Features To Fix the 401(k)

The 401(k) is not working effectively for most American workers. Despite popular opinion, this has nothing to do with the stock market or economy. It has to do with participant inertia and ignorance, which exist in both bull and bear markets. Participants do not understand the investments made available to them. They are confused by concepts like asset allocation, account rebalancing, and target-date funds. Participants tend to panic when their accounts have lost money (like most have over the past 18 months) and get stuck in an ongoing cycle of buying high and selling low. Contribution rates are much lower than they need to be, generally in line with what the company is willing to match. As a result, many employees simply will not have enough money to support their income needs at retirement.

Assuming the above generalizations reflect reality for the majority of 401(k) participants, the obvious question is: What can plan sponsors and advisers do to help improve this situation?

Participant Meetings. I have seen in practice that most participants do not want to be educated, but want to be told what to do. Group education meetings are a reasonably effective way to disperse general retirement plan information, but typically do not lead to action being taken. Providing individual meetings in addition to group sessions will increase enrollment, deferral rates, and lead to better participant investment decisions. These meetings do not need to take place more often than annually and may be conducted by the plan provider or adviser.

Retroactive Auto Features. I call employee inertia the “never get around to it” phenomenon. Many employees know they need to save for retirement, but never get around to signing up for their plan. If they do eventually sign up, they never get around to increasing their deferral percentage or establishing an appropriate asset allocation.

There are three ways to turn this inertia on its head and use it to benefit plan participants: auto-enrollment, auto-escalation, and auto-investment into defaults. Instead of implementing these features for new employees only, consider going back and retroactively implementing these for all employees who have not enrolled. It may seem drastic but it’s very effective and typically leads to low opt-out rates. Gradually increasing auto-deferral rates each year will help participants achieve an optimal savings level.

It is vitally important that auto-contributions are defaulted into a qualified default investment alternative (QDIA). Establishing a QDIA will protect the fiduciaries from liability associated with the performance of their default investment. Target-date funds have become one the most popular QDIA choices, but are also facing intense scrutiny. The recent market downturn has led many to realize that there are drastic differences among the underlying holdings, asset allocations, glide paths, and expenses of these types of investments. Fiduciaries need to make sure they evaluate these components to determine which target-date funds are appropriate for their participants.

Provide “Gap Analysis” Reports. Most participants think about the amount that they can afford to save today, but few think about whether or not they are on track to have enough money at retirement. A way to change this type of thinking is to provide “gap analysis” reports to all eligible employees. These reports will show employees if they are on track to have enough money to replace an adequate percentage (usually 80%) of their income at retirement based on their current balance, savings rate, and asset allocation. They should be distributed to all eligible employees, so that nonparticipators see how little they will have at retirement if they do not begin saving.

The above strategies are all effective individually, but work best when implemented collectively. The ultimate solution to today’s participant challenges could look something like this: Every employee is enrolled automatically beginning at 5% of pay. Their deferrals are invested automatically in an age-appropriate target retirement date portfolio that has been thoroughly evaluated by the plan fiduciaries. Each year, their deferral will increase automatically by 1% until it reaches a maximum of 15% of pay. All employees are offered individual meetings on an annual basis with an independent retirement adviser who can provide a custom gap analysis.

If the above scenario were implemented in every 401(k) plan today, I believe the current state of 401(k) participants would be greatly improved. If we do not change the way we are addressing retirement savings behavior, we may face one of the worst financial emergencies our country has seen in a long time. The retirement savings crisis is real and urgent, but is not beyond repair if we begin focusing on more effective strategies to help our  participants.