401(k): An Accidental Solution To The Retirement Problem
The greatest thing about defined-benefit plans was that workers didn't have to do anything other than show up for work to get the desired result: a guaranteed income for life. It was a good system in that most workers didn't want control, responsibility, fancy websites or investment options; in fact, all anyone wanted was a secure retirement.
But the defined-benefit plan is gone and it's not coming back. Instead it's been replaced by the 401(k), an accidental solution to the retirement problem. And as a replacement for the traditional defined-benefit plan, it's been a dismal failure. The worker is still just looking for a secure retirement with little to no input required. Unfortunately, very few workers are on track to get that these days.
Why It's Not Working
Another great thing about defined-benefit plans was that the company paid for the employee's retirement, regardless of how the investments in the plan performed. But, the 401(k) plan shifts a huge part (sometimes all) of the cost to the employee. The 401(k) is essentially an employee funded system. That's a lot to ask of employees in a country with a low savings rate.
It shouldn't be a big surprise that participation and deferral rates are far below what is necessary to fund the retirement of the average participant. Even worse, the employee is often asked to contribute to a system where the investment choices are limited, substandard, dirt poor and grossly overpriced. In many cases, the plan options and costs are so bad that the employee would be better served to opt out and invest on his or her own.
The various shortcomings of the 401(k) are well known so there has been a lot of attention by regulators and legislators to shore up the system. Working within the existing framework, we can now craft plans which will make the 401(k) much more user friendly and effective for the participant. Just by showing up and accepting the plan design suggestions, the employee can accumulate sufficient assets to retire on schedule and with a high percentage of his or her working income.
Step one is to improve the fiduciary standards of the plans, including but not limited to cost, investment options, transparency and avoidance of conflicts of interest. This would be a big step forward, but it doesn't transform the system in the eyes of the participant.
That said, the worker still just wants a secure retirement. Even given the finest, lowest cost investment options, most employees won't and can't effectively use them to manage a comprehensive investment strategy that will achieve financial security at retirement.
However, all is not lost. The Pension Protection Act of 2006 (PPA) enabled major changes in the system, and the nascent science of behavioral economics provides the insights to guide or nudge employees to act in their best interests.
The 401(k) can now be designed to look and feel much more like a traditional pension. With a little thought, it is also possible to create a plan so automatic that the employee reaches the secure retirement she wants with almost no active management or supervision on her part.
The PPA allows plan sponsors to reverse the three traditional 401(k) defaults which prevented an autopilot approach to plan design. Building on research in behavioral economics, the science of determining how individuals make economic decisions, the following measures "nudge" participants toward better outcomes. Prior to PPA, various state laws might have prevented implementation of these improvements.
- Automatic Enrollment: New employees are automatically enrolled into the plan with a default initial deferral rate.
- Non-Cash Default Investment: This is technically called a qualified default investment alternative (QDIA). If the employee makes no investment election, he or she is automatically assigned one that might be a balanced account, target risk or target date asset allocation plan. Prior to the PPA, employees who made no election would generally be assigned to a "safe" investment pool like a stable value fund or money market fund. While a "safe" alternative protected the employer against downside risk, it was potentially the worst investment alternative for employees' long-term investment needs.
- Automatic Escalation of Deferrals: Nicknamed the SMART Plan for Save More Tomorrow, as the employee's compensation increases a portion of that raise is contributed to the 401(k). Employees perceive this as relatively painless savings because each raise that they receive leaves them with both more money in their pockets and increased savings in their retirement plans. Over time, companies that have adopted this strategy have experienced dramatic improvement in their deferral rates.
While employees always have the right to opt out of the plan defaults, few do. Participation rates and deferral percentages soar in plans that have incorporated these simple defaults. Average employees begin to save enough to actually retire.
Target Date or Target Risk Portfolios
So far, so good. But asset allocation decisions and portfolio construction are not skills that the typical worker possesses. Few have the time, inclination, training, tools or discipline to make prudent decisions and continuously monitor and adjust their portfolios. Here is where a well-thought-out, professionally-designed asset allocation plan can help.
With a single click, employees can select portfolios at various target risk levels appropriate for their circumstances. Target risk portfolios are a semiautomatic approach to portfolio management in which the participant need only select her risk level and the remainder of the portfolio construction is done for her.
Target date portfolios, on the other hand, are the alternative, full autopilot solution where the participant identifies her desired retirement date and the entire process is handled for her. These allocation plans continuously adjust without any supervision or input from the employee as she approaches her scheduled retirement date.
There has been wide acceptance of the idea. But, selection of the target portfolio must be carefully considered. As with any other fiduciary decision, serious issues of glide slope, asset allocation, risk levels, costs, disclosure and conflicts of interest must be addressed.
Recent experience points out just how important participant education is because there was wide misunderstanding of how target portfolio strategies might perform during market fluctuations.
The ultimate purpose of a pension plan is to ensure that employees can retire on schedule with dignity and with enough financial assets to replace their earned income. Appropriate benchmarking techniques can determine whether a plan is being properly used by the workforce to achieve that objective. However, these benchmarks go beyond simple fiduciary review, cost comparisons and performance of investment offerings. For instance:
- Participation Rate: How many eligible participants enter the plan?
- Deferral Rate: What is the deferral rate of the employee by age and salary group?
- Success Probability: Are the deferrals sufficient, along with the accumulated balances, to provide 75% of the employees with 80% of their final income at their scheduled retirement date?
- Investment Choices: Are participants selecting appropriate levels of risk for the stage of their careers? How many are in cash? How many are selecting the target risk or target date asset allocation appropriate for their age?
The Bottom Line
The 401(k) will probably never be a perfect substitute for the defined-benefit plan. The employee must still fund the plan, bear investment risk and must make up for any shortfalls in the ultimate accumulation. However, a combination of the above techniques can relieve the employee of many of the duties and responsibilities that he or she didn't want is unqualified to carry out. Assuming that the plan sponsor follows prudent practices that provide an economical, high-quality investment menu, by simply accepting the default suggestions of automatic entry, automatic deferral escalation and target portfolio selection, the probability of a successful and secure retirement for the participant can be substantially increased.