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Stable Value to Have a Home in Roth 401(k)s

On January 1, 2006, it becomes legal for employers to offer a Roth 401(k) qualified retirement plan to their employees. While it is unclear just how many employers will offer these new investment vehicles, it does appear that stable value investments will play just as big a role in any that are created as they do in traditional 401(k)s.

“Stable value will be just as appropriate an investment for Roth-style contributions as for regular (k) contributions during the accumulation phase of retirement savings,” says Chris Bowman, Vice President for Retirement and Investor Services at Principal Financial Group, one of the nation's largest 401(k) plan vendors. “Participants who are less tolerant of market swings, and those who are closer to retirement, will still be very interested in stable value.”

Roth 401(k)s were authorized by the Economic Growth & Tax Relief Reconciliation Act of 2001 and are similar in concept to Roth IRAs, which were introduced in 1998. Contributions to a Roth 401(k) are made on an after-tax basis, and, as a consequence, can be withdrawn tax-free. Earnings can be withdrawn tax-free, too, if the participant has maintained the account for at least five years and is at least 59½ years of age, or is taking the distribution upon death, disability, termination of employment, or hardship. By contrast, contributions to a traditional 401(k) plan are made on a pretax basis, but both contributions and earnings are taxable upon withdrawal.

“The Roth 401(k) followed the Roth IRA and the premise that we should not tax any investment earnings,” observes Dallas Salisbury, President and Chief Executive Officer of the Employee Benefits Research Institute in Washington, D.C. “That was the bias of (Sen. William) Roth, (the Delaware Republican who sponsored the enabling legislation), and of the current administration.”

Any employer who offers Roth accounts must assume that some individuals will be better off paying taxes now on their retirement-plan contributions instead of deferring those tax payments until retirement. “Roth-style contributions inside a 401(k) plan allow people to make choices based on their individual circumstances,” says Bowman. “This could encourage some people to save who might not otherwise have done so.”

Conventional wisdom holds that Roth 401(k) accounts will appeal principally to investors who expect their income or their income tax rate to be higher after retirement than it is now. But retirement plan provider Vanguard Group notes that the Roth 401(k) also will appeal to workers whose incomes are sufficiently low today that they currently pay no federal income taxes. For them, there is no immediate tax advantage to contributing to a regular 401(k) plan. With a Roth 401(k), though, they eliminate the possibility of paying taxes on their retirement savings once they stop working.

Despite the potential benefits to some workers, many employers are not prepared to offer Roth 401(k)s when January rolls around. Lori Lucas, Director of Participant Research for Hewitt Associates, a human resources outsourcing and consulting firm, says only about a third of the nearly 200 plan sponsors surveyed by her firm late last year planned to add a Roth 401(k) account to their retirement plans anytime soon. By late May of this year, she says, sentiment among plan sponsors hadn't changed much.

Mary Kazan, Group Vice President for Corporate Benefits at apparel manufacturer Phillips-Van Heusen Co., says her company is among those not ready to commit to the Roth 401(k). “We have given it some thought, and at this point we're really not looking seriously at it,” Kazan says. “It's not something we think is going to add a lot of value for our employees.” She notes that many of Phillips-Van Heusen's employees work in factory and warehouse positions that pay near the minimum wage—an income level where it can be difficult to squeeze any savings out of a paycheck.

Other employers who haven't committed to the Roth 401(k) worry about other stumbling blocks, including increased administrative burdens and the challenge of educating participants about the new accounts. Sponsors who offer automatic enrollment in their retirement plans also will have to decide which type of account to open for employees who don't select one on their own—a traditional 401(k) or a Roth.

Adding a Roth 401(k) option to a plan with a stable value option will, at a minimum, cause stable value managers and GIC/synthetic wrap issuers to pay close attention.  If the Roth 401(k) stable value option is commingled with the regular stable value option in the plan, then GIC and wrap issuers will likely consider the Roth addition just another source for contributions and thus no added "risk."  After all, perhaps the Roth 401(k) contributions will look the same as normal after-tax voluntary participant contributions.  However, if the Roth stable value option somehow is a separate option in the plan available for transfers too and from the other non-Roth stable value option, there would likely be competing fund transfer restrictions.  

Lucas says many plan sponsors also are concerned that offering a Roth 401(k) could make the retirement savings landscape more complicated for their employees. Behavioral studies have shown that some investors choose not to invest at all when they feel overwhelmed by the number of decisions they must make. In a bid to minimize that problem, retirement plan providers are counseling employers to make the investment options available in the Roth 401(k) the same as those in their traditional 401(k) plan. “We've been advising clients on the importance of narrowing the focus of the decision making to the tax implications,” says Lucas. “There is no reason to have different investment options. In fact, we believe having different investment options could lend confusion to the decision-making process.”

Not everyone is gun-shy, of course. Salisbury says EBRI will offer a Roth 401(k) to its employees come January 1, assuming its recordkeeper is prepared to handle the paperwork. “Recent reports from the Government Accounting Office and the Congressional Budget Office make it clear that future tax rates will be much higher, and that getting taxes paid now will be a wise thing to do,” Salisbury says. He also argues that a Roth 401(k) should prove the smarter option for the many retirement plan investors who make heavy allocations to equities in their accounts. With a regular 401(k), he explains, investors don't get to take advantage of the lower tax rates currently available on capital gains and dividends, since all distributions from a regular 401(k) are taxed as ordinary income. “A Roth would move the tax rate to zero,” he says. “For those that put money in their account for retirement and leave it there, a Roth would be better for their equities.”

More plan sponsors might jump on the Roth 401(k) wagon, says David Wray, President of the Profit Sharing/401(k) Council of America, if employees, spurred on by the media and financial advisors, start to demand it. “Pressure from employees does have an impact on plan design,” Wray says. “We are beginning to see people write about this, and if they say that a certain type of person definitely wants to be in the Roth 401(k), we'll see what kind of public pressure is brought to bear on plans. Right now, participants have no clue what this is about. But in four months, there will be a drumbeat of publicity.”

Regardless of how many plan sponsors offer the Roth 401(k)—public school systems and other tax-exempt organizations that offer 403(b) retirement plans can also do it—there is no reason to expect their decisions to have any near-term impact on cash flows into and out of stable value funds. That's because EGTRRA does not allow workers to transfer assets from their traditional 401(k) or 403(b) into a Roth account. Instead, the Roth will be open only to new contributions taken from paychecks earned in 2006 and later. In addition, the benefits of a stable-value investment—steady, principal-guaranteed returns on par with the returns on a short-term bond portfolio—accrue to investors in a Roth account just as they do in a traditional account.

Although it is impossible to predict how investors might behave many years from now, Principal Financial's Bowman does note that once investors retire, it is possible that some might be slightly more inclined to take money from a Roth account than they would from a traditional 401(k) because there would be no income tax associated with the withdrawal. It's probably premature to worry about that right now, though, especially since the Roth 401(k) could be a short-lived phenomenon. Like all of EGTRRA's provisions, it's scheduled to expire in 2010 unless Washington takes action to extend it.

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