Experts at odds on tax law’s effect on 401(k)s

Defined-contribution plans may not be in the best interests of participants, because of recent tax changes, Dalbar Inc. officials assert. But industry experts aren’t so sure.

According to Dalbar, a Boston-based financial services research firm, the main advantage of defined-contribution plans to participants – tax-sheltered growth of assets – is no longer realistic following this year’s dividend and capital gains tax cuts. Investors can earn more by investing in non-qualified plans, Dalbar officials say.

The firm plans to work with investment managers, consultants and defined-contribution providers to come up with alternatives that will preserve traditional DC benefits by adding a non-qualified component to existing plans that will accept automatic deferrals along with qualified plan contributions.

According to Heather Hopkins, Dalbar’s director of marketing, “Fiduciaries are no longer meeting their responsibilities if they encourage participants to save for retirement in a 401(k) plan.”

Instead, she says, “product providers need to develop new products to make these plans viable in the future.”

Model developed

Dalbar has developed a model that compares tax-deferred investing with the same investments on an after-tax basis.

“The results show that without the tax cut, most employees were better off in the tax-deferred plan – but the reduced taxes on dividends now make after-tax investing more attractive,” according to a statement from the company.

That model doesn’t take into account employer matches, and critics say this oversight considerably weakens the Dalbar model, since matching provides an immediate tax-exempt return. Also, in most cases, tax-exempt accumulations provide impressive tax advantages for 401(k) plans over non-qualified-plan investing.

The Dalbar statement cited an example in which one year of 401(k) equity investing in an Standard & Poor’s 500 stock index fund produced $27,000 at retirement. This figure is based on one year’s experience of an employee in the 35% tax bracket deferring 15% of a $75,000 annual salary. Dalbar assumes a 10% annual appreciation over a 20-year working career.

Under the old tax code, the same investment in a non-qualified retirement plan would be worth 7% less, or $25,200, but “the tax cut increases the $25,200 in the after-tax approach to $30,375, making the after-tax approach more attractive than the 401(k) plan. The after-tax advantage occurs because both dividends and capital gains are now taxed at much lower rates (15%) than ordinary income.”

Using the same methodology, the only way employees would be better off in a 401(k) plan, according to the statement, is if they invested the deferred taxes in a non-qualified plan, which would raise the total value at retirement to $37,631.

Matching contributions

Ms. Hopkins acknowledges that matching contributions weren’t considered in the Dalbar methodology.

“Matching is an important consideration … but we had to normalize [the study], looking at pre-retirement saving versus post-retirement savings. Companies that offer a match, that’s certainly a great message to promote in communications instead of the advantages of pretax savings,” she says. “The point is, the messages need to change because they can’t be the same as they used to be.”

The vast majority of employers with 401(k) plans provide a match: approximately 87% of plans with more than $5 million in assets, according to a 2003 study by SPARK Research Group Inc. in Simsbury, Conn. Even so, the after-tax approach “raises the serious question of the fiduciary responsibility of retirement plan sponsors to inform employees that their plan may no longer be the best retirement saving alternative,” according to the statement.

Officials at Dalbar haven’t request-ed a legal or compliance review, but Ms. Hopkins says the company is confident of the validity of its claims.

Some experts who looked at the proposal say Dalbar officials should rethink the idea. Dalbar ignores the effect of company matching contributions in building 401(k) account balances, they note. Plus, the comparison between pretax and after-tax investing isn’t valid, they add.