Some 401(k) plan participants have been known to shoot themselves in the foot when taking aim at higher investment returns. Some of these individuals may not be open to advice but, as plan sponsor, you can still provide information about the dangers of firing blindly and expecting to hit a target. Case in point: front-loading deferrals in hopes of boosting returns over the course of the year.
Theory Behind Front-Loading
While front-loading deferrals could theoretically pay off, success depends on two factors:
A steady increase in the value of the securities or funds invested in by the participant, and
A minimal or nonexistent employer matching contribution.
Generally, making a large up-front investment isn’t considered as wise as taking a dollar-cost averaging approach. The latter strings out an investment in installments to blunt the impact of a sudden drop in value. Many participants may understand this concept but still choose to roll the dice and invest as much as possible as soon as possible.
Role of Matching Formula
Understanding the impact of a 401(k) plan matching formula on a front-loading strategy is trickier for many participants. Here’s an illustration based on a pay-period matching basis:
Suppose your plan, like many, provides a 50% match on up to 6% of compensation. An employee earning an annual salary of $120,000 bites the bullet and defers 25% of pay to reach the $19,000 maximum deferral amount as soon as possible.
Assuming a biweekly gross paycheck of $4,615, the employee defers $1,154 per pay period and hits the 2019 deferral ceiling of $19,000 after around 16 pay periods. Because the participant’s deferral exceeds the 6% ceiling on matching contributions, the participant is eligible for the maximum match (50% of 6% is 3%) for each pay period deferrals were made. That amounts to $138.46 for about 16 pay periods, or $2,215.
But what if, instead of front-loading contributions, the participant had set deferrals to hit the $19,000 limit by year end? Doing so would have meant deferring around $731 per pay period instead of $1,154. That $731 deferral per pay period would still entitle the participant to the same matching contribution ($138.45) as under the first scenario, because $731 is about 16% of the participant’s pay — well above the 6% ceiling for the matching contribution. As a result, the participant would get $138.45 matching contributions for every pay period of the year, totaling $3,600, or about 63% more than the contributions received under the front-loading scenario.
A Sure Thing
Although the difference between the two scenarios is only about $1,400, it’s a sure thing under the dollar-cost averaging approach — unlike the investment returns using front-loaded deferrals. Be prepared to explain this to your participants who have “itchy trigger fingers” when it comes to their 401(k) plan deferrals.