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To boost retirement savings, future plans may turn every step from enrollment to rollover into a ''default'' choice for employees.
Roy Harris, CFO Magazine
April 1, 2005
Rule No. 1: Inertia dominates human actions. Rule No. 2: People fear loss more than they value gain.
As two tenets of behavioral finance, these principles are still largely confined to being studied in the world's business schools. But the twin theories already serve as the underpinning of a 401(k) plan design that some providers feel may soon catch on with sponsoring companies.
The approach is the "automatic" 401(k) account, sometimes called an autopilot plan. And it bypasses Rule No. 1 by setting "default" plan participation levels for employees who make no choice about their 401(k) investing options. First developed in the 1990s by private industry and researchers at the U.S. Treasury Department, the concept has found its way into plans being offered by Vanguard Group, Principal Financial Group, Prudential Financial Inc., and others, as well as into some self-administered corporate plans.
"When we started this process back in April 1997, our participation rate was at 71 percent. It's steady at around 86 percent now," says Philip Perez, retirement delivery manager for Plano, Texas-based J.C. Penney Co. Under Penney's current plan, workers with a year's service automatically have 4 percent of their pretax salary diverted to a 401(k) account, unless they specifically say they don't want to participate. Penney, which administers its own plan of 22 funds and matches up to 6 percent of employee compensation, has boosted the minimum contribution percentage twice in eight years. "A number of plan members have thanked us for enrolling them, because they really wanted to increase their participation," says Perez, even if they concede that they wouldn't have signed up on their own, as most other plans require.
Penney hopes the higher participation will help more employees avoid retiring with insufficient savings. The nation's more than 400,000 401(k) or similar defined-contribution plans now have a total of 42 million members, which in 2001 constituted around 58 percent of workers covered by company-sponsored pensions. But according to statistics cited in a recent Brookings Institution/Georgetown University study, half of the 401(k) plan members between the ages of 55 and 59 had balances of $50,000 or less.
Faced with difficult choices about whether to set aside precious salary dollars for the future on a tax-advantaged basis, many new employees "simply procrastinate, and thereby avoid dealing with the issues altogether, which dramatically raises the likelihood that they will save inadequate amounts for retirement," according to the Brookings/Georgetown study. And many employees simply cash out of smaller plans when they change companies. Calling the autopilot concept "disarmingly simple," the study says that it "has the potential to cut through this Gordian knot and improve retirement security for millions of workers via a set of commonsense reforms."
The Profit Sharing/401(k) Council of America (PSCA) calculates that about 8 percent of companies, mostly larger corporations, have adopted some form of automatic plan membership. Enrollment, however, represents only the first of four autopilot steps that some plan designers envision for helping participants boost their balances—in part by counteracting the inertia principle.
These experts would like default enrollment to be followed by automatic escalation of employee contribution percentages as pay levels increase. Next, the mix of investments would change on its own, reflecting a preapproved asset-allocation schedule with elements of today's managed retirement or "lifestyle" accounts. By creating balanced default portfolios that include more-aggressive elements—which employees might otherwise avoid—automatic allocation could correct any harm from behavioral Rule No. 2.
"In the average human being, you have a fair amount of reckless conservatism in their defined-contribution-plan behavior," says Scott Sleyster, Prudential's executive vice president of full-service retirement. "People should be conservative in planning for retirement, but they still need some form of inflation protection."
The automatic escalation and allocation steps—especially if enhanced by corporate matches—would move employees closer to saving "the 12-to-15 percent of income that most people need to secure a proper retirement," says Sleyster. Prudential, which manages defined-contribution plans for about 5,000 corporate clients, has only recently begun rolling out autopilot plan offerings that go beyond automatic enrollment. "But the reception has been very good, and we hope to have a good group of clients by year-end," he says. After a successful pilot program in 2003, Principal Financial has signed up 535 employers who are interested in a modified autopilot plan, called Step Ahead, in which participant contributions are automatically increased by a set percentage annually. Vanguard calls its program One Step.
As the fourth element in the autopilot 401(k) process, Brookings nonresident scholar J. Mark Iwry raises the possibility of a default rollover policy that would direct any retirement-savings balance into a new tax-deferred account when the employee leaves a company. (Congress has already provided for this in accounts of $1,000 to $5,000.) As with automatic enrollment, which Iwry sees as the easiest measure for employers to adopt, "if the employee asserts him- or herself, then all those defaults go away. It's just a matter of saying, 'I need the money.'"
By encouraging savings, the automatic approach could help offset an inequity that exists toward lower-income employees. Currently, if a worker's tax bracket is low, so is the aftertax value of his or her savings. "So the system under current law tends to give the smallest benefit to those who need savings the most," says Iwry, former benefits-tax counsel at Treasury who helped develop the autopilot model.
"I call these automatic programs 'empowered paternalism,'" says David L. Wray, president of PSCA, which was also involved in early plan designs. They're necessary because "401(k) plans are not retail investors. And there is a need to think about getting results for employees on the basis of how you design the plan." Critics of current 401(k) designs note that defined-benefit plans, which have been largely replaced by 401(k)s, at least call for automatic enrollment, and provide for management of balances toward some level of compensation replacement.
A Few Notes of Caution
While providers generally enroll participants on a no-fee basis, more enrollees mean higher administrative and recordkeeping costs. Prudential's Sleyster says additional costs from printing more statements and running a larger call center generally would be recovered by plan sponsors combining automatic enrollment with escalation or allocation, thus generating higher returns.
Some companies, though, balk at automatic enrollment because they don't want the widest possible 401(k) participation—especially if their workforce tends to have high turnover among low-income employees, forcing the need to manage many smaller "orphaned accounts" when workers move on. "There can be a good argument made that you're going to be dealing with a larger number of account balances," says Penney's Perez, who says that in his company's case, an automatic enrollment plan is valuable because it helps meet corporate HR objectives. (See "A Benefit at the Top") Nationally, "I think you're going to see momentum" in the use of automatic 401(k) elements, he predicts. "President Bush and Congress are talking a lot about an ownership society. This is one way to advance that."
But for now, Penney has decided not to pursue autopilot steps beyond enrollment. That's because "we'd like to see some more support out there, from Congress and Treasury," Perez says. In March 2004, the Internal Revenue Service wrote an information letter supporting default escalation, to go with its support years earlier for the concept of automatic enrollment.
A final plan-sponsor concern might seem to be the potential for lawsuits filed by employees who didn't want any pay diverted to a retirement savings account. For the most part, "that risk is mitigated because there's ample written notice given," says Iwry. Still, employees have shown an inclination to sue over other perceived wrongs, some of them connected with plans being stacked with their employers' stock. (See "The Cost of Loyalty," December 2004.) To avoid such liability, experts suggest that default investments should be in a balanced fund that mixes fixed-income securities and inflation-indexed bonds with diversified equities.
If that's the case, employees would have little to gripe about. "Because automatic enrollment typically generates employer matching contributions," notes Iwry, "the return is typically higher than anything they would see on their own, even if the investment itself has done poorly."
Roy Harris (firstname.lastname@example.org) is senior editor of CFO.
A Benefit at the Top
Companies like the way autopilot 401(k) measures help their lower-income employees boost savings for retirement. But there's a nice kick for high-income employees, too.
Under government "nondiscrimination standards," a formula allows companies that increase overall 401(k) participation to proportionally boost the tax-deferred pension contributions of executives and other highly compensated employees even more. For example, says Brookings Institution nonresident scholar J. Mark Iwry, "an increase in the percentage contribution for lower-paid workers from 6 percent to 7 percent might allow the contribution for higher-paid employees to rise from 8 percent to 9 percent."
"I wouldn't say it's the most important reason to adopt an automatic plan," says Scott Sleyster, executive vice president of full-service retirement for Prudential Financial Inc., which has launched a major marketing push for automatic 401(k) measures this year. "But it's a definite side benefit."
Over the life of J.C. Penney Co.'s eight-year-old automatic enrollment plan, "the primary driver for the change in the deferral rate was to give our participants more of an opportunity to share in company profits" through the 401(k)'s annual match, says the company's retirement delivery manager, Philip Perez. But, he adds, "there is no question that a byproduct is potential improvement in the annual testing," which earns higher-paid employees more in tax-deferred contributions.—R.H.