DC Prevalence Magnifies Importance of Education

“Employees around the world are bearing the risk and responsibility of managing their retirement, and we must do more to help ensure they aren’t going to outlive their money,” says Jim McCaughan, CEO of Principal Global Investors.

The call to action comes with the release of a new white paper published by CREATE-Research and Principal Financial Group, “Financial Literacy: Smoothing the path to improved retirement savings.” As the title implies, the paper steps out how longer life expectancies, coupled with rapid adoption of defined contribution (DC) retirement plans, are driving the need for more basic investment education worldwide.

“Plan features such as auto-enrollment and default investment options have been an important first step to increasing participation, but they should be supplemented with education around the basic rules of investing,” McCaughan says.

According to the paper, it is essential for the long-term success of the DC system, both in the U.S. and globally, for plan sponsors to practice ”nudge economics,” subtly but consistently pushing employees into participating in carefully designed savings plans. While sponsors have increasingly adopted auto-enrollment and auto-escalation, researchers point to a need for more auto-education.

“These innovations need to be complemented by higher financial literacy to counter two investor traits that conspire against better retirement outcomes, which are short-termism, the focus on short-term results over long-term investing, and herding, the tendency for investors to gravitate to similar investments based on how others are investing,” the paper explains. “There are implications of inaction for all future retirees, but especially Millennials, who are expected to spend as many years in retirement as they do in the workforce if the retirement age doesn’t rise along with life expectancy.”

NEXT: Active education needed 

According to Principal and CREATE, asset managers and advisers should play a more active role in educating savers on the investment basics, including the “importance of the savings rate, understanding what investing is all about, why things can go wrong, and how to minimize downsides and turn them into opportunities.”

These were traditionally issues tackled handily (and behind the scenes) on behalf of plan participants by skilled defined benefit plan sponsors, but such matters now have to be confronted directly by untrained individuals—especially in cases where the plan sponsor is unwilling to take a paternalistic approach to the retirement benefit.

“New government education initiatives are helping to close the knowledge gap, but a holistic approach is needed that includes plan sponsors, participants, financial advisers and asset managers,” warns Amin Rajan, CEO of CREATE-Research and author of the report. “Participants need objective, jargon-free, emotionally inspired education that shows how knowledge of investment basics can benefit their retirement nest egg.”

High-quality education of this type may not be easy/affordable to deliver from the perspective of both providers and consumers of retirement plan services, but it is increasingly essential for the smooth functioning of the DC system, the paper argues.

“Even Millennials with advanced education and high income levels tend to have low levels of financial literacy,” Rajan adds. “Fortunately, you do not have to become an expert to make progress in your retirement savings. Good plan design, coupled with a baseline understanding of the costs and benefits of major asset classes, will go a long way.”

NEXT: What exactly is quality education? 

“While the auto-features of the 2006 Pension Protection Act helped to bring more American employees into the system and prevent them from making suboptimal asset choices, more must be done to help instill good savings habits in this age of rampant consumerism and easy credit,” the paper warns. “The DC system in the U.S. has succeeded in putting millions of Americans on track for retirement. But more can be done.”

The paper points to evidence “showing that the bias towards immediate gratification is a big factor in determining the size of the retirement pot.” Another major factor to be considered by any education program: “Making key retirement decisions is not as straightforward as buying a house; rather they are often driven by changes in family, health, job and market circumstances.”

According to Principal, at an operational level, “financial literacy aims to enhance an individual’s ability, willingness and self-discipline to carry out budgeting and saving.” This discipline should be strong enough and practically minded enough to help the individual think beyond day-to-day financial needs and start actually believing in the need to save for retirement—or an unexpected rainy day.

Borrowing and credit card usage are also particularly important to address, according to the paper, with both workers and retirees needing to “ensure consumerism does not triumph over thrift.”

While the auto-features of the PPA are still reshaping the U.S. DC market, “one thing is clear,” the paper concludes. “The current level of financial literacy remains disturbingly low. Investors globally scored barely a ‘D’ grade in our financial literacy test. Nearly half of them didn’t know the annual return on their investments. Sixty-four percent didn’t know the fees they were charged.”

The full white paper is available here. Additional information on CREATE-Research can be found at www.create-research.co.uk.