A Supercharged 401(k)
Imagine a company sponsoring a defined contribution (DC) plan that automatically enrolls new employees into a qualified default investment alternative (QDIA) target-date fund (TDF) or managed account with a deferral rate of 6%—taking full advantage of the standard matching formula right away—and 1% annual escalation increases, up to a threshold of 12% or 15%. A company that re-enrolls existing, nonparticipating employees into this DC plan at these rates every two years to ensure that as many participants are saving as possible.
Imagine a company that puts so much emphasis on participant education that, much like an investment policy statement (IPS) with stated goals, it has an education policy statement (EPS). And, to determine the success of the plan, benchmarks of participation, deferral and retirement readiness rates are used not only at the sponsor level but also the participant level. And, finally, that the plan considers the livelihood of retired employees with guaranteed retirement income and drawdown provisions.
While automatic enrollment and target-date funds have, recently, been the most popular enhancements that today’s retirement plans have embraced, industry experts agree that retirement plan advisers are beginning to help sponsors consider turning their plan into a “supercharged 401(k).”
‘The Golden Age’
“The golden age of the 401(k) is nigh,” says Kris Garlewicz, financial adviser with Chicago Oakbrook Financial Group in Oak Brook, Illinois. “Auto-everything is just about here—enrollments, escalation, reinvestments and rebalancing. Studies by various financial services firms show that plans designed with auto[matic] features truly increase participation, contributions and overall success of retirement plan outcomes for participants.”
“There is no question that this whole topic of ‘auto’ is starting to become more mainstream,” agrees Stig Nybo, president of Transamerica Retirement Services in San Francisco. “But it is fairly early on. We had a lot of activity toward automatic enrollment and target-date funds after the Pension Protection Act [PPA] was passed in 2006. We are now in the second leg of that journey, where creating better results and outcomes through additional automatic features is the focus.”
Although automatic enrollment has been gaining traction over the past several years, particularly since the passage of the PPA, it is far from universal, data from last year’s annual PLANSPONSOR Defined Contribution Survey show. Automatic enrollment appeared in 41.7% of all plans in 2012, up from 33.4% in 2011 and 29.4% in 2010. Among micro plans, which have less than $5 million in assets under management, only 28.2% automatically enroll new employees. The larger the plan, the more prevalent the adoption of automatic enrollment—up to 58.5% among plans with more than $1 billion in assets under management.
Next Big Steps
The most common default deferral rate for automatic enrollment across all plan sizes is 3%, used by nearly half (45.6%). That is followed by a deferral rate of 2% (found in 12.2% of plans) and then a deferral rate of 4% (used by 10.4% of plans), the PLANSPONSOR data show. As far as automatic escalation is concerned, less than one-third (29.6%) of all plans had this in 2012, up from 16.7% in 2011.
Experts say those rates are far too low and retirement plans need to embrace higher deferral rates and automatic escalation. “We have to change from the mindset that an automatic 3% default rate is enough,” says Tom Gonnella, executive vice president with Lincoln Trust in Denver. “Everyone seems to start at a 3% default rate, and most do not have auto-escalation. That’s not the right answer. A 3% deferral rate with auto-escalation is still not the right answer.
“The good news is that we’re seeing a lot of interest among plan sponsors to change to a much more aggressive auto-enrollment, with a 6% default rate and 1% or 2% annual escalations—getting people up to deferral rates of 10%, 12% or more,” Gonnella says. “That gets to be a pretty healthy plan design. To make sure the industry moves in this direction, plan advisers can help educate sponsors on the upside of company matches, auto-enrollment and auto-escalation.”
There is plenty of room for improvement. In fact, Lincoln educated itself on its retirement plan, Gonnella says, and examined deferral rates and average balances. Thirty percent of Lincoln Trust’s defined contribution participants were contributing less than 5% of their salary, and the average balance was $77,000, he notes. “It was a wake-up call for us as a company and as an industry.”
As a result of the findings, in January, Lincoln Trust launched a newly designed plan for its employees. In the plan, automatically enrolled employee contributions start at 5%, with 1% annual increases up to a 10% cap. Contributions are placed in one of five diversified, risk-based asset-allocation models according to a participant’s age and risk profile. “This plan gives participants a greater chance for retirement success,” Gonnella says. “We put our money where our mouth is on this issue.”
This year, Lincoln Trust is making this model available to its plan sponsor and adviser clients, and, while the company has yet to actively advertise or market the new design, Gonnella says he has already received inquiries from a number of retirement plan advisers.
At retirement plan consultant Longfellow Advisors in Boston, “auto-escalation is more and more commonly becoming part of our discussions with sponsors,” said the firm’s assistant vice president of retirement plans, John Buckley. In fact, Longfellow believes “auto-escalation will be the next big thing” and that if advisers are not already having this conversation with their plan sponsor clients, they should be.
To make auto-enrollment, auto-escalation, higher deferral rates and even periodic re-enrollment for existing employees more common topics of conversation with the plan sponsor, advisers and providers need to put these options in the “context of the need for a deeper level of engagement with participants,” says Chris Augelli, vice president of product marketing and business development with ADP Retirement Plan Services in Florham Park, New Jersey. “We need to be more focused on making sure that automatic enrollment is maximized and that participants are actually preparing themselves adequately for retirement.”
Target-Date Funds
The next step plans need to take in their automatic enrollment efforts is to use a target-date, lifecycle, balanced fund or managed account as the QDIA—with the goal of ensuring that participants are properly diversified, experts say. With nearly two-thirds of plans now embracing some type of target-date fund as their QDIA, an adviser to a plan lacking an asset-allocation fund in that role may want to rethink that plan design. The results from the 2012 PLANSPONSOR DC Survey show that 56.9% of plans have a TDF as the QDIA; the most common is a retail actively managed TDF (found in 31.1% of plans) followed by a retail indexed TDF (15.8%) and a custom TDF (10%).
“We are encouraged by the approach we are seeing plan sponsors take, which is a real focus on plan design and many of those features that drive better outcomes,” says Sue Fulshaw, managing director of retirement plan product management with TIAA-CREF, based in Boston. “This includes automatically enrolling participants to a lifecycle fund, escalating their contributions each year and offering simplified investment lineups that include secure retirement income as well as growth funds. While these services have been available for a number of years, they continue to gain momentum, and we see plan sponsors taking increased interest in boosting outcomes every year.”
As far as re-enrolling employees, this has yet to become a standard practice, Fulshaw and her peers agree. “Most employers shy away from that option,” she explains. “They know their population and why employees have opted not to stay in the plan.”
Some plan sponsors view the practice as “too paternalistic,” notes ADP’s Augelli. Indeed, PLANSPONSOR found that less than a third (29.1%) of plans that use auto-enrollment enroll existing employees not already in the plan.
Benchmarking
To help improve plan design and results, retirement plan advisers also benchmark plan participation, deferral rates and balances at the plan sponsor level, so that companies offering retirement plans can see how their plan stacks up against others of similar size and in their industry sector. Advisers are now taking this a step farther, by beginning to bring benchmarking to the participant level, showing investors how their own deferral rates and balances compare with others in their income bracket and age—with the aim of motivating them to outpace their peers.
“Showing investors how their balance compares with others’, like a leader board on a pinball machine, offers investors a new, lighthearted, ‘game-ification’ approach to retirement planning,” says Chad Parks, president and CEO of The Online 401(k), a Web-based retirement plan provider headquartered in San Francisco. “People, particularly younger investors, are now used to online banking and financial software, tools and calculators like Quicken and Mint.com. Why not match technology with behavioral finance? Why not try to motivate younger investors at lower income levels to save for retirement by using a calculator that shows them the immediate tax benefits of contributing to their 401(k) and what tax deferred investing means?”
Automated functions and online tools cannot exist in a vacuum, however, experts agree. Because people change jobs, on average, every five years, becoming able to cash out of their portfolio as well as roll it over—not to mention that they can take hardship withdrawals and loans in almost all 401(k) plans—education on “leakage” control is paramount.
“We need to change people’s beliefs about their ability and need to save for retirement,” says Transamerica’s Nybo, who is advocating for an industrywide campaign to raise retirement savings awareness among Americans, along the lines of other major public service campaigns, such as “Keep America Beautiful” and “Click It or Ticket.”
“Luckily, we have moved beyond the basics, such as investment due diligence,” Nybo says. “Now that we are looking at improving outcomes, we are at an exciting inflection point in our industry.
Cost Concerns
How sponsors can mitigate costs as participation rises
Many plan sponsors are concerned that, if they offer company matches and automatically enroll employees in their defined contribution (DC) plan, as participation rises, their match and administrative costs will become burdensome, experts say. However, they recommend several ways plan sponsors can mitigate these costs, such as by negotiating for lower fees, seeking unbundled plans, restructuring their company match and modifying the vesting and eligibility requirements.
To begin with, automatic enrollment might not make sense for industries, such as fast food, that have high employee turnover—and thus the risk of administering a proliferation of accounts with very small balances, says Tom Gonnella, executive vice president with Lincoln Trust.
Whenever employers start thinking about implementing automatic enrollment, the expense of their matching contribution is a concern, says John Buckley, assistant vice president of retirement plans at Longfellow Advisors. Advisers can help sponsors mitigate these costs by comparing different matching formulas, he says. For instance, rather than matching 100% on the dollar of the first 6% in contributions, the sponsor could match 100% up to the first 3% and then 50 cents on the next 3%, he says.
Or, suggests Kris Garlewicz, a financial adviser with Chicago Oakbrook Financial Group, a plan sponsor might consider stretching the amount a participant has to defer to maximize the match from the employer. Instead of matching 100% of the first 2.5% of deferrals, an employer could match 25% on the dollar of every 1% of contributions, up to 10%. This would translate to a maximum of 2.5% in matching contributions and only marginally increase the cost to the employer when automatically enrolling employees at 3%, he says.
At least by offering the match, it would get participants over the “mental handlebar” of getting their company’s matches, he says. “The employees win because they are saving more, and the employer wins because [it is] containing costs,” Garlewicz says.
“Vesting, eligibility and matching formulas—all of these can be reconfigured to lower a plan’s cost,” says Chris Augelli, vice president of product marketing and business development at ADP Retirement Services. It should also be remembered that, as assets in a plan rise, economies of scale can be realized. Advisers can help sponsors select “a provider that is aligned with their plans’ interests,” Augelli says.
All of these are factors retirement plan advisers can bear in mind as they work with their plan sponsor clients to boost participation rates.