401(k) Plan Design and its Effect on Employees’ Retirement Readiness
Most American adults are concerned that they will not be able to retire or will outlive their retirement income. In fact, research shows that Americans are not saving enough for retirement. This retirement crisis is, in part, a result of individuals not participating in or not utilizing employer-sponsored retirement plans. Retirement plans, primarily employer-sponsored 401(k) plans, remain the main source of retirement income. The change in employer preference from traditional pension plans to 401(k) plans shifts the responsibility onto the individual rather than the employer. A few reasons why employees do not effectively save for retirement include human inertia and an inability to predict the amount of money needed for retirement. Financial literacy and retirement education can only do so much. This is especially true when common human behaviors and instincts have a large impact on financial decision-making.
Employers as retirement plan sponsors have plenty of latitude in customizing retirement plans to fit the needs of its employees. 401(k) plans can be designed to be most effective in encouraging or “nudging” its employees to contribute and save for retirement by aligning design with employees’ natural behavioral patterns.
Basic Principles of Behavioral Economics
The study of behavior on financial decision-making is known as behavioral economics, which plays a large role in how Americans save for retirement. Human inertia is an important factor in an individual’s decision-making. Better said, human inertia is the reason for a person’s lack of decision-making. Due to human inertia, people tend to stay or remain with the status quo rather than proactively make a choice. Translated to retirement plans, having an employee actively make decisions regarding enrollment, investments, saving amount, etc. can serve as barriers to retirement saving rather than inducements for employee participation. Research shows, in addition to human inertia, that people overestimate their self-control with regards to spending and underestimate the amount needed for retirement. Insufficient retirement savings is also due to not appreciating the natural human impulse to spend rather than save. Therefore, the most effective way to save for retirement is for funds to be taken out of paychecks before employees have possession of the money to spend it.
The Pension Protection Act of 2006 (PPA) made substantial modifications to the Employee Retirement Income Security Act of 1974 (ERISA). With some of the changes, the PPA utilized behavioral economics to transform 401(k) plans by permitting certain plan design options for employers to encourage retirement savings among its workforce. Some of the ways the PPA has utilized behavioral economics to transform 401(k) plan design include automatic enrollment and default decision-making for participants.
Plan Design Options that Encourage Employee Retirement Savings
- Auto-Enrollment. Many employees intend to enroll in their employer’s retirement plan but simply never get around to completing the paperwork. Rather than opting in to participate in the plan, employers can design their plan to provide for enrollment of all employees upon hire to allow them the option to opt out of participating. This plan design option has been shown to increase total plan participation as well as nudge employees to save for tomorrow. If an employer did not want to institute auto-enrollment, simplification of the enrollment process would also facilitate participation.
- Matching Contributions. Another method to induce employee participation in employer-sponsored retirement plans is to provide for employer matching contributions. While this plan design option does cost the employer, an employee is more likely to contribute generally or contribute a higher amount up to the employer match percentage.
- Prevent Leakage. Retirement plan “leakage” is any type of withdrawal that is made before retirement that permanently removes money from an employee’s retirement plan savings. This includes in-service withdrawals, for hardship or for employees over 59.5 years, plan loans, and cash-outs upon termination. Designing a plan without some or all of these features ensures that the funds will be used for retirement and prevents the employees from viewing or using their 401(k) account as an additional bank account.
- Default Contribution Rate and Auto-Escalation. Adding to the difficulty with retirement readiness is the inability to calculate the funds needed to retire. This amount is unique to each individual and varies depending on a variety of factors such as retirement age, other sources of income or investments, years in the workforce, compensation, increases in salary, etc. This results in many employees arbitrarily picking a contribution percentage and usually not adjusting that percentage when changes occur in their personal financial landscape. With auto-enrollment, employers set a default contribution rate for employees. Employees will always have the choice to adjust this rate, but the default provides a starting point. In addition, employers can provide an auto-escalation feature. Auto-escalation means that an employee’s contribution to his or her 401(k) account will automatically increase on a specified schedule up to a certain percentage.
- Auto-Investment. The inability to predict future financial needs and wants at retirement makes it difficult to make future-minded decisions. This includes not only the amount or percentage to save per paycheck, but also how contributions are invested. If an employee is auto-enrolled, the contributions are invested in a qualified default investment alternative (QDIA). Generally, QDIAs are target or glide-path funds. Even without auto-enrollment, simplification of investment options, through target or glide-path funds, provides for less volatility and requires less investment management.
Again, an employee would have the option to opt-out or adjust their contribution percentage, but the auto features would facilitate employee retirement saving, especially for individuals who do not want to actively manage their 401(k) account.
Employers, through the use of behavioral economics in retirement plan design, have the ability to impact retirement readiness of its workforce. With any implementation of the automatic and default plan design options, employers are required to provide participants with certain notices and disclosures, to provide employees with opportunity to opt-out. The notice must be distributed to participants upon enrollment and at least thirty (30) days before the beginning of each plan year, even if the plan design remains consistent from year to year. Employers that wish to change their retirement plan to include some or all of the automatic or default design options discussed should enlist the help of an ERISA advisor to fully understand the impact of plan changes and any related reporting requirements.
This blog was written by Mary Claire Blythe at Miles & Stockbridge.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.