Guiding Light

According to various studies, at least half of all defined contribution plan participants are uninterested in or unwilling to take part in the financial planning activities that are critical to achieving their retirement objectives. To make matters worse, they seem incapable of the minor action and discipline required to solve this problem. When confronted with difficult decisions, participants tend to take the path of least resistance and do nothing or accept the default option, if offered, rather than making an active and well-planned choice. Inertia and procrastination have a significant impact on participant decision-making or lack thereof.

Retirement advisors have tried to provide education and guidance to plan sponsors and participants through in-person meetings and Internet tools, but these efforts alone did not bring about meaningful changes in participant behavior. Today the trend is moving past traditional education techniques to automatic features and default options that compel rather than convince participants to join a plan, increase their deferral rates over time, and invest appropriately. Education efforts now focus more on plan design, automatic versus voluntary program specifics, and ongoing plan maintenance

Advisors’ efforts, coupled with a more paternalistic attitude among plan sponsors, have changed participant behavior for the better, but much work remains to complete the task. Advisors must not only encourage plan sponsors to adopt the “auto-everything” model, we must also give participants the support they need to get actively involved in their plans and avoid the inertia allowed by automatic defaults.

Buoyed by policymakers and interpretive guidance, plan sponsors are taking a more proactive approach to encouraging participation in their defined contribution plans and offering more resources for investment advice. The “control” promoted in the self-directed model became more of a burden than a benefit to employees, motivating employers to get back in the act.

Rather than waiting for employees to do the right thing voluntarily, the paternalistic auto-everything model exploits participant inertia by making basic participation the reward for doing nothing. Auto-enrollment removes the decision of whether or not to join the plan; action is required only to opt out. An auto-escalator, which increases the deferral rate over time, is palatable to employees because its impact is somewhere in the future, presumably when their salaries will be higher. The four auto-pilot touch points–enrollment, deferral escalation, age-based asset allocation adjustment, and rollovers–are in various stages of adoption. Auto-enrollment is leading the way.

Not a Panacea

The automated approach changes behavior and drives better results, but it also has potential drawbacks. Auto-enrollment will likely increase the number of participants in a plan, but it might not increase total plan savings in aggregate, and it may leave participants invested too conservatively. If their enrollment had been voluntary, auto-enrolled participants may actually have elected a higher savings rate and more aggressive and appropriate asset allocation mixes. The default options that reward inertia may be better than not participating, but they may still be far from adequate.

Despite our best efforts to provide auto-everything participants with the education and communication they need to move their plan forward, many feel little allegiance or emotional attachment to the program because they have not actively participated in any of the decision-making. With little or no up-front buy-in, some participants may opt out prematurely when they realize that their hand was “forced” into participating.

Plan sponsor challenges center around cost and fiduciary exposure. Increased participation leads to higher administration costs, especially in high-turnover plans. Plans with low average account balances and high turnover rates have a greater need for advisors to serve participants, yet as an industry we struggle to deliver meaningful solutions given the economics associated with these types of plans. The auto-everything approach might provide better long-term investment performance that would mitigate the effect of passing these costs on to the participants, but this argument is difficult to quantify and convey.

Moreover, some sponsors remain reluctant to deploy higher default deferral rates and more fully diversified investment vehicles. Auto-enrollment default deferral percentages have increased slightly from the 3% provided in the initial IRS “example” but are still too low to create sufficient retirement savings.