Ted's Table

June 19, 2001 This Week, Ted Tackles: I invest my 401(k) money in the stock purchase plan offered by my employer. They say I own units rather than shares of stock. How does this work? ... Can a company force its employees to fund an ESOP with their own 401(k) contributions? ... How do I calculate my rate of return? ... If I cash out of my 401(k) because I'm leaving my job, when will I get my money?

Question: I invest my 401(k) money in the stock purchase plan offered by my employer. Company contributions are also in stock. When I asked my employer about my investments it said I don't own stock, I own "units." I asked how to correlate the units to the number of shares of stock it represents and my employer said there is no correlation. Can you explain how this works? At one time I believe I had $2 million in my account and approximately 25,000 shares of stock.

Also, the plan information says the money I put in the 401(k) is not all placed into the plan — a portion is held in a money market fund to pay for the plan fees. This amount is never shown in a quarterly statement and no plan fees are shown either.

How can I find out what I am being charged for or credited for in my company's 401(k) plan? For instance, I never received a dividend. What happened to that money?

TB: Although you are participating in a stock purchase or Employee Stock Ownership Plan (ESOP), these plans can hold investments other than employer stock. It is common to retain some cash in the plan to handle benefit distributions for those who don't want to receive shares of stock when they leave the company, particularly if the stock isn't publicly traded. There are two methods of reporting the plan holdings to participants.

One approach is to show the shares of stock and cash investments separately on the participant statements. With this method, your shares of stock are reported separately from your other plan investments such as cash. You would know how many shares of stock you have in your plan account with this method and how much cash.

The other method, which sounds like your situation, is to run all the investments the plan holds as a single, unitized fund similar to how mutual funds operate. Your interest in the fund is reported as units, in this case, rather than shares of stock plus cash. All transactions of money into and out of the plan take place at the unit value with this method. The price of a unit won't move up or down at the same rate as shares of the stock because not all the money is invested in company stock. If the only plan assets are cash and stock, the unit price won't go up as fast or drop as much as the shares of stock. The amount held in cash dampens the change in unit value during up and down moves compared to 100 percent stock.

Most companies don't pay dividends on their stock. This may be the situation with your employer. That could be the reason why there aren't any dividends. If there are dividends, they should be included in the total investment income that is reported when you receive your statement. The dividends are most likely combined with other investment gains and are reported as a combined item on your statement.

You also indicate that contributions are invested in a money market fund for some period of time and the interest earned is used to pay administrative expenses. In most instances, participant contributions are invested in the applicable plan investments as soon as they are deposited in the plan. I am aware of situations where new contributions are deposited into a money market fund for a short period because they can't be invested directly in the applicable mutual fund or other plan investments. One example would be the lack of sufficient cash flow allocated to a specific fund to meet the minimum investment level each time contributions are deposited. In such an instance, it may be necessary to park money in a money market fund until a sufficient amount has accumulated, perhaps over a two- to three-month period. It is also common in this type of situation to use the investment income to pay plan administrative expenses. The reason is that often the work involved in allocating among participants the small amount of interest earned costs more than the interest that is earned.

One final point, $2 million of stock in your account is great (Wow!) but apparently it is worth less now. You should think about diversifying by moving money into other investments at some point if you have this option. You have too much invested in only one stock. As I am sure you are aware, the stocks of many companies have been hammered during recent times, with many of the losses exceeding 50 percent. The list includes stocks of a number of larger companies that had only gone up for many years prior to this decline. This recent experience underscores the fact that no company seems to be able to stay among the high flyers for more than a decade or so.

Question: Can an employer force company employees to fund an ESOP with their own 401(k) funds?

TB: In a way, yes. A growing number of employers are using what is called automatic enrollment, whereby newly hired employees are automatically signed up for the plan. A typical contribution is 3 percent of pay. Employees are permitted to opt out of the plan before contributions start to be deducted from their pay.

One of the key decisions employers must make when setting up an automatic enrollment mechanism is how the contributions will be invested. The employer is responsible for choosing an investment or mix of investments that is in the best interests of the employee. Company stock could be one of the selections if the company operates an ESOP.

Question: When I am trying to calculate my balance projection I have to calculate my rate of return. What exactly is that?

TB: I am assuming you are projecting how much you will have when you retire so you will be able to determine whether you are on track to meet your retirement goals, and you are probably using a retirement calculator that asks you to input your rate of return. It is necessary to use what you think will be the rate of return you will achieve between now and retirement. The rate that you use should be in line with long-term historical returns for the types of investments that you hold in your account. The following are ones I use:

These are somewhat lower than the average for these types of investments for the past decade, but they are more in line with long-term returns. I recommend using these conservative rates of projected return when you do your calculations because it is much better to get a return that is higher than what you assumed rather than one that is lower.

A way to determine your actual, approximate return is to divide your total investment gain or loss for the year by your beginning-of-year balance plus 50 percent of all deposits and minus 50 percent of all withdrawals that occurred during the year. Here is an example assuming the following:

Question: If I cash out of my 401(k) because I'm leaving my job, how long can my company hold my money? Also, can I pay my taxes when I shut it down or do I have to pay them when I file?

TB: When you get paid will depend entirely upon the provisions in your plan document and the administrative procedures at your company. It is permissible to structure the plan so that your benefit is held in the plan until the normal retirement age, which is usually age 65. This is unusual for 401(k) plans, but it is permitted.

The most common approach is to pay out shortly after the employee leaves. Many employers don't want the administrative hassles and extra expense of maintaining accounts for departed employees.

The administrative procedures for some plans are such that payments are made only once a year after the annual valuation has been completed.

As you can see, employers have a lot of latitude when they design the plan. However, once the specific structure has been established, employers must administer the plan in accordance with the plan document. The plan must also be administered in a uniform and non-discriminatory manner. You should be able to obtain the applicable information for your plan from the summary plan description, from the person who oversees the plan at your company, by contacting someone at the financial company that manages the plan, or by asking some former employees.

Concerning taxes, if you roll the money directly to an IRA or a new employer's qualified plan, there is no tax consequence. However, if you take the money with the intent of spending it, your employer will automatically withhold 20 percent for taxes. You will have to reconcile with the IRS the final tax owed (depending on your tax bracket) when you file your yearly tax return. Further, you will have to pay a 10 percent early withdrawal penalty, unless you are older than age 59ý or are taking early retirement at age 55. Additionally, you will have to pay any applicable state and local taxes.

As you can see, you will lose 30 percent of your money right off the top if you cash out (Ouch!) and probably more when you file your return.

Your question is common, especially among folks with small balances in their plan. I urge you not to underestimate the potential earning power your money has. Many people don't understand the concept of the time value of money. That's what makes even a small initial balance have a large earning potential through interest compounding. You spent time accumulating your current balance, and it has spent time compounding. It's hard to make up for that time if you cash out.

I recommend rolling your money into an IRA or a new employer's plan.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every Tuesday. With over 30 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored two books, Helping Employees Achieve Retirement Income Security and Escaping the Coming Retirement Crisis, and is President of the 401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and comments have appeared in numerous publications, including The New York Times and The Wall Street Journal.

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The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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