feel comfortable in their decision to maintain a 403(b) plan when alternative plans are marketed to them
Michael Webb, TGPC, AIF™, CEBS, is the NTSAA Education Committee Co-Chair and a Vice President at Cammack Retirement.
Cammack Retirement is an independent retirement plan consulting firm specializing in non-profit industries. Offering tailored, actionable solutions, to help clients achieve the greatest return on their employee investment, Cammack Retirement delivers end-to-end solutions for complex retirement plan challenges.
Please note that this article is for general informational purposes only, is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal advisor before taking any actions suggested in this article.