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The Role of Roth in Defined Contribution PlansBy Pamela Hess, CFA, Director of Retirement Research, Aon Hewitt, and Valerie Kupferschmidt, JD, Benefits Counsel, Aon Hewitt Most financial experts agree that a Roth savings feature can provide a significant benefit to a variety of savers—across various ages and pay levels. Although governmental 457(b) plans do not allow Roth contributions today, effective January 1, 2011, with the enactment of the Small Business Jobs and Credit Act of 2010, those plans will have the option to add a Roth contribution feature. The Act will also allow certain qualified participants to convert before-tax and after-tax money to a Roth account within a plan.
In the private sector, the Roth feature has been available to plan sponsors since 2006 (for 401(k) and 403(b) plans). Among early adopters, participant usage of Roth has been robust, especially among newly enrolling employees. With recent legislative enhancements and proven success among participants, Roth is expected to be a standard part of defined contribution plans in the coming years, including among 457(b) plans.
Background on Roth Provision
Roth contributions were introduced to 401(k) and 403(b) plans beginning January 1, 2006, and were made permanent with the Pension Protection Act of 2006. Corporate plan sponsor adoption began in 2006, and currently nearly one-third of 401(k) plans offer a Roth feature. This number is expected to escalate significantly in 2011. With the recent passage of the Small Business Jobs and Credit Act of 2010, governmental 457(b) plans will be able to offer this feature in 2011 and beyond.
A Roth feature allows participants to make after-tax contributions to their 457(b) plan, which accrue earnings tax-free and allow for tax-free distributions in retirement if the Roth account is held for at least five years and distributed after age 59½. Apart from differences in tax treatment, Roth and before-tax contributions bear many similarities:
The evolution of Roth in the employer plan environment also includes the concept of Roth conversions. The Pension Protection Act created the opportunity for employer plan savings to be converted directly to a Roth IRA, and interest in these Roth conversions has grown even stronger since the income limits went away at the end of 2009. Now, the same law that will allow Roth features to be added to governmental 457(b) plans also gives plans with a Roth feature the option of allowing conversions of before-tax plan money to the plan’s Roth account. For governmental 457(b) plans, this means that any plan money that employees can convert to a Roth IRA will be able to be converted to the plan’s Roth 457(b) account—allowing those employees to continue to benefit from lower costs, protections and features of a 457(b) plan.
Employee Usage
Aon Hewitt analyzed participant behavior among 20 large 401(k) plans that had implemented Roth, covering 504,000 eligible employees. The study found that where available, in total, 7.4% of active workers elected to save in the plan’s Roth account. Usage was substantially higher among newly enrolled workers (nearly 13%).
Overall participant usage tends to grow through years one and two, and then stabilizes after three years. Chart 1 shows the overall participant utilization post adoption, with 7% of participants making
 Roth contributions one year post implementation and 15% on average three years after. It appears to plateau at three to four years and remain steady; however, little is known at this point given the Roth’s limited tenure. Usage of a Roth 401(k) feature varied significantly by company - ranging from 4% to 22% of participants. Most companies that saw low Roth usage either recently implemented the feature or automatically default their new hires into a before-tax option (rather than Roth). Plans with relatively higher usage had been early adopters of Roth and/or were organizations with more financially savvy populations. It is notable that most of the early adopters were insurance, financial services, or professional services organizations.
 Younger participants are more likely to use a Roth 401(k) feature than older participants. In addition, those earning between $60,000 and $80,000 had the highest usage of a Roth 401(k) feature. However, considerable adoption was also seen in all income levels above $40,000 (Chart 2). Slightly more than half of the Roth contributors also contributed to before-tax accounts. New enrollees and younger participants were more likely to make all contributions to a Roth account versus splitting their contributions between Roth and before-tax accounts, compared to existing participants and older workers. Those who split their contributions between a Roth 401(k) and a before/after-tax account usually had a higher contribution rate than those who contributed solely to a Roth account.
Conclusion
Given its relatively short history, a Roth option has proved beneficial to a meaningful segment of plan participants within the 401(k) marketplace. The Roth feature is becoming increasingly prevalent in 401(k) and 403(b) plans, and it is likely to become an inherent feature within 457(b) plans given recent legislative changes and the popularity of Roth in other defined contribution plans.
As governmental 457(b) plans begin adopting Roth, it requires thoughtful planning, implementation and communication. The following are helpful considerations to make a Roth implementation a success:
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