A Putnam Institute research paper, Defined contribution plans: Missing the forest for the trees?, shows that a number of variables are at work in determining plan effectiveness, including deferral rates and plan design, asset allocation, rebalancing behavior, and individual fund performance. Putnam contends that the industry would do well to bear in mind this hierarchy when considering ways to boost retirement preparedness.
“As we look at the progress participants are making toward securing a better retirement savings outcome, deferral rates are one of the most important factors to stress, whether in communication to participants about how to accumulate more wealth or in restructuring DC plans for better saving and investing success,” W. Van Harlow, Ph.D., CFA, director of research at the Putnam Institute, wrote in the paper.
While it is not surprising that if a person saves and invests more, he might be more likely to accumulate greater wealth, but the study found the size of the difference in terminal wealth can be dramatic. As an individual’s contribution increases from 3% of income to 4%, 6%, and 8%, the final balance after 29 years jumps from $136,000 to $181,000, $272,000, and $334,000, respectively.
Even a 4% deferral—which represents a 1% increase that does not take advantage of the plan’s full matching contribution—would have a wealth accumulation impact 30% larger than the “crystal ball” fund selection strategy, nearly 100% larger than the growth allocation strategy, and approximately 2,000% larger than rebalancing. “Putting deferral rate changes in these terms, the performance of underlying funds and rebalancing, in particular, appear to become far less meaningful when compared with the impact of higher deferral rates,” Harlow noted.
The study data suggest that focusing on helping eligible employees enroll and/or increase their deferrals into their DC plan is an effective way to help boost wealth accumulation potential. Therefore, Putnam says services such as auto-enrollment and auto-deferral increases are two critical best practices that plan sponsors should consider implementing.
According to the paper, a qualified automatic contribution arrangement (QACA) that increases an individual participant’s deferral rates from 3% to 10% by one percentage point annually—and then maintains a 10% deferral rate thereafter—would have roughly the same impact as an 8% deferral rate over the 29-year time frame employed in the study. “Clearly, auto-escalation features can play a vital role in helping secure substantially higher savings for plan participants, particularly the majority of savers who have historically tended to participate passively in their plans,” Harlow said.The research paper is available here.