These efforts often encompass a significant educational program, aimed at improving participation rates, deferral rates, and asset allocation. This education has been designed to empower participants to make decisions regarding their financial future. Despite this concerted effort, media reports continue to describe how the vast majority of plan participants remain unprepared for retirement. As a result, plan sponsors are starting to move away from concentrating on participant education, and toward effecting successful retirement outcomes among their employee population.
Behavioral finance expert, Shlomo Benartzi, a professor at UCLA Anderson School of Management, advocates that plan sponsors strive to achieve 90-10-90 target rates: 90% participation rate, 10% deferral rate, 90% of contributions allocated towards professionally managed investments, such as target-date funds. If plans as a whole can reach these input targets, individual plan participants will be more likely to achieve outcomes that will allow them to maintain their standard of living in retirement.
One of the ways that plan sponsors are working to enhance retirement readiness is through plan design optimization. Providing education can help foster participant decision-making, but cannot guarantee that the best decisions will be made; therefore, plan sponsors are re-engineering the internal mechanisms of the plans to directly impact participation and savings rates. This restructuring greatly enhances the potential for participants’ successful retirement outcomes. Here are some of the ways plan sponsors are trying to optimize their plan designs.
Shift in Employer ContributionsMany plan sponsors offer their participants an employer base contribution in the retirement plan. This type of benefit does not require participants to do anything in order to receive the contribution, other than work for the organization for a specified length of time. But even the most generous employer base contribution is unlikely to fund a participant’s entire retirement needs. Given the frequency with which workers change jobs, and the inevitable difference in retirement benefits offered from one job to the next, it is imperative that employees undertake some saving for retirement out of their own paycheck.
An employer base contribution does not encourage participants to contribute individually. Yet an employer matching contribution does require that participants engage through salary deferral, in order to receive the employer benefit. Tying the receipt of the employer benefit to an employee’s contribution leads to higher plan participation rates.
Most plan sponsors are aware of this concept. Many have already added a matching contribution component, and/or shifted base contribution dollars into the matching contribution formula as a way to increase participation. Nevertheless, the combination of the employee contribution, plus the employer match, still may not be enough to meet future retirement needs.
The most common matching plan formula is a $0.50 match for every $1.00 of participant salary deferral, up to 6% of compensation. While this formula is often successful in encouraging participants to contribute up to 6% of pay, many participants will need to contribute more than 6% (plus the 3% employer matching contribution), to accumulate enough in their accounts to maintain their standard of living in retirement. This concern has led some plan sponsors to adjust their matching formula.
One way to adjust this formula is to implement a $0.25 match per $1.00 contribution up to 12% of pay. Accordingly, participants are encouraged to double their contribution in order to receive the maximum match from the employer. Making this change adds no cost to plan sponsors’ retirement budgets—the maximum possible employer contribution is still 3% of compensation for all eligible employees.
Automatic EnrollmentSome plan sponsors have chosen an alternative plan design change to increase contributions. Rather than have employees opt in to elect salary deferral contributions, the plan sponsor automatically deducts salary deferrals unless employees opt out. By implementing automatic enrollment, plan sponsors help employees overcome inertia, which is one of the biggest impediments to participation.
Plan sponsors may resist automatic enrollment for two main reasons. The first relates to cost. Any plan sponsor offering a matching contribution that implements automatic enrollment will experience an increase in the cost of the employer match with the higher participation rate. Depending on the level of current participation, this cost increase could be significant. However, either by adjusting the matching formula (per the above), modifying the vesting schedule, or both, plan sponsors can alter their current plan design so that the cost of the greater participation rate still falls within budget.
Plan sponsors also commonly resist automatic enrollment because they do not want to impose the contribution without employees’ affirmative election. As mentioned above, employees do have the opportunity to opt out of the automatic enrollment provision, and affirmatively elect not to participate, or to participate at a different deferral rate. Nevertheless, the overwhelming majority of employees do not do this, which reflects their desire to contribute to a retirement savings vehicle.
Industry studies have shown that when plans automatically enroll employees, the participation rate typically exceeds 80%, and often 90%. These results apply to plans that use anywhere up to 5% as the automatic deferral amount. According to a 2011 Fidelity study, the opt-out rates for plans that defer participants at a rate of 5%, versus as low as 1%, are no higher. In addition, the plan sponsors that have had the most success in attaining high rates of participation have undertaken automatic enrollment for both new and existing employees. These plan sponsors conduct an annual enrollment, whereby the non-participants must elect to opt out each year. By using these methods, plan sponsors are able to capture employees who want to participate, but who have been unable to overcome inertia and actively enroll.
Automatic enrollment offers many positive features for encouraging participants to save. One drawback, however, is that when their salary deferrals begin automatically, participants often take a hands-off approach to saving for retirement. Rather than considering how much they need to save, or which investment option(s) to select, participants may just accept the automatically provided features and never make any change. So while the plan sponsor succeeds in raising the participation rate, the average deferral rate for the plan can actually decline, as these new participants do not adjust their contribution amount upwards over time to save enough for retirement.
A solution to this problem is to implement an automatic deferral escalation feature in conjunction with automatic enrollment. The plan sponsor adjusts the plan design to include an automatic 1% or 2% increase annually to each participant’s contribution rate. For instance, an employee originally enrolled at a 6% salary deferral rate could be contributing 8% after completing one year, and 10% after two years. These automatic escalation features typically have a maximum salary deferral rate at which contributions are capped; the plan sponsor usually sets this cap somewhere between 10% and 12% of compensation.
Plan sponsors achieve the best results when they set the salary deferral increases to coincide with the timing for compensation increases. In this way, participants take home a higher salary amount and save a greater portion for retirement at the same time. Alternatively, plan sponsors often design for the increases to occur on January 1 of each year.
By implementing automatic enrollment and automatic escalation, plan sponsors have a much greater chance of achieving the 90% participation rate and the 10% salary deferral rate. But they will likely still need to take action to get 90% of contributions allocated towards professionally managed funds, such as target-date funds.
As mentioned above, when using automatic enrollment, plan sponsors must select the investment option into which those salary deferrals will be allocated. In 2006, the Department of Labor (DOL) passed the Pension Protection Act which identified Qualified Default Investment Alternatives (QDIAs), of which target-date funds are the most popular. By passing this regulation, the DOL signaled its approval for granting plan sponsors fiduciary protection if a QDIA is used as the default option. As a result, the usage of target-date funds in DC plans has risen dramatically over the past six years.
According to a Morningstar study from May 2012, target-date fund assets in defined contribution plans increased by 500% from the end of 2005 to the end of 2011. Nevertheless, participant elections, combined with automatic enrollment defaults, are still unlikely to shift the plan as a whole to the 90% allocation target.
In view of this, some plan sponsors have implemented re-enrollment of investment allocation. Participants, who are not using the target-date funds, or some other professionally managed investment allocation, are asked to reelect their investment choices. Those participants who are truly committed to their investment allocation will likely re-enroll using the same funds, or a similar allocation. It is likely, however, that others will either enroll in the target-date funds, or not re-enroll at all. Once again, plan sponsors can help overcome participant inertia by automatically moving participants to the target-date fund that most closely matches the year the participant will reach age 65, if the participant does not re-elect investment options. Some plan sponsors do so on a recurring basis when they have open enrollment for health benefit elections. This re-enrollment, coupled with the default investment selection, can bring plans much closer to the 90% target allocation.
With all of these automatic features, at any time participants have the ability to change salary deferral contribution amounts, opt out of the automatic escalation feature, change the investment selection, or to stop contributing altogether. Moreover, these design optimization steps are not intended to replace plan education. It is still important for plan participants to receive regular communication about the plan and its features, so that they can understand their options and take control of their financial future beyond the set default mechanisms.
However, by implementing changes to plan designs, plan sponsors can help solve the problem of inertia and promote greater savings for the participants. While a plan may not achieve the 90-10-90 target benchmarks, taking steps to alter the plan design can help foster growth in the participation rate, deferral rate and rate of allocation to professionally managed investments. These design changes should help enable those participants who never take control of their retirement account to accumulate a retirement balance, and still have a better chance of maintaining their standard of living in retirement.
Earle W. Allen, vice president of Retirement at Cammack LaRhette Consulting
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.