401(k) plans are currently the predominant source of retirement wealth for most Americans. Two-thirds of employers (67%) report that these plans are the primary retirement savings vehicle for the employees they cover.1 And the plans have proved successful in helping workers save for retirement; more than $3 trillion has been accumulated in them as of the end of 2011.2
While 401(k) plans have positive attributes — convenience, tax deferral, participant investment selection from among plan offerings, employer matching and portability — there are concerns about them as well, including limited participation, investment risks assumed by participants, lack of financial education and fee levels. In this edition of "Washington Insights," we'll examine some ways to rebuild these plans to address these concerns.
Adopt automatic enrollment. Auto enrollment in 401(k) plans (enrolling all new eligible employees automatically, with an individual choice to opt out of participation) has grown steadily since Pension Protection Act of 2006 rules clarified its use. Auto enrollment helps counteract the inertia of eligible employees who might not otherwise take the necessary steps to sign up. Because only about half of US 401(k) plans currently have the auto enrollment feature, there is room for further expansion.
Plan sponsors could be more aggressive in how they default participants into the plan by automatically enrolling them at a higher deferral percentage rate — say, 6% rather than the typical 3%. While some plan sponsors fear that participants will reject a higher auto enrollment deferral rate, studies have shown that 60% of participants leave the default rate unchanged.3 Plan sponsors may also wish to consider extending auto enrollment to current employees as well as to new hires.
Another recent study shows that 94% of plan sponsors who have adopted automatic features — such as auto enrollment; automatic escalation; and qualified default investment alternatives (QDIAs), which are designated investment options when a participant doesn't make an affirmative investment selection — credit them with helping address plan-related goals and driving higher participation and deferral rates.4
Focus on effective employee communication. Traditional outreach methods, such as printed educational materials, in-person workshops and interactive planning tools, are still popular. But the increasing adoption of automatic features signals the need to move beyond education that is entirely plan-centered, such as the enrollment process or investments offered, toward engaging participants in more personalized discussion about individual savings behaviors and strategies, such as their future monthly retirement income needs, spending power and projected retirement lifestyle.4
Many employee communications are ineffective for one reason — new hires and participants don't read them because they're riddled with complex "plan-speak." Invesco Consulting is a leading industry advocate of using clear, effective terms and avoiding technical jargon in educating plan sponsors and participants.
Preserve employer and worker incentives to contribute. A tax-reform proposal eliminating the existing favorable tax treatment of both employer and worker contributions was recently floated. A subsequent survey determined that if workers' ability to deduct any amount of the 401(k) contribution from taxable income were removed, 65% of the plan sponsors surveyed would have less desire to continue offering their 401(k) plan.5 Retaining incentives for retirement plan savings is critical in the effort to maintain or increase participation.
Encourage more savings. Before the recent financial downturn, service providers and researchers estimated that in retirement, workers would need to replace between 70% and 75% of preretirement income. While the replacement rate will differ for each person's situation, estimates now drift toward 80% in the face of questions about Social Security, the rising cost of health care, longevity and other financial planning considerations.6
Despite a challenging economic environment, there may still be room for additional retirement savings. In a recent defined contribution investor survey, 83% of respondents said they could cut their household budgets by at least 5% to save more, including 64% who said they could reduce their budgets by 10% or more.7
Adopt automatic escalation. Automatic escalation — automatically raising participant salary deferral rates on a regular basis, up to a stated ceiling, typically 10% — has proved effective in ratcheting up savings rates. Plans with automatic escalation experienced deferral rates of 8% or higher, compared with the average deferral rates of 4% or less for the majority of plans.4 Plan sponsors may wish to consider:
- Raising automatic escalation above 10%.
- Arranging (with an opt-out provision) for a portion of each raise to flow automatically to the participant's 401(k) account.
As always, plan sponsors should continually communicate the importance of deferring substantial savings for retirement.
Encourage diversification. Professionally managed investment options can be a valuable tool in diversifying investments. The increasing use of target date funds as QDIAs has also helped with the diversification of asset allocation within participant accounts.
Keep an eye on expenses. Plan sponsors should carefully track expenses because fees and expenses can significantly affect a participant's total long-term earnings. Negotiating better fee arrangements could help drive down costs over time. But plan sponsors must also consider the value and quality of investment options; the lowest-priced fund may not always be the best selection for plan participants.
"Stretch" the match. For example, rather than matching 50 cents on the dollar for the first 6% of an employee's pay, an employer could consider "stretching" the match up to a higher percentage of pay, such as 30 cents on the first 10% of pay. Doing so may encourage participants to defer a higher percentage of pay to get the maximum match.
Encourage participants to work longer. It is estimated that fewer than half of US workers will have enough money saved to retire at 65.8 But according to a study by the Center for Retirement Research at Boston College, if they keep working until age 70, the picture potentially improves dramatically, with 86% likely to be financially comfortable in retirement. The study concludes that starting to save early for retirement and working longer may be more effective levers for ensuring retirement security than earning a higher return on savings.8 The later an individual is in his career, the more effective it is to work a few years more because:
- Delaying Social Security benefits can help maximize them.
- People have additional years to contribute to their 401(k)s and allow balances to grow when they postpone retirement.
- A later retirement age means fewer years of dependence on accumulated retirement assets.
While working full time past age 65 is not feasible for everyone, a phased retirement — as opposed to going straight from working life into full retirement — is set to become the norm as more people expect to continue some kind of work activity past traditional retirement age. While 54% of the current generation of retirees went straight from work into full retirement, only 30% of the current working generation expects a similar path.9
Improve plan loan features. When a participant quits or changes employers, any outstanding 401(k) plan loan balance is generally due in full within 60 days. Loans that default in this manner represent a form of "leakage" from the plan.
From a public policy perspective, policymakers should consider extending the 401(k) loan repayment period for terminated participants. A provision of the Savings Enhancement by Alleviating Leakage in 401(k) Savings Act of 2011 (SEAL Act), introduced in November 2011, allows a participant to contribute the outstanding plan loan amount to an IRA by the time they file taxes for that year. Other ideas for reforming 401(k) loans include enabling the outstanding loan balance to be transferred to another 401(k) plan, limiting the number or size of 401(k) loans in the first place and automatically enrolling 401(k) borrowers into loan protection insurance.
People who default on plan loans get hit on three fronts: Aside from depleting their retirement accounts, they incur a tax on their borrowing and an additional penalty of 10% if they are under age 59½.
Enhancing financial education
Close the gap. A recent survey disclosed the gap between understanding what's important and knowing how to take action. For example, 78% of respondents think it's important to determine how much they'll need to save to have a secure retirement, yet only 33% feel knowledgeable about it. Likewise, 82% think it's important to know how to make retirement savings last a lifetime, but just 28% say they know how to achieve this.7
Expand education efforts. Financial education has been shown to improve participants' knowledge and awareness about saving for retirement. Plan sponsors should consider offering classes for participants and enlisting a financial advisor to assist.
Focusing on outcomes
Emphasize retirement income. Traditional defined benefit (DB) pension plans — which typically provide annuities paying monthly installments — are being gradually supplanted by defined contribution (DC) plans such as 401(k)s, which focus on capital accumulation and were originally intended to supplement pension plans. While the amount of accumulated savings is critical, a retirement plan's success is increasingly being measured by how effectively a participant's income will be replaced in retirement. Retirement income options in DC plans help ensure that retirees can match income with expenses by allowing participants to think in monthly terms, as they would with DB plans. By putting savings into the context of the employee's future income, plan sponsors can help participants estimate how much they will have when they retire, which can help them see the plan's value. Gap analysis tells participants whether they are on course to have adequate retirement income, and if not, what they need to do.
Placing a higher priority on retirement income creates the need for more specialized education on such key issues as income replacement ratios, Social Security benefits, life expectancy, the probabilities of exceeding life expectancy and sustainable withdrawal rates in retirement.
Overcome obstacles to retirement income options. Currently, only 28% of plan sponsors automatically show online projections of the retirement income that can be generated from a participant's 401(k) account, with roughly the same percentage showing this information on participant statements.10 But recent regulatory and legislative initiatives aim to raise those percentages:
- Treasury Department guidance on lifetime income options issued in February 2012 recognizes the importance of making retirement assets last for a lifetime.
- The Lifetime Income Disclosure Act, introduced in Congress in February 2011, would require DC plan sponsors to notify participants annually about the projected monthly income they could anticipate receiving (based on their account assets) if they take distributions as annuities.
- An upcoming Department of Labor rule on benefit statements will also demonstrate how to show participants how much their account balance would provide in terms of monthly income at retirement.
Retirement income options in DC plans are not currently popular; only 15% of plan sponsors offer a lifetime annuity payout option. There is increasing interest in overcoming obstacles to providing them. For participants, concerns include portability (within and outside of the plan), control, perceived complexity and cost. For plan sponsors, concerns include recordkeeping, the investment provider's reputation, liability and product mitigation of risk.
Making 401(k) plans stronger
While 401(k) plans have been successful in getting workers across all income levels to save for retirement,11 plan sponsors can strengthen them by:
- Increasing participation.
- Boosting savings levels.
- Enhancing and emphasizing financial education.
- Addressing concerns about retirement income options.
Because the retirement income challenge will become increasingly important, plan sponsors need to reframe the focus of their DC plans from savings to retirement income, consider providing retirement income options to participants and educate them about the importance of generating a retirement income that can last a lifetime.