Financial Illiteracy Challenges Those Investing Only in DC Plans

A research report suggests that people whose only exposure to investment decisions is by virtue of their participation in an employer-sponsored defined contribution (DC) plan are poorly equipped to make sound investment decisions.

Using data from the 2015 National Financial Capability Study, the researchers found that workplace-only investors are very different from other investors. Their level of financial literacy is strikingly low and much lower than the financial literacy of active investors. The difference is reflected in both financial literacy questions which measure basic financial knowledge and the questions that deal with more sophisticated concepts, such as the concept of compound interest. Specifically, only slightly more than one-third (37%) of workplace-only investors have some basic financial knowledge and only 35% can answer the question about compound interest correctly.

In addition, only half of workplace-only investors have some rudimentary knowledge of risk diversification, and only 26% know about basic asset pricing.

The researchers say, “One may argue that retirement accounts will introduce workers to investment and finance and that their financial literacy will improve over time. At least within our sample, this does not seem to be the case. When we split the sample into two age groups, those younger and those older than age 40, we find that the knowledge gap between workplace-only investors and other investors does not decrease across age groups.”

They argue that financial illiteracy impedes plan participants’ ability to determine how to invest their savings, and they note that the Employee Retirement Income Security Act (ERISA) explicitly limits plan sponsors’ liability when a range of appropriate investment choices are provided to participants. (Alluding to ERISA Section 404(c).)

According to the researchers, these concerns are magnified in DC plans that use auto enrollment and auto escalation and default investment options. “Although employees can, in theory, reject their employers’ decisions, financially illiterate plan participants are poorly positioned to do so,” they say. The researchers argue that one size does not fit all. Over the course of a plan participant’s career, he may need to adjust investment allocations. “But the use of defaults is premised on the assumption that employees can determine whether the defaults are appropriate, and in many cases, the low levels of financial literacy suggest they cannot,” they write in their report.

The paper also addresses the concern about the effect of financial illiteracy on plan participant’s decisions about how to decumulate assets once they retire.

The researchers propose one possible solution to the financial illiteracy of workplace-only investors: place greater responsibility on plan sponsors to ensure that participants are investing appropriately for retirement. For example, Congress could narrow or eliminate the ERISA safe harbor for participant-directed plans, or ERISA could be amended to require plan sponsors to oversee or ensure the appropriateness of the choices made by participants.

They also propose mandated employer-provided financial education to address limited employee financial literacy. According to the researchers, three requirements that a financial education program should incorporate are a self-assessment, minimum substantive components and timing. “Formalizing the employer role in evaluating and increasing financial literacy among plan participants is a key step in providing retirement plan participants with the resources necessary to manage important decisions regarding retirement planning and, ultimately, for enhancing the financial security of American workers,” they conclude.

The research report, “Defined Contribution Plans and the Challenge of Financial Illiteracy,” by researchers from the University of Pennsylvania Law School and George Washington University, may be downloaded from here. A registration may be required.