Big Ideas
On August 17, 2006, at approximately 1:30 p.m. EST, President George W. Bush signed into law what he called “the most sweeping reform of America’s pension laws in over 30 years.”
During the signing ceremony for the Pension Protection Act of 2006, aka the PPA, much of the president’s speech focused on aspects of the law that had to do with ensuring employers better addressed their underfunded defined benefit (DB) pensions. He praised, for example, the new requirement that companies with underfunded pension plans would have to pay additional government insurance premiums. The president also highlighted the extension of the requirement that companies terminating their pensions must provide extra funding for the federally backed Pension Benefit Guaranty Corporation (PBGC), among other developments aimed at improving the stability of the employer-sponsored pension system.
More than 10 years out, for many retirement plan advisers, the PPA’s expansion of automatic enrollment for 401(k) plans and other defined contribution (DC) plans—along with its creation of the qualified default investment alternative (QDIA) safe harbor and the approval of automatic salary deferral escalations—has completely redefined the old approach to plan design. The adviser’s primary role is no longer about encouraging eligible employees to enroll in the plan or educating participants about investment choices to craft appropriate portfolios. The PPA lets plan fiduciaries do these things automatically, and, thus, advisers and their clients have been freed to focus on plan design and participant outcomes in a whole host of new and exciting ways.
As David Musto, president of Ascensus in Dresher, Pennsylvania, says, the paradigm-shifting PPA was the hard-fought result of a sustained surge of interest and discussion bridging the public–private divide.
“It was a pretty remarkable surge of interest and enthusiasm that helped propel the Pension Protection Act of 2006 into law, under a Republican administration and a divided Congress, no less,” Musto recalls. Like other retirement industry leaders, he says the time is ripe this year for legislators at the federal level to “capitalize on industry and public zeal” and build on the major successes of the PPA—to expand, or even require, the use of automatic plan features and otherwise factor behavioral psychology and powerful new theories about choice architecture into retirement planning laws and regulations.
Musto says the evidence is clear that the DC-plan-focused PPA provisions have had a tremendous impact on improving the overall retirement readiness of U.S. workers, making the PPA a model for future reforms that could potentially have as much of an impact on the retirement planning industry.
What Would a ‘New PPA’ Include?
Similar to the atmosphere in 2006 surrounding the original PPA, Musto says, there is an “increasing unity and cohesiveness within the retirement plan industry advocacy, academic and lobbying community with respect to a wish list of regulatory and legislative reforms.” To name just a few, these include expanding the potential for small businesses to join together to create automated multiple employer plans (MEPs) without demanding they be in related industries; approving and even potentially requiring the use of higher rates for auto-enrollment and more aggressive automatic deferral escalation within DC plans; and easing the fiduciary burden associated with offering “in-plan” lifetime income products.
“In the last couple of years, there has been a re-emerging consistency to the voice of industry experts in advocating for the needs of retirement plans and participants, and I find this to be very encouraging for the future,” Musto says. “This cohesive voice helped to ensure that the final Tax Cuts and Jobs Act, for example, did not seem to target retirement plans in any big or negative ways. … We’re seeing the public and private sector become more aligned around the desire to get more Americans engaged in retirement saving.”
Musto points to some bills already circulating in Congress that could represent a framework for the start of a new PPA. For example, there is the Automatic Retirement Plan Act, introduced by House Ways and Means Committee Ranking Member Richard Neal, D-Massachusetts. The bill would require all employers—except those with 10 or fewer employees, those in business less than three years, and governmental and church employers—to maintain an automatic contribution (AC) plan for their workers, beginning in 2020. Employers who fail to maintain an AC plan would generally be assessed a $10-per-employee-per-day penalty. The bill would also enhance employers’ ability to participate in a MEP and permit participants to elect to receive at least 50% of their account balance in the form of a distribution that guarantees them lifetime income.
Neal has also introduced a companion measure known as the Retirement Plan Simplification and Enhancement Act, which would expand retirement plan coverage and increase savings levels. Similarly, other members of Congress have put forward their own proposals, including the Increasing Access to a Secure Retirement Act, a bipartisan bill that clarifies and strengthens existing rules to make it easier for retirement plan sponsors to provide guaranteed lifetime income products as part of their employee benefits.
Broad Support
Melissa Kahn, managing director of retirement policy for the defined contribution team at State Street Global Advisors, in Washington, D.C., says she is “optimistic that we are in for positive change” and cites, like Musto, a newly emerging unity among industry advocates and government stakeholders. Hedging her predictions with a healthy dose of caution, Kahn speculates that, to some extent depending on the outcome of the 2018 mid-term Congressional elections, “we could see something major take shape in 2018 akin to a new PPA.”
On Kahn’s analysis, there are many key provisions in Neal’s bills, but, in her eyes, perhaps the most crucial item is “to take the automatic individual retirement account [IRA] idea and go a step further.” In other words, the proposals would essentially create an automatic 401(k) plan requirement for all employers. Instead of having to auto-enroll workers into an IRA, this would establish that any employer not currently offering a tax-qualified employer-sponsored plan for workers would have to do so. And the salary deferral on auto-enrollment would be significant, 6%, automatically escalating up to 10% over three years.
Naturally, some of the same political factions that have so adamantly opposed President Barack Obama’s signature Patient Protection and Affordable Care Act (ACA), view both the Automatic Retirement Plan Act and the Enhancement and Simplification Act as massive government overreach. From Kahn’s perspective, however, she looks forward to participating in this healthy debate “during 2018 and beyond,” and she feels the side in favor of a new PPA can ultimately win the day.
“When one projects the future of Social Security, Medicaid and other entitlement programs, we simply do not have a choice but to act now in a dramatic fashion to increase the amount and consistency of individual savings,” Kahn says. “None of this will be a slam-dunk in 2018, but I think what Congressman Neal is doing here is an honest attempt to help solve the retirement plan coverage gap, and, for that reason, it could go a long way, even in today’s political environment.”
Making It Work for Small Employers
According to Kahn, her team sees the Automatic Retirement Plan Act as being “very thoughtful and workable. … [T]he bill provides additional tax credits for helping to defray the cost of plan administration for the first five years. So you have, really, an eight-year window to prove a business is viable before having to fully commit to offering a plan—and then for the employers who continue down this road, there’s no requirement whatsoever to make matching contributions. But if they do, they get a tax credit for that as well.”
Kahn says the other main takeaway is the boost to the open MEP discussion. “I really do see open MEPs as the future—and not just for small employers, as we are hearing about today,” she says. “Farther down the road, I think it’s going to be midsize, and even large, employers as well that are attracted to utilizing the open MEP approach. I think that employers of all sizes will see value in offshoring the administration of the plan, the selection of the recordkeeper, the selection of a fund menu and all the other details that go along with being the fiduciary plan sponsor.”
New Lessons of Behavioral Finance
It’s not exactly rocket science to recognize that requiring employers to offer 401(k) plans and encouraging higher default enrollment rates will improve the U.S. retirement outlook, says Shlomo Benartzi, Ph.D., UCLA Anderson School of Management, and senior academic adviser to the Voya Behavioral Finance Institute for Innovation. But it is the honest truth, he says. It is also true that, left to their own devices, many employers fail to craft retirement plans that truly promote retirement readiness—including many that have already adopted auto-enrollment.
Benartzi indicates that employers all naturally wonder how to best serve their employee population with respect to retirement planning. Some plan sponsors have the sense that it is best to take a hands-off approach and allow employees to define their own financial priorities, whether that is paying down college debt, saving for a first home/car purchase or saving for retirement. Others feel it is important to get most, if not all, of their employees automatically enrolled in a tax-qualified retirement savings plan, Benartzi says, but they fear redirecting too much of new employees’ paychecks and thereby causing a financial hardship.
“And so the employer makes a compromise and sets the automatic salary deferral rate at a mere 2% or perhaps 3%. Both of these outlooks are quite common, but if successful retirement plan outcomes are truly the goal, neither approach is satisfactory,” Benartzi warns.
Based on his work and that of many respected colleagues, Benartzi says the empirical evidence clearly shows the importance of making it easy to start saving, and ensuring that employers and governments send the right signals about what is to be considered optimal retirement plan behavior. In fact, his research supports the more aggressive deferral rates proposed in the Automatic Retirement Plan Act—and points to their potential to go even higher.
“The suggested default savings rate [since the PPA] has been extremely low—but we now have the empirical data showing that a 6% automatic deferral or even higher works just as well as 2% or 3% from the retention perspective,” Benartzi continues. “Simply put, new employees do not opt out of the plan at greater [savings] levels due to more aggressive automatic enrollment. They are looking for guidance about the right way to participate.”
Significantly Higher Deferral Rates
One study Benartzi helped conduct asked whether an 8%, or even a 10%, automatic deferral rate would work better for long-term outcomes.
“We took 10,000 participants who were directed to the Voya website and were trying to enroll in a plan for the first time—many of them naturally were Millennials—and we suggested different savings rates for different segments of this group,” Benartzi says. “Then we measured a few things, including, would they run away at some point when the number we suggest got too high? What we found is that, by and large, people do not run away, regardless of the enrollment level we suggest. So we had very similar rates of retention for 6%, 7%, 8%, 9% or 10% auto-enrollment.”
This finding, Benartzi says, shows that more important than a newly enrolled worker’s debt level or outside financial priorities are the signals he receives from the employer about the importance and ease of saving for retirement. There is a limit, of course, and researchers saw that once they implemented an auto-enrollment rate at an 11% salary deferral, there was a slight drop-off in new participant retention. Still the drop-off was not significant.
This “shows that there is a very broad spectrum of savings rates that we can propose and that newly enrolled workers will take seriously,” Benartzi notes. “It is really up to sponsors and legislators to take this initiative to help those people who are newly enrolling in their plans. They have the power and knowledge to promote plan success.”
Benartzi concludes with one intriguing caveat: “As you keep increasing the default rate beyond 7% and up to 8%, 9% or 10%, you see an increased rate of participants actually engaging with the plan and lowering their deferral rate to a percentage they actually liked, typically a percentage or two below the default that was suggested. At first blush, this may seem like a negative outcome, but we actually see it as a positive sign of real engagement with the plan as a direct result of these higher default rates.”
Art by Jon Han