401(k) Plan Withdrawal Discrepancy Protection

By David Langer, FCA, ASA, EA, David Langer Company, Inc., Consulting Acturaries

Large fluctuations in the stock market have made administrators of 401(k) plans keenly aware of the need to protect against discrepancies between amounts withdrawn from a fund on a given date, for whatever reason, and the amount actually in the fund on that date. Discrepancies can arise from 1) normal delays in completing transactions after a valuation date and 2) investment selection against the plan. An illustration follows that demonstrates how the discrepancies might happen.

Normal Delays in Completing Transactions
Mary Smith terminates employment on August 25, 1994 and requests payment of the balances in her GIC and equity accounts as of September 30, 1994, the next plan valuation date. By the time participant and financial data have been prepared and delivered to the record keeper and the valuation completed, several weeks may have elapsed, and Mary's check will not be cut until perhaps November 15, 1994. Her values are as follows:

9/30 11/15 Change
GIC fund $30,000 $30,300 +$300 (1%)
Equity fund $20,000 $19,000 -$1,000 (-5%)

GIC Fund: The GIC fund rose 1% between 9/30 and 11/15. Each remaining participant therefore experienced a 1% increase in account balance. In addition, since Mary received $30,000 as her distribution, the $300 increase in her account will be reallocated to others. If the total of their GIC accounts on 9/30 is $2,000,000, then they will receive $20,000 as direct investment yield plus $300 as a reallocation of the yield on Mary's account that she will not receive. The total of $20,300 represents a yield for the others of 1.015% rather than 1%.

Equity Fund: The equity fund dropped 5% from 9/30 to 11/15. Each remaining participant therefore experienced a 5% decrease in account balance. In addition, since Mary received $20,000 as her distribution, the $1,000 decrease in her account will be reallocated to the others. If the total of their equity accounts on 9/30 is $1,000,000, then they will suffer a direct investment loss of $50,000 plus another $1,000 as a reallocation of the loss on Mary's account that will not be charged against her. The total of $51,000 represents a loss in yield for the others of 5.1% rather than 5%.

Several simultaneous resignations or a large market drop will exacerbate the discrepancies.

Investment selection against the plan
John Jones terminates employment on March 5, 1995. Under the terms of the plan, he is entitled to request payment of his accounts as of December 31, 1994, the preceding valuation date. John is fully aware that the 10% decline in the stock market in early 1995 caused his equity account to depreciate and naturally exercises his option for receipt of the December 31, 1994 value. Since he was bullish on the stock market, his money is all in the equity fund. As of 12/31/94 it was worth $100,000; as of 3/5/94 it had dropped by 10% to $90,000, a loss of $10,000. If the total of the other participants' equity accounts on 12/31/94 was $1,000,000, then they will have suffered a direct loss of $100,000 plus a reallocation of the $10,000 drop in John's account for a total loss of $110,000, an aggregate negative yield of 11%.

Besides payments made on termination of employment, other transactions that can create discrepancies are transfers between funds and withdrawals (and loans to some extent). In general, the larger the amount of the transaction, the greater the effect of discrepancies on the other participants.

Should Mary have been paid the $300 accrual on her GIC account and borne the $1,000 loss on her equity account? Should John have been allowed to select against the other participants by being given the right to receive his 12/31/94 equity account value, which allowed him to put $10,000 more in his pocket, but at the expense of the remaining participants? While moderate amounts of discrepancies can be tolerated, particularly in a very large fund, it is usually more satisfactory on balance to eliminate them to the greatest extent possible to preserve equity. Any method to accomplish this purpose should preferably be as simple as possible. Some remedies worthy of consideration are the following:

• Monitor changes in asset value. If a change in an account between the valuation date and the transaction date is more than a specified value, say 2%, then halt any transactions until another valuation can be run.

• Speed up the valuation. This creates a shorter time between the valuation date and the completion of the transaction, but requires, of course, faster collection and communication of contribution and financial data.

• Do more frequent valuations. This tends to reduce the magnitude of asset value changes if transactions are based on the preceding valuation, but will not prevent antiselection if a sudden change in the market occurs. It also permits faster completion of transactions if these are based on the next valuation date.

• Use close estimates of changes. In the easy cases of a GIC or a Treasury bill fund, credit the known or estimated interest yield for the period. For stock and bond funds, ask the investment manager on the transaction date for the exact or reasonably estimated change in fund value and recalculate the amount to be withdrawn from the fund on or as soon as possible after that date. Changes in the value of any interim contribution can usually be ignored or estimated, since they will be relatively small. If share values are available, then greater precision may be possible.

• Transfer to money market account. Transfer the amount (or estimate) of the withdrawal to a money market account as soon as it is known to reduce fluctuations that can occur before the payment is actually made.

• Prevent antiselection. To prevent antiselection, permit transactions only as of the next or next future valuation date, with any adjustments that are reasonable.

A remedy should clearly be related to the type of investment, the frequency and method of valuing assets, the sponsor's objectives, and the flexibility of the record keeping system. The plan document should, of course, provide the applicable fiduciary with the authority to establish plan rules in this area.

Copyright 1996 The CPA Journal
Reproduced with permission.