Where is all this leading? Changes are coming – and you can help your small business clients anticipate them and move forward in a positive direction, even before regulators and Congress act.

The model retirement plan of the present and future has existed since 1997. With a little tweaking in the right direction by policymakers, it can help to align the needs of business owners, employees, and the investment industry. It is the Savings Incentive Match Plans for Employees (SIMPLE).

If you think you already know SIMPLEs, this article will expand your thinking. It also will offer a new template for delivering service to SIMPLEs, their sponsors and participants.

401(k)s Blues – What Happened?

Like a few other financial inventions of recent decades, 401(k)s became too successful for their own good. The strong stock market returns of the 1990s caused millions of participants to believe 401(k)s were a road to riches, and plan sponsors began promoting investment performance over savings discipline. During profitable times, companies created an expectation of large matching contributions that were not sustainable during an economic downturn. The cost structures of some plans were never subjected to scrutiny.

Design flaws built into 401(k) regulations – such as overly generous loan terms – were finally exposed when many households ran into liquidity problems. The investment industry, specifically mutual funds, also fell under the spell of 401(k) success, advocating equity-heavy target date and lifecycle funds as a solid way for new plan participants to start building retirement security.

In 2009, the time finally came to look more critically at 401(k)s. Here is a round-up of recent developments:

• The Employee Benefit Research Institute reported that the average 401(k) balance declined from $65,454 at the end of 2007 to just $45,519 by the end of 2008.

• In August, the U.S. Government Accountability Office (GAO) issued a report on proposed policy changes that could reduce the leakage of 401(k) savings. It defined "leakage" as hardship withdrawals, loans and cash-outs of account balances at job separation. This was perhaps the first official U.S. Government report in which 401(k) loans have been described as a problem, not a benefit. You can read the full report at:

http://www.gao.gov/new.items/d09715.pdf

The report indicated that huge numbers of Americans (especially those who are young, lower paid and working in smaller firms) still lack any workplace coverage – mainly because their employers do not offer retirement plans. The table below summarizes.

The GAO report includes a detailed analysis of proposals to mandate "Automatic IRA" accounts among employers that lack a workplace plan. It noted that 10 states (CA, CT, MD, MA, MI, PA, RI, VT, VA, and WA) have considered proposals that would create some version of these 100% employee-funded payroll deduction accounts, which employers would be required to offer and administer. The GAO observed that: 1) huge complexities and cost barriers may prevent states from implementing these proposals; and 2) these plans would impose additional administrative burdens on small employers during times of economic difficulty.

The Small Employer's Perspective

Small employers are frustrated with 401(k) plans, too, but for different reasons, including:

• Employee dissatisfaction with investment choices, performance and costs.
• Economic pressures on employers to continue making matching contributions in a weaker economy.
• Administrative burdens in filing required reports, disclosures and notices.
• Staff time and cost in processing hardship withdrawal and loan requests.
• Limitations imposed by nondiscrimination testing and top-heavy rules.

Apart from problems integral to 401(k)s, the spiraling cost of health insurance premiums has made it more difficult for small businesses to continue funding retirement plans, until they see health care reform and cost relief.

Given the current gloomy mood toward 401(k)s, many small employers would welcome the opportunity to trade their 401(k)s for Automatic IRAs. But by putting even more funding responsibility on employees, this would be a giant step backward for defined contribution plans.

A better model for employer-employee teamwork already exists, and eventually it can provide a template for moving U.S. retirement plans forward, especially for small employers and perhaps for all.

SIMPLEs, Then and Now

Created by 1996 legislation, the SIMPLE became effective in 1997. Originally, it was designed as a "lite" version of a 401(k) plan for companies with 100 or fewer eligible employees.

In return for making plan sponsorship and red-tape less burdensome for employers, SIMPLEs imposed lower elective deferral and matching limits. The table below compares those limits for 2009.

A SIMPLE is easy-to-adopt and administer, and it is relatively economical for a small company to fund. All deferrals and contributions are 100% immediately vested in SIMPLE-IRAs set up for each participant. Deferrals and contributions for company owners and highly paid employees are not limited by nondiscrimination tests or top-heavy rules.

From the beginning, the design of SIMPLEs avoided leakage problems and employer administrative headaches. For example, loans are not allowed in SIMPLEs, and there are no "trigger events" at which withdrawals may be taken. Participants are free to take withdrawals at any time, and employers are not burdened by the need to process loans or document hardships.

On a year-by-year basis, the company can choose to meet SIMPLE funding requirements in one of two ways: 1) by making a 3% dollar-for-dollar matching contribution for all eligible participants; in any two of five years, the match may be reduced to as low as 1%; or 2) by making a non-elective 2% contribution (as a percentage of compensation) for all eligible employees. These contributions, especially matching, can skew total employer costs heavily toward owners and highly paid executives.

For example, consider a corporation in which there are two owners, each age 50 and earning $400,000 per year, and 10 rank-and-file workers, each of whom earns $40,000 per year. Half of the rank-and-file workers (five) make elective deferrals equal to at least 3% of compensation, and the other half choose not to defer money. The two owners make the maximum elective deferrals allowed. The table below summarizes plan funding.

* The 2% non-elective contribution is limited to compensation of $245,000 in 2009.For matching contributions, there is no cap on the compensation considered.

The SIMPLE is a good bargain for the company and its owners or highly-paid executives. They can make steady progress toward personal retirement goals while offering workers a competitive plan and keeping the company's costs reasonable.

The "Two-year Event"

The real advantage of a SIMPLE, for employers and employees alike, lies in a feature that is often not well understood or communicated. At any time after two years of participation, each SIMPLE participant can make a tax-free direct transfer to any other Traditional IRA of his/her choice – or convert any or all amounts to a Roth IRA. Rollovers/transfers are not allowed in the first two years (except to another SIMPLE-IRA) and premature withdrawals during the first two years are subject to a 25% federal tax penalty, unless an exception applies.

It is this "two-year election" – more than any other feature – that makes SIMPLEs a model for small-employer plans during times of 401(k) frustration. The two-year event also creates a better model for encouraging sound long-term retirement savings habits than the automatic enrollment templates adopted by many 401(k)s or the Automatic IRAs being considered by ten states.

What's Wrong with Automatic Enrollment?

There is nothing inherently wrong with the concept of automatic enrollment. But for many small plans and their participants, the timing of its implementation has been a nightmare.

The Department of Labor's regulations for adopting Qualified Automatic Contribution Arrangements (QACAs) and Qualified Default Investment Alternatives (QDIAs) evolved during 2006 and 2007, and they are cumbersome and complex for small companies to follow. Also, the QDIA regulations created three permanent "safe-harbor" investments that plan sponsors may choose – target date/lifecycle funds, balanced funds and investment management services. Yet, none of these choices offer "capital preservation" (e.g., a stable value fund) as a permanent investment objective. As a result, many new participants who were automatically enrolled in 2006 and 2007 were shoved into target date or lifecycle mutual funds with high allocations to equities. Before these participants could blink an eye as retirement savers, they had lost money and become frustrated with 401(k)s.

Note: The final QDIA regulation permitted a capital preservation option for the first 120 days of participation only. The Department of Labor fact sheet on the regulation is here:http://www.dol.gov/ebsa/newsroom/fsqdia.html

The premise behind most target date/lifecycle fund structures is debatable ? namely, risk should start high and be gradually reduced as a plan participant grows older. In the real world, many first-time investors need to build knowledge and confidence before they are ready to take on risk. Retirement plans are a first investment experience for many young people, and it can take a couple of years to "learn the ropes" and feel comfortable.

Of course, each new participant has different personal needs. After the market crash of 2008, a growing number of plan sponsors have recognized the basic flaw in automatic enrollment ? namely, no one investment, chosen by the employer, can cover the diverse needs of all new participants, and the inertia created by automatic enrollment can have cumulative impact over time. Every plan participant eventually should receive personal financial guidance and make an affirmative investment decision based on personal knowledge and confidence.

Savings Habits Vs. Investment Performance

SIMPLEs are structured to maximize the savings progress younger, lower-paid employees can make, with or without investment risk. For example, consider the hypothetical example of "Mary," a 28-year-old who has never invested or saved for retirement, before she joined a company offering a SIMPLE. Mary is married and files a joint return, and she and her spouse together report an income of $36,000.

We'll assume that she sets aside 3% of her own $30,000 salary ($900) as elective deferrals, each year over a five-year period. This is matched dollar-for-dollar by the employer, and her income also qualifies for a 20% federal Saver's Credit. (2009 income limits for the Saver's Credit are shown at the conclusion of this article.) We'll assume she invests all deferrals and contributions in a stable value fund earning 3.5% per year.

How much will Mary accumulate in her first five years of plan participation, and what will be the "internal rate of return" on her out-of-pocket cost?

• Mary's out-of-pocket cost is $720 per year – the $900 elective deferral less $180 federal Saver's Credit (20% of $900).
• Her plan will accumulate $1,800 per year – her own $900 plus $900 of employer matching. After 5 years at 3.5% growth per year, her account will be worth $9,990.
• After five years, her internal rate of return on out-of-pocket cost ($720 per year) is 36% per year!

If Mary can earn 36% per year starting a retirement savings discipline in a capital preservation fund, as a novice investor, why does she need to take more risk?

By offering the combination of a SIMPLE and a low-risk investment choice, Mary's employer has done everything possible to assure her a great start and build her confidence.

Personal Guidance at the Two-Year Event

Now, let's take our example one step farther.

When Mary reaches her two-year event as a SIMPLE participant, the employer says to her: "You have reached the point at which you should have personal financial guidance. We have chosen a qualified advisor, whom we will make available to you at company expense for an hour of consultation. The advisor will explain your choices for moving any or all of your SIMPLE money to an IRA designed just for you."

This consultation is in Mary's interest because she now has made progress in establishing a retirement savings habit and building assets. She is ready to discuss investment risks and take control of her own IRA for the rest of her life.

The two-year event is in the employer's interest, because it means Mary will never have reason to complain about the plan's investment choices or costs. If she chooses to transfer SIMPLE money at the two-year event, her deferrals and employer contributions will continue to be collected in the original SIMPLE-IRA. She then can make an annual "sweep transfer" of her accumulated deferrals and employer contributions into her personal IRA. When she leave the company or retires, her "rollover planning" will be a non-event.

This version of a SIMPLE can be in your interest, too, if you know how to offer it.

Ideas for Offering SIMPLEs

• The current market for SIMPLEs consists of any company with 100 or fewer eligible employees. An eligible employee has earned $5,000 in each of the last two years and is expected to earn $5,000 this year. Companies with a transient or high-turnover workforce can be eligible, even if they have more than 100 employees.
• Make SIMPLEs as easy as possible for employers to administer. A basic "plain-vanilla" mutual fund turnkey plan often will work best. Make sure the plan offers one fund for preservation of capital (stable value, GIC or money market) and at least one low-cost index equity fund or balanced fund. Make it easy for the employer to avoid complaints about investment choices or high investment costs.

• Two versions of the SIMPLE are available and each can be adopted with an IRS approved Model Form. Form 5305-SIMPLE is for use with a Designated Financial Institution – i.e., when the employer will choose individual IRAs for each participant. Form 5304-SIMPLE is used when each participant has the ability to select his/her own SIMPLE-IRA. In many cases, it will be easiest for the employer to choose Form 5305 because this enables employees to be enrolled easily, with employer contributions and deferrals made to one IRA custodian. However, Form 5305 includes an important requirement that Form 5304 does not: "The employer will not impose any cost or penalty on a participant for the transfer of the participant's SIMPLE-IRA balance to another IRA." Participants must receive annual notification that they have a right to transfer to another SIMPLE-IRA. So, if Form 5305 is used, do not use any plan funding choices that impose surrender charges – e.g., deferred annuities or mutual fund B shares.

Note: In Notice 2009-67, the IRS issued a model amendment that a Form 5305 SIMPLE may use in adopting automatic enrollment. It is located here:http://www.irs.gov/pub/irs-drop/n-09-67.pdf

In Summary

Today's SIMPLE is inherently a sound template for addressing problems related to "401(k) frustration" and shortfalls in workplace retirement plan coverage. It is superior to the Automatic IRAs being proposed by ten states, because it gives the employer an incentive to provide financial help in starting sound retirement plan savings habits.

The "two-year event" built into SIMPLE plan design is a forward-thinking concept, because it gives a new participant the opportunity to choose a personal IRA strategy after starting a savings habit and learning from plan participation. The combination of dollar-for-dollar employer matching and the federal Saver's Credit can help younger and lower-paid employees get their plans off to a great start, even in the most conservative investments.

The flaw in modern automatic enrollment strategies has been in assuming that sound habits will be built around early investment success, rather than early savings success. For some new plan participants, starting a first retirement plan with a heavy allocation to an equity-focused fund can be a recipe for failure and lost confidence, as 2008 demonstrated.

By counseling SIMPLE participants at their "two-year events," you will be in the right place at the right time to offer personal guidance, influence diversified long-term investment programs and build strong client relationships.

How the Federal Government Could Make the SIMPLE Model Even Better

• Expand the limit on company size – so that companies with more than 100 eligible employees can participate in SIMPLEs.
• Encourage a "strong start" to retirement savings habits by offering a business tax credit for employer matching contributions in the early years of plan participation.
• Offer businesses an additional tax credit for paying the cost of a one-hour financial consultation for each SIMPLE participant at the two-year event.
• Increase the Saver's Credit income limits and make the credit refundable.

Federal Saver's Credit Limits for 2009

The credit is available to taxpayers age 18 and older who are not full-time students and are not claimed as a dependent by another taxpayer. It equals the "Credit Rate" shown below multiplied by personal contributions to a retirement plan, up to $2,000 per year.