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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.