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Which makes more sense: offering a 401(k) or a 403(b) plan?
That is the question thousands of private, non-profit employers, such as educational institutions and hospitals, are starting to ask after being given a choice.
Beginning this year, a new federal law went into effect removing a 10-year-old ban and allowing non-profit employers to offer 401(k) plans to their employees.
While that ban was in effect, 403(b) plans were the principal defined contribution plan that not-for-profit employers provided to their workers.
The two plans share certain features, most notably the ability of employees to make pretax contributions.
But 403(b) and 401(k) plans have many differences. The most significant one: Employers with 401(k) plans have to run a non-discrimination test to prove that salary deferrals made by highly compensated employees do not exceed those of lower-paid employees by a certain amount. There is no comparable requirement for employers with 403(b) plans.
On the other hand, 401(k) plans have certain advantages over 403(b) plans, including more flexibility for employees to invest contributions.
While non-profit employers now are analyzing how their 403(b) plans compare to 401(k) plans, only a handful to date have opted to establish 401(k) plans, benefit consultants say.
"I'm not aware of any of my clients who are making the change," said Paul Zeisler, a principal with William M. Mercer Inc. in Chicago.
"While there has been some discussion of switching, I don't think you will see a massive movement away from 403(b) to 401(k) plans," added Roger Grayson, a managing consultant with A. Foster Higgins & Co. Inc. in Washington.
Indeed, while benefit managers at non-profit organizations say they are continuing to review how their 403(b) plans stack up against 401(k) plans, they continue to give the nod to 403(b) plans.
"Based on our first initial look, thus far our 403(b) plan better meets our and our employees' needs," said Douglas Terp, director of personnel at Colby College, a liberal arts college in Waterville, Maine.
"We do not anticipate changing plans. Both administrators and employees like our plan. We do not see any perceived advantages to 401(k) plans," said Don Hunkins, vp-finance at Northwood University in Midland, Mich.
But some non-profit organizations have switched over to 401(k) plans while freezing their existing 403(b) plans.
For example, a Midwest hospital decided earlier this year to establish a 401(k) plan because of greater flexibility in transferring savings plan distributions to other types of pension plans, said David Blecher, a consultant with Hewitt Associates L.L.C. in Lincolnshire, Ill.
Under law, a lump-sum distribution from a 401(k) plan can be rolled over into any qualified employer plan-so long as the new company accepts the distribution-or to an individual retirement account. By contrast, 403(b) plan distributions only can be rolled over to another 403(b) plan or to an IRA.
In the case of the hospital that established a 401(k) plan, it wanted the flexibility of being able to accept new employees' distributions from their prior employers' savings plans.
"This definitely was one of the drivers," Mr. Blecher said.
Still, Mr. Blecher acknowledges that the example of the hospital switching over to a 401(k) plan is an exception. "For most employers, the reasons for changing over will not be powerful enough," he said.
While few non-profit employers with 403(b) plans are moving to 401(k) plans, benefit consultants say the change in law means the time is ripe for employers to compare the two plans.
Experts agree that the most important difference between the two plans is that 403(b) plans are exempt from the basic non-discrimination test-known as the actual deferral percentage test-that 401(k) plan sponsors must run annually to compare salary deferrals of higher-paid employees with lower-paid employees.
To pass the ADP test, average salary deferrals of highly compensated employees-generally those earning more than $80,000 a year-cannot exceed deferrals of lower-paid employees by more than two percentage points.
To pass the test, many companies with 401(k) plans are forced to restrict deferrals by highly paid employees to an amount below the annual $9,500 maximum.
Because they are exempt from running the ADP test, employers with 403(b) plans do not have to deal with ADP testing. Nor do their highly compensated employees, such as veteran professors and top administrators, have to worry that how much they can defer to the 403(b) plan will depend on deferrals made by lower-paid employees.
This freedom from ADP testing is a major advantage of 403(b) plans over 401(k) plans, say benefit managers at non-profit organizations and other experts.
"The 403(b) plan is a lot simpler to administer," said Mr. Terp of Colby College.
Said Peter Gold, a principal at Buck Consultants Inc. in Stamford, Conn.: "The biggest advantage of a 403(b) plan over a 401(k) plan is that the amounts the highly compensated contribute to 403(b) plans do not depend on how much non-highly compensated employees defer."
"It is a key difference," notes Michael Heller, vp of actuarial and pension services for Teachers Insurance & Annuity Assn.-College Retirement Equities Fund in New York, a major 403(b) plan administrator and provider of investment options to the plans. "In reality, the ADP test limits the contributions of many 401(k) plan participants."
In addition, if their employers moved to 401(k) plans, certain highly compensated employees at non-profit organizations could face cutbacks in their maximum deferrals for another reason: 403(b) plan participants at educational, hospital or certain other health care-related organizations with at least 15 years of service can defer up to $12,500 a year for five years. A comparable deferral bonus for veteran employees does not exist in the 401(k) plan universe.
"This is yet another advantage of a 403(b) plan. You can put in more money when you have more service and probably more discretionary income," said Mercer's Mr. Zeisler.
In the area of reporting requirements, 403(b) plans also are more attractive than 401(k) plans, benefit consultants say.
For example, one type of 403(b) plan-often referred to as tax-deferred annuity arrangements-funded solely by salary reduction is essentially exempt from federal reporting rules, such as Form 5500, a plan's annual financial report to the Internal Revenue Service.
And even 403(b) plans in which employers contribute do not have to file as much as information to the federal government as 401(k) plan sponsors. Among other things, 403(b) plan sponsors generally do not have to file an accountant's report with their Form 5500.
While 403(b) plans have certain advantages over 401(k) plans from both an employer and employee perspective, 401(k) plans are not without their own attractive features, experts note.
One advantage is that 401(k) plans give plan participants' virtually unlimited investment options. By contrast, federal law limits 403(b) plan contributions to annuity contracts and mutual funds. That would rule out, for example, the ability of employees to set up an account with a broker in which the employee self-directed the investment of contributions.
But given the plethora of mutual funds available in the 403(b) plan market, the inability of participants to self-direct investments probably matters only to a relative handful of employees.
In addition, lump-sum distributions from 401(k) plans are eligible for a favorable tax calculation known as five-year forward averaging. Distributions from 403(b) plans do not qualify for five-year forward averaging.
Another 401(k) plan advantage affects employers with both for-profit and non-profit units. Effective this year, those employers could offer a 401(k) plan to all their employees. But if such an employer offered a 403(b) plan to employees at its non-profit unit, it couldn't offer the same plan to employees at its for-profit unit. That employer likely would offer 401(k) plans to their employees at its for-profit unit, which would add to its administrative work.
One situation where this could occur: a not-for-profit hospital maintaining a for-profit pharmacy. "If you go with a 401(k) plan, the HR department only has to follow one set of rules," said Mr. Gold.