From the Editor
401(k)s on Autopilot
D
espite the talk about empowering workers to handle their own
retirement planning, experience has shown that for most workers, the fewer financial decisions they are asked to make, the better
off they are. Increasingly, companies are acting on that knowledge
and using the power of inertia to entice workers with too little interest, willpower, time, or experience to put their long-term savings
strategies on autopilot. The evidence so far is overwhelming that
the introduction of options such as automatic enrollment, contribution escalations, and lifecycle default investments will enable many
employees to be better financially prepared for retirement.
Admittedly, the idea is somewhat counterintuitive. With the advent
of 401(k) plans some quarter century ago, employers started putting
workers in control of their retirement plans. A young, mobile workforce seemed eager to take charge and unimpressed by the simplicity
of the traditional company pension plan. For their part, employers
were only too happy to shift the responsibility of saving for retirement
to employees. Pension plans had become costly, highly regulated, difficult to administer, and financially risky.
In the “new” 401(k) plans, employees were provided with convenient, tax-efficient ways to save through company programs that
offered an ever-growing list of investment options, daily valuation, and other bells and whistles. Savings were “portable,” able
to be transferred by departing workers to a rollover IRA or a new
employer’s plan. When the outsized stock market gains of the 1980s
and 1990s swelled balances in worker-managed accounts, the 401(k)
looked unbeatable.
The subsequent market crash revealed that, in fact, many workers were not properly using the company 401(k) plan—or any other
vehicle—to adequately save for retirement. The problems have been
well-documented: employees have a tendency to save too little, dip
into their retirement accounts prematurely, invest too conservatively
or too aggressively, and fail to diversify.
Faced with a decision whether to enroll in the company 401(k)
or which investment funds to choose, too many employees tend to
do nothing. The solution is to use the employees’ inertia to increase
retirement savings. In 1998, the IRS began allowing employers to
add “negative election features” to their 401(k) plans, under which
participants would automatically have a set percentage of their pay
deducted unless they chose to opt-out or elected a different contribution rate. Although workers must be notified of this feature and
given sufficient opportunity to decline to contribute, many take no
action and end up contributing. Employees also tend to leave their
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“This article was republished with permission from Benefits Law Journal, Vol. 18, No. 4, Winter 2005, Copyright 2005, Aspen Publishers, Inc.
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From the Editor
automatic contributions in place for years. (Despite initial concern
that negative elections might violate state wage and hour laws, ERISA
appears to preempt any state impediment.)
So far, more than 20 percent of large employers offer automatic
enrollment. Besides requiring no effort, automatic enrollment makes
it psychologically easier to save by creating distance between workers and their pay: they never see the money. One study found that
plans with automatic enrollment had a participation rate of over
90 percent versus 66 percent for plans that did not. J.C. Penney, a
company with a significant number of lower-paid workers, reported
that its participation rate jumped from 71 percent to 85 percent after
adding an automatic enrollment feature. Employees have tended to
leave their automatic deductions in place for years. An added benefit of negative elections is that the higher participation levels help
employers pass the ADP and ACP tests. Ironically, the only downside to automatic enrollment is that some thrifty workers may end
up contributing less.
Backed by recent studies of economic behavior, employers are
now looking into more ways to coax workers into sound retirement
planning. A number of 401(k) vendors are offering a contribution
escalation feature in which a participant’s rate of deferral automatically increases each year. This can be accomplished by allowing
employees to voluntarily enroll (some employees find it easier to
agree to contribute more next year) or to opt-out from automatic
increases in their deferral rate. It’s too soon to tell whether this feature will increase contributions, but given human nature, it is likely
to succeed. By harnessing the power of inertia, the opt-out approach
should be quite effective.
Investment strategy is another area where employers are starting to
reassess their programs. The more investment options that are available (the average plan now has around 10 offerings), the harder it is
for many participants to make a decision. Thus, many workers end up
in the default investment option, which typically is a money market or
stable value fund. Employers use such ultraconservative investments
as the default fund because they offer modest income with preservation of capital. It may be safe for the employer, but these investments
may not even keep pace with inflation. Now some employers are
changing their plans’ default investment to a blended or other asset
allocation fund. These diversified vehicles are more appropriate for
a long-term investor, especially one who is not going to make any
decision on his or her own. The Department of Labor is expected to
offer some help by extending ERISA 404(c) protection to employers
that use an asset allocation fund as the default investment.
Another inertia-related issue occurs when participants make an
investment decision upon enrollment but then fail to reassess their
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From the Editor
investment choice[s] and rebalance or change their asset allocation
as they age or their financial circumstances evolve. Employers have
begun to address this issue with more intensive investment education
programs, offering employees automatic rebalancing, access to outside expert investment advice, and promoting asset allocation funds.
Lifestyle funds, which automatically adjust based on an assumed
retirement age, are particularly well-suited for someone who would
otherwise never make any changes.
How important are these changes? A July 2005 study published
jointly by the Employee Benefit Research Institute and Investment
Company Institute estimates that if the average worker participated in
a 401(k) plan with a 3 percent default contribution rate and a default
money market investment for his or her entire career, the worker
would have saved enough money to replace over one-third of preretirement income. Increase the percentage to 6 percent and switch
the default investment to an asset allocation fund, and the replacement rate jumps to over 50 percent. And that doesn’t even factor in
an employer contribution or Social Security. As the average preretiree
(between 55 and 64) currently has a 401(k) accumulation of under
$50,000, clearly a different approach is in order.
Congress has joined the autopilot bandwagon with talk of legislation to make it easier for employers to offer automatic enrollment.
Congress did act in 2004 on the plan distribution front, in response
to concerns about “leakage” of funds when employees switched jobs
and transferred their accounts. The automatic cash-out rules were
amended to provide that distributions between $1,000 to $5,000 must
be rolled over to an IRA unless the participant asks for cash. Of
course, many employees would be better off if their plans made it
harder to access their 401(k) funds before retirement. But with loans
and hardship withdrawals ubiquitous, and in light of the high cost of
maintaining accounts for former employees, that is wishful thinking
for now.
Having foisted responsibility for their retirement planning on workers, employers should consider how to assist those that fail to act.
Ideally, the 401(k) plan of the future may offer all the new bells and
whistles that consultants can come up with, but put financial couch
potatoes on autopilot.
David E. Morse
Editor-in-Chief
Kirkpatrick & Lockhart Nicholson
Graham LLP
New York, NY
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