Defined Contribution Plans: Participation & Distribution in the US vs the UK
In the United States, A 401(k) plan, named after the tax code section that provides the plan’s tax-deferred nature, is the most common type of employer-sponsored defined contribution plans. A 401(k) defined contribution plan is based on employee contributions, profit-sharing contributions, and employer matching contributions, all of which are generally tax-deferred at the time of contribution and invested in accounts over which the employee has investment control.
In the UK, occupational defined contribution plans, group personal pension plans, and master trusts are the most common types of employer-sponsored defined contribution plans.
Contributions made by employees and employers to these plans are tax-favoured. Therefore, investments can grow free of capital gains and income tax while inside the scheme. In addition, employees will typically have a variety of investment options to choose from. Here, we’ll talk about how participation and distribution of defined contribution retirement plans are enrolled and managed in the US and the US.
Employers and policymakers have identified that broad participation is critical to the success of defined contribution plans, as they are funded in part (or entirely) by employee contributions. The US and the UK have approached this issue in similar ways but with different enforcement procedures.
The United States
In the US, auto-enrollment is a popular method of encouraging participation in defined contribution plans. Under this strategy, newly recruited employees are automatically enrolled in the plan and are considered to elect deferrals at a specified percentage (e.g., 3% of pay) unless they opt out. However, because of the power of inertia, many employees simply accept the contribution percentage.
A variation on this strategy is to auto-enrol all employees, including current employees, excluding those already participating, at a predetermined rate, usually. In addition, some employers have implemented auto-escalation, in which an automatically enrolled employee’s contribution percentage is automatically increased each year by a specified percentage up to a maxed amount unless the employee opt-out.
Both auto-enrollment and auto-escalation are not required by law. Employers, on the other hand, have an incentive to apply these features. The US tax code needs 401(k) plans to meet annual contribution testing. This testing, known as the “ADP test,” requires that, as a condition of tax-favoured treatment, the highly compensated employees cannot contribute significantly more than the non-highly compensated employees.
Because the most highly compensated employees are likely to prefer to maximise contributions to the plan, employers are driven to find methods to encourage broad and meaningful employee participation. Employers, of course, want their employees to participate in 401(k) plans because it is in their best interests.
Although many employers have implemented auto-enrollment and auto-escalation methods, some may be uncertain because an operational error in applying these rules can lead to significant adverse tax consequences for them.
The United Kingdom
The UK has identified the value of auto-enrolment, but it has gone a step further by automatically requiring all employers to enrol eligible employees in a qualified pension plan. The plan must satisfy minimum quality standards, including a minimum rate of employer contributions. The rules were phased in, first with the largest employers and gradually expanding to include smaller employers. In this case, employers are also obligated to automatically re-enrol employees who have opted out and continue to fulfil the eligibility requirements every three years.
Although auto-escalation is legal in the UK, it is not required and is seldom practised. However, as employers become more concerned about employees in defined contribution plans having enough funds to retire, this feature may become more frequent to use.
The effectiveness of a defined contribution plan as a retirement vehicle is heavily reliant on how employees withdraw their account balances. Early and fast distributions might result in insufficient retirement savings and poor financial decisions.
As an outcome, employers and policymakers in the US have set up mechanisms to support long-term, intentional distribution patterns in defined contribution plans. As a result, in the US, savers have had more control over how they utilise their retirement assets stored in defined contribution plans since 2014.
The United States
401(k) plans in the US usually provide distribution in a lump payment upon cessation of employment. The lump sum can be withdrawn as taxable cash or moved tax-free into an individual retirement account (commonly known as an IRA). You have a flexible income drawdown once transferred to an IRA. Some 401(k) plans also allow for instalment payouts and, in rare cases, purchasing an annuity with the account balance.
Some employers have been discouraged from giving any forms of payment other than lump-sum due to the expense, additional administration, and fiduciary risk of supplying items like instalments and annuity purchases. As a result, the US government has taken certain regulatory steps in an attempt to persuade 401(k) defined contribution plans sponsors to provide these distribution options. One measure was intended to decrease the fiduciary risk associated with selecting an annuity product to offer through the plan.
Another step was designed to smooth the way for the introduction of a new annuity product known as a qualified longevity annuity. This product is intended to be purchased with a portion of the employee’s account balance and provides an annuity benefit only if the employee lives to a specific age. This protects against the possibility that the employee may use up their account balance too quickly.
Although this product has not yet been widely adopted due to concerns about administration and portability, among other things, it may become an appealing way to offer employees the best of both worlds, a controllable account balance and protection in the event they outlive their 401k defined contribution assets.
The United Kingdom
Generally speaking, employees in the UK can access their defined contribution plan funds without penalty at the age of 55 (increasing to 57 by 2028) or sooner if they are unwell. They also have had far greater control over distributions from their pension pot.
Savers may withdraw up to 25% of their savings as tax-free cash, and then with the remaining 75%, they can take an annuity or have a flexible income drawdown.
In the past, employees that took more than 25% of their savings as cash would have to pay a 55% tax penalty on the excess, above 25%. As a result, only a small number of people performed this step.
Furthermore, systematic withdrawal alternatives were only available to those with substantial pension funds. However, substantial modifications to the tax regulations were enacted in April 2015’s Pension Scheme Act, which means that:
As savers reach the age of 55 and begin to make decisions regarding the distribution of their pension funds, the decline in the predominance of annuity distributions needs more support and knowledge. Providers are also considering the possibility of offering default decumulation alternatives for those who do not make a decision for any reason.
To summarise, the US and the UK confront comparable issues regarding the essential role of defined contribution plans in retirement planning. Some similar remedies have been applied by the countries, while the methods have been extremely diverse in other situations. Employers and policymakers in each jurisdiction would benefit from learning about the trials, successes, and challenges that each country has faced in this area.
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