401(k) Update: Q3 2019
by Vita, on July 9, 2019
Form 5500 Season – Ready, Set, File!
It’s that time of year again! For calendar year plans, the 2018 Form 5500 and Form 8955-SSA (if applicable) must be filed by July 31, unless an application for extension has already been submitted. In most cases, the extension will be automatically prepared and filed by your retirement plan service provider on your behalf. If you are unsure as to the status of your Plan’s Form 5500 or Form 8955-SSA, you are invited to contact our team for assistance.
View our Compliance Calendar to see other important administrative tasks.
Beware Your Definition of Compensation
Your retirement plan document includes a definition of compensation and it is important that you follow this in operating your Plan. The improper application of the definition of compensation can quickly become a compliance pitfall. For example, plan sponsors might assume contributions are solely based on an employee’s base pay amount.
The most commonly used definition of compensation for 401(k) deferrals is “W2 wages.” It is important to remember that this particular definition allows for 401(k) deferral contributions beyond “salary.” For example, plan sponsors must allow participants to extend deferral contributions to bonus payments and to “K-1 earned income,” unless these items are explicitly excluded from your definition of compensation.
Please be sure to review how your Plan defines compensation with your payroll and/or accounting team to ensure that your practices are in line with your plan document.
New Flavor of the Month: After-Tax Contributions
There has been an increased awareness of contributing after-tax dollars into a 401(k) plan. These contributions are separate from pre-tax or Roth contributions and allow participants to contribute after-tax dollars into their 401(k) account up to the total 2019 maximum employee plus employer contribution of $56,000 ($62,000 with catch-up). While we support any provision that encourages and allows participants to save more for retirement, after-tax contributions are not for everyone or every plan.
First and foremost, this provision must be allowed by an amendment to your plan and there must be a separate money-type set up to account for these contributions with your payroll vendor and recordkeeper. Second, after-tax contributions are not matched. Hence, participants should first consider maximizing their pre-tax and Roth deferrals, which are matched. Finally, it is usually only highly compensated employees that can take advantage of contributing after-tax dollars. This can lead to the failure of non-discrimination testing, either the Average Contribution Percentage or top-heavy tests.
Our After-Tax Contribution Overview is linked here. Please let us know if you would like to discuss in greater detail whether these contributions are appropriate for your retirement savings plan.
A Patchwork of Retirement Savings Legislation is Moving Through Congress
A number of different bills aimed at updating current retirement savings legislation are moving through Congress. The final legislation that comes out of the Conference Committee between the House and Senate versions are still unclear. However, some of the notable provisions in the various bills include:
- The extension of Multi-Employer Plans (aka, Pooled Employer Plans) to non-associated companies
- Allowing for electronic distribution as the default for all required notices
- Mandating a retirement income estimate be provided for all participant accounts
- Mandating Auto Enrollment
- Extending the required minimum distribution age
After a tumultuous May, the first half of 2019 ended positively for all asset classes. Year-to-date (“YTD”), the S&P 500 Index is up 18.5%, the MSCI EAFE Index (foreign equities) up 14.49% and the US Aggregate Bond Index up 6.11%. Much of the rally, in both equity and bond markets, seems to be a result of the increased expectation that the Fed will lower interest rates in the third and possibly fourth quarters. While this may have helped markets in the short-term, economic fundamentals would seem to point to more difficult markets ahead.
US economic growth in Q1 2019 came in at 3.2% year-on-year (“YOY”) and is expected to fall to between 1.0% - 2.0% YOY in the second and third quarters. This moderation in US economic growth has been anticipated as the stimulative effects of 2018 tax cuts and fiscal policy diminish. This should lead to a US GDP growth of around 2.0% for 2019, which is a return to the level generally seen during the length of the current expansion. Unemployment remains low at 3.6%. Seen against the background of slower economic growth and decreased workforce participation, it is hard to see unemployment falling much further. The consumer continues to lead the US economy with consumer spending surprisingly strong in April. This is in sharp contrast to continued low levels of corporate investment spending and the rise in inventories. While US economic growth is off its recent 2018 highs, the picture is one of a slow-down and not recession.
When the Fed announced in Q1 the end to the current round of Fed Fund rate increases, the real Fed Funds (nominal rate less inflation) was 0.66%. This compares to an average of 3.38% after the previous six Fed rounds of tightening. The Fed raised rates by 0.68% per year during the current round of tightening, compared to an average of 2.04% per year in previous tightenings. During this round of Fed tightening, US economic growth actually spiked. Thus, it is hard to see how lowering interest rates will stimulate economic growth; the level of interest rates does not appear to be a significant factor in stifling economic growth.
So, we must look toward inflation as the reason for a possible Fed rate cut. Inflation in the US remains subdued and well below the Fed’s target of 2%. The Fed’s Headline Personal Consumption Expenditure (“HPCE”) deflator is at 1.5% and Core PCE (excluding food and energy) is at 1.6%. The Fed has described the current level of inflation as “transitory.” It is precisely the desire to stimulate inflation that seems to be motivation for the Fed signaling the possibility of a Q3 rate cut. But with investment spending low, wage growth flat (+3.4% in May), and US oil production more than able to keep oil prices around $55/barrel in the face of announced decreases in OPEC production, it is hard to see this as anything but a very stable inflation environment.
The Fed’s decision to cut rates in July is likely to be based whether there is an agreement on trade, the June jobs number, and the initial Q2 GDP figure. Equity and bond markets seem to have largely priced in a Fed Funds rate cut in July. Traders will be severely “wrong-footed” if the Fed decides not to cut, with the possibility of a significant sell-off of both bond and equity prices. Though down from the double-digit growth of 2018, S&P 500 corporate earnings per share rose 4% YOY in Q1 2019 and are generally expected to continue to see mid-single-digit growth for the rest of the year. But US equities are once again fully valued with forward P/E ratios trading at 16.74x, back above the long-term average of 16.19x. Against the background of moderate economic growth, stable employment and inflation, it is difficult to see equity price appreciation at the same double-digit rate recorded in the half of 2019. Bond markets may continue to see price appreciation with a Fed cut, but with the 10 yr Treasury yielding 2.0% at the end of June, bonds are effectively at the rate of inflation. On a relative basis, equities yield is still better than bonds for those investors looking for income. Yet if a worst-case scenario eventuates - the Fed’s anticipated rate cuts do not result in either a pickup of inflation or economic growth - then bonds do offer their traditional “insurance” role against a fall in equity prices. Among fixed income products, US Treasuries are historically the least correlated asset class to US equities, with high-yield and convertible most highly correlated. A balanced portfolio will want to have both quality equity and bond exposure to guard against any one of a number of possible scenarios for the rest of 2019.