Data & Research February 20, 2015

Who Has a Realistic View of Retirement Readiness?

A study examines the factors that make individuals optimistic about their preparedness for retirement despite having inadequate resources.
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Forty-two percent of U.S. households are adequately prepared for retirement, while 46% perceive they will have an adequate retirement, recent research finds.

Among all households that are adequately prepared or not, about 52% have a realistic perception of their retirement readiness.

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A study, “Do U.S. Households Perceive Their Retirement Preparedness Realistically?” analyzed the deviation between households’ actual preparedness for retirement and their assessment of retirement readiness, focusing on what factors make some unrealistically optimistic despite being inadequately prepared. Researchers KyoungTae Kim, from the University of Alabama Department of Consumer Sciences, and Sherman D. Hanna, from Ohio State University, found households with a defined benefit (DB) pension plan are more likely to be unrealistic than similar households without one.

The researchers note this is contrary to their expectations, because households with DB plans are able to assess their guaranteed retirement income. A possible explanation is that these households might lack a good understanding of the retirement income generated by their DB accounts, and may just assume that simply having these plans will achieve adequacy.

Similarly, households with a defined contribution (DC) plan are less likely to be realistic than those without one. The researchers say it is plausible that many workers with DC plans are unfamiliar with features of their plans, may be unable to accurately assess retirement adequacy, or may assume that just having a plan may lead to retirement adequacy. They add that these results suggest the need for better employer education for workers with such plans.

According to the research report, it is also possible that workers with these plans have greater financial experience and are more likely to expect mean reversion in returns—that the rebound from a financial downturn will be greater than the downturn—than less-experienced workers without such plans.

 

Among financial experience variables, the study found the age of the household head is positively associated with the likelihood of being unrealistically optimistic. It is possible that cognitive decline may play a role in this pattern, but the researchers say it seems unlikely that this could be the only factor. They point to cognitive dissonance as the reason for the effect of age on over-optimism. The theory of cognitive dissonance posits that individuals are distressed by conflicting beliefs, so they attempt to decrease their dissonance by either changing their past values, feelings or opinions, or attempting to justify or rationalize their choices. With financial experience, people should be better able to evaluate objective situations, but cognitive dissonance may lead to accepting a lower standard of living in retirement, the researchers say.

Another explanation might be that older investors have more experience in stock market cycles and have more belief in the possibility of a stock market recovery by retirement, but that younger investors, with more limited experience, might be pessimistic.

A puzzling finding of the study was that households that use a financial planner are significantly more likely to be unrealistic than those that do not. The researchers say this raises questions about the accuracy or benefit of the financial planning services these households receive.

The researchers also found households headed by a person with a college degree have a lower rate of being unrealistic optimists than those headed by a person with less than a high school degree. In addition, whites are less likely to be unrealistic than households categorized as black or Hispanic and Asian/others. The researchers say other studies have shown whites have more financial experience with stock ownership than minority households, so it seems plausible that the racial/ethnic differences in being realistic about retirement adequacy might stem from differences in investor experience.

The researchers say the findings in the study are partially consistent with their two hypotheses, indicating that households with greater cognitive ability and more financial experience are likelier to assess their retirement preparedness accurately. However, some findings appear puzzling, and they note this may be because one cannot directly measure the degree of cognitive ability and financial experience from the Survey of Consumer Finances (SCF) data set used for the study. They suggest that to obtain more robust results for retirement perception research, a different data set should be used with direct measures of cognitive ability and/or financial literacy related to the retirement context, such as the Health and Retirement Study (HRS).

The research paper may be downloaded from the Social Science Research Network website.

 

Compliance February 19, 2015

Getting Auto-Enrollment Implementation Right

Implementing automatic enrollment without thinking through plan design can result in compliance and administrative issues.
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“When a retirement plan sponsor tells me they want to implement automatic enrollment, I always ask them why,” says Scott M. Dufek, a partner with Dufek & Co. Certified Public Accountants in Chicago, which provides auditing services for retirement plans.

Dufek notes that he often gets blank looks when he asks that question, or the plan sponsor attended an event and heard that it was a good thing to do. “Some plan sponsors jump into it without thinking it through, and they often do not meet their goals or create administrative headaches,” he says.

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“Each plan sponsor has independent reasons to auto-enroll or not,” adds Dennis Sain, senior vice president of Retirement Services at The Newport Group, who is based in Chicago.  He gives the example of a client with only 60% participation in its 401(k) plan, for which Newport has suggested automatic enrollment. The client offers a very rich plan, with 100% match of employee deferrals up to 6%, as well as a profit sharing contribution that all eligible employees receive. The company balked at the additional cost auto-enrolling employees would create. It didn’t have problems with nondiscrimination testing and felt the richness of its plan was accomplishing the goal of attracting physicians to its group, so it decided against auto-enrollment.

However, a plan sponsor more concerned about the relatively low participation rate, or that was having problems with nondiscrimination testing may have decided to implement automatic enrollment. Dufek says if a client is concerned about increasing its costs by auto-enrolling employees, he sometimes suggests the company amend its match formula at the same time. For example, a company matching 50% of up to 6% of employee deferrals may decide to instead match 25% of up to 12% of deferrals. This could also accomplish the goal of encouraging employees to save more.

When plan sponsors have a goal of increasing participation or helping more employees save for retirement, they may consider implementing auto-enrollment for all employees, including existing employees, and not just new hires. The plan sponsor’s goal can determine how conservative or aggressive they are going to be with automatic enrollment, says Sain. An example of a conservative approach, according to Sain, is a client that implemented automatic enrollment to all participants at only a 2% default deferral, without also implementing automatic deferral increases. An aggressive approach was implemented by another client that automatically enrolled all participants at a 6% default deferral and also implemented a 2% per year automatic deferral increase up to 10%.

According to Dufek, a lot of times, companies do have nondiscrimination testing issues and want to implement automatic enrollment so highly compensated employees can defer what they want and not have deferrals returned due to failed nondiscrimination tests. However, if a plan sponsor sets the auto-enrollment deferral rate too low, the average deferral rate may still be too low to help highly compensated employees contribute more. Dufek says companies wanting to solve this issue should auto-enroll at higher deferral rates.

Immediate eligibility for defined contribution retirement plans is increasingly being used as plan sponsors try to improve employees’ retirement outcomes. However, this can be an issue if implementing automatic enrollment. “If there is no service requirement, plan sponsors can end up missing someone, or more likely, auto-enrollment is inconsistent; some employees may be enrolled with their first paycheck, some with the second, some with the third,” notes Dufek.

He recommends plan sponsors change to a service requirement of 60 days and provide for an entry date as of the first of the month coinciding with or following the service requirement. “This gives time for paperwork to be processed and for participants to opt out. It also establishes only one payroll period per month for new enrollments, instead of each pay period,” Dufek says. He adds that this mitigates compliance issues, and it can also solve the issue of having small plan balances for employees who opted out of auto-enrollment after payroll started deferrals, which can add more costs for plan sponsors.

According to Sain, a 30-day service requirement offers enough time for payroll and the plan provider to be notified of the enrollment. He notes that the plan can be amended to allow for a distribution of small plan balances caused by employees opting out of auto-enrollment. The Employee Retirement Income Security Act (ERISA) allows plan sponsors to provide participants with a period of up to 90 days to opt out of automatic enrollment and receive a permissible distribution of those balances with no tax consequences. Sain admits this will add an additional layer of communication and administration for plan sponsors, but it can be helpful in ensuring auto-enrollment goes smoothly.

Some plan sponsors adopt automatic deferral increases along with automatic enrollment, and some provide that the deferral increase is made on a participant’s plan anniversary date, Dufek notes. “I can’t think of an instance where this didn’t cause problems,” he says. He always recommends the increase be effective every January 1 or every January 1 and July 1. “To have to monitor this each payroll date is an administrative nightmare.”

Dufek concludes: “As auditors we see a lot of failures due to automatic enrollment, either breaking the law or operational failures, so plan sponsors should put language in their plan document that is easy to follow and not burdensome to live with.”

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