This article was originally published on June 27, 2017.
Are Americans saving enough for retirement? Not according to conventional measurements, but the trend is improving as more attention is being paid to retirement readiness. Here are five essential ingredients for plan sponsors to encourage better participant outcomes.
The shift from defined benefit to defined contribution plans over the past 35 years has created a new retirement reality where employees contribute most of the money and make most of the decisions. To help employers encourage better saving and investing behaviors, the Pension Protection Act of 2006 (PPA) introduced a host of features — like automatic enrollment, automatic escalation and investment reenrollment — that have led to measurable improvement in savings and participation rates.
Before PPA, retirees had saved only a fraction more than their final yearly salary on average. Ten years later, they have 4.5 times their final earnings saved at retirement. For example, what would have been a $100,000 retirement nest egg is now $450,000. This is a great start that should encourage plan sponsors to maximize the auto features available in their plans.
The most common auto feature, auto-enrollment, is now used by 88.6% of defined contribution plans. With more people saving for retirement, employers are starting to boost average participant savings by employing another auto-feature: auto-increase. A typical strategy is to ramp up the default contribution percentage from 3% to 6%.
Mid-sized plans—those between 1,000 and 4,999 participants— are leading the way, with significantly higher use of auto-enrollment than plans above 5,000 participants. Yet despite a default rate more than twice as high as the largest plans, the opt-out rates are exactly the same: 7.6%. So participants aren’t opting out in droves if plans boost the default rate to 6%. They may in fact be recognizing the importance of sacrificing a little now in the interest of retirement security.
There’s still the matter of where the contributions will be invested. The PPA also created “safe harbor” default investments for participants lacking the time or expertise to select their own retirement investments. The most common Qualified Default Investment Alternative (QDIA) is a target date series, which provides a one-stop diversified investment based on the participant’s age.
The success of target date funds has made the selection of a target date provider one of the most important investment decisions a plan sponsor makes. There are many factors to consider when selecting a target date provider, including track record, fees, investment allocations, experience, long-term approach to investing and the quality of the underlying funds.
Whatever the lens, even incremental differences in return can make a big difference.
In this hypothetical example of a 10% yearly contribution over 40 years, an excess return of 50 basis points (0.5%) yielded six more years of retirement income. 100 bps (1%) created 12 additional years of spending in retirement.
What about the participants who make their own investment decisions? To serve them, retirement plans have significantly increased the number of investment menu options in recent decades. This was done in the interest of providing better choice and diversification to participants, but it’s reached the point where the average defined contribution plan has 19 separate investment choices.
Is that too much choice? Fear, indecision, procrastination, and irrational investment decisions occur when participants feel confused or overwhelmed.
To ensure participants make the best possible decisions, plan sponsors can simplify their choices by merging the existing investment menu into broader and more flexible options that cover the same spectrum of underlying securities. This not only ensures wide diversification, it may result in better outcomes as well.
Shoppers don’t usually make buying decisions based on where the product was made; neither should investors, especially in the new reality of global investing. Geographical flexibility has delivered more excess return relative to the benchmark over the past decade than investing in U.S. or international alone.
It’s not enough for participants to set savings aside and choose appropriate investments. They also need to stay on track with their goals over time as markets and personal situations change. Investment re-enrollment is a great tool to do just that.
With an investment re-enrollment, participant investments are reset into the QDIA — usually a target date fund — at a particular point in time. That way, unbalanced investments — older employees investing in the same aggressive stocks they chose years before, for example — are reset to align with the glide path that tracks their age. This can have a powerful effect in keeping participant retirement savings goals on track.
Before investment re-enrollment, allocations can become unbalanced over time, as participants frequently don’t make any attempt to change or rebalance their original investment choices. After investment re-enrollment, the majority of participants are reset close to the glide path, so their investment allocation matches the one that would be most appropriate at that stage of life.
Investment re-enrollment can be surprisingly easy to implement. Participants can opt-out of having their investments reset if they choose, and the company can do it one time or as many times as they like.
Best of all, like most of the tools discussed in this article, participants may appreciate it. They respect that their employer is making it easier to invest for retirement and to keep those investments aligned with their goals.
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