Why Grandfathering Can Backfire
On paper, grandfathering often sounds like a good idea when a retirement plan change might be perceived by existing employees as being a negative. Implementing auto-enrollment? Let’s not disrupt existing employees and only auto-enroll new ones. Cutting back on employer contributions due to COVID-19? Let’s grandfather existing employees into the old formula. Changing a plan investment? Let’s only do it for future contributions and allow employees to keep their existing money right where it is. Excellent employee relations, right? The new hires will not know what they are “missing,” so there is nothing to be concerned about.
However, when plan sponsors attempt to soften the blow, they often come to regret it - whether it be immediately or five years down the road. Here are some of the reasons why:
- The new hires eventually find out — New hires interact with existing employees, and, in the area of benefits, there are generally no secrets. Nothing says, “Welcome to the firm…” quite like “Oh, and by the way, your colleague in the same position who was here a few months longer than you has much better benefits.”
- Sometimes, in the zeal to avoid employee disruption, the EXISTING employees may end up with the short end of the stick — For example, when automatic enrollment was first introduced, those few employers who rolled it out to all were rewarded by employees having spectacular retirement readiness today. However, the employers who rolled it out only to new hires have found that their existing employees now approaching retirement have among the worst retirement readiness figures of any age demographic, due to missing the power of compounding in their earlier years. Some of these employees are forced to continue working at their employer longer than either they, or their employer, wanted them to.
- There are compliance issues — In a world with no rules, giving certain employees more contributions than others would have no consequences with the government. However, the IRS tends to like treating employees equally, and structures its rules accordingly. Thus, for plans subject to non-discrimination testing requirements (which is most), grandfathering employees often results in the failure of these tests, which is not a good thing. Even worse, the testing failures often do not occur right away, lulling plan sponsors into a false sense of security, until the grandfathered group becomes disproportionately highly compensated, which then blows up the test for years on end.
- The road to prudent fiduciary compliance is paved with good intentions — Consider the example above about not mapping assets when an investment change is made, and, thus, allowing existing employees to retain their old investments. While this may be a brilliant exercise in non-disruptiveness, if the plan is subject to ERISA or similar fiduciary conduct rules, you may find yourself explaining to an investigator that, “Yes, these investments were bad and we replaced them, but we didn’t want to disrupt existing employees, so we allowed them to retain existing assets in those investments even though we KNEW they were horrible.” Here’s another example: those very employees you were trying to protect may now find themselves without enough retirement savings because you decided to auto-enroll some, but not all. They likely won’t be pleased about the issue and will be looking for someone to blame (hint: it won’t be themselves!).
Now there are some limited circumstances in which it makes sense to grandfather employees. For example, reducing the number of outstanding loans from unlimited to, say, three, it makes sense not to force that employee with 50 outstanding loans to pay off 47 right away. But, for the most part, if a change is going to be made that is best for the plan as a whole, plan sponsors who rip off the band-aid and make the change for all will be happier in the end.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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