Redesigning defined contribution retirement plans to boost retirement readiness
By E. Thomas Foster Jr.E. Thomas Foster Jr., Esq., is The Hartford’s national spokesperson for qualified retirement plans. Foster works directly with broker/dealer firms and advisers to help them build their qualified retirement plan business and educate them about industry issues.
Thomas Jefferson once said he preferred the “dreams of the future better than the history of the past.”
Jefferson is arguably one of America’s greatest futurists. He conceived the spirit of America through authorship of the Declaration of Independence, envisioned westward expansion when he secured the Louisiana Purchase, and promoted the importance of higher education by founding the University of Virginia.
But what would Jefferson say about one of today’s most pressing problems: the need for Americans to prepare for a long life in retirement?
Another futurist, Ted Benna, conceived the 401(k) plan in 1978. Today, about half of all Americans have access to an employer-sponsored retirement savings plan. Yet, the Employee Benefits Research Institute (EBRI) reports that only two in five employees take advantage of it and of those who do, 56 percent have less than $25,000 saved.*
It’s clearly time for some changes. But while some have criticized the dependence on defined contribution plans for retirement security, the 401(k) and its cousins, 457(b) and 403(b) plans, aren’t going away anytime soon. It’s time to fix what’s available and, in the process, to supercharge its performance.
Many employers do fret about employees not saving enough for retirement and would make changes in their retirement savings plan if they only knew what might help. Increasingly, employers are learning about and implementing new strategies with help from financial advisors and third party administrators. Strategies that encourage greater employee participation typically boost savings rates, make it easier for lower-paid employees to find dollars for retirement savings, and help all employees create a guaranteed income in retirement that they cannot outlive.
Put it on automatic
One strategy that an increasing number of employers are adopting is automatic enrollment. Employers can create a plan or redesign their plan to automatically enroll employees into a 401(k) as long as plan participants are allowed to stop their contributions within 90 days of initial enrollment. The automatic contributions are determined by a default percentage and a default investment option established by the plan to address situations where no election is made. Automatic enrollment is subject to administrative requirements.
Like the settlers who staked their claims in Jefferson’s new western territories, employees who are automatically enrolled in their employer’s 401(k) tend to stay put. They quickly discover that their retirement plan contributions have less of an impact on their paycheck than they expected because contributions are taken pre-tax. More importantly, they come to appreciate being able to watch their retirement savings – as well as their financial independence – grow.
Many retirement savers select a savings percentage and then change it whenever they see a blue moon, which is to say “never.” Too many workers contribute far too little and many don’t even set aside enough savings to take advantage of their employer’s full matching contribution, if available. With many financial experts recommending annual retirement savings of 10 percent or more, it’s time to push the envelope.
Increasingly, retirement savings plans that incorporate automatic enrollment are also automatically increasing the percentage of contributions made by employees to their 401(k) each year. Typically, automatic contributions begin at about 3 percent and automatically rise by 1 percent each year until they hit a predetermined level, often 10 percent. Of course, there are administrative requirements such as allowing employees to opt out or stop the escalation at a specific percentage rate.
Raise the bar
Some employers have taken a more aggressive approach to promoting the importance of retirement savings by raising the bar to qualify for matching contributions. Today, many employers provide a 50 percent match on the first 6 percent of pay contributed by participants to their 401(k). It’s a formula that has helped generate more than $4 trillion in retirement savings. But it’s not enough.
Consider what might happen if an employer offered a 25 percent match on the first 12 percent of pay contributed by an employee. Someone earning $50,000 a year would have to contribute $6,000 to obtain a $1,500 match. The bottom line: the employer encourages more retirement savings without incurring any additional costs. Of course, before employer embraces such a plan they need to consider the ability of their employees to contribute additional savings.
While most Americans can and should save more for retirement, some people today are struggling to simply get by in a tough economy. But all is not lost because their Uncle Sam has created a program to help lower income earners put aside money for retirement. The program is called the Savers Credit and it is one of the most-overlooked retirement savings incentives available.
The Savers Credit can be applied to contributions to a defined contribution plan or an IRA. The Credit can reduce the amount of federal income tax paid by individuals with incomes of not more than $28,750 if single, $43,125 if filing as head of a household or $57,500 if married filing jointly. The rate of the Credit can be as high as 50 percent or as low as 10 percent of retirement plan contributions, depending upon the participant’s income. The maximum amount of contributions taken into account for eligibility is $2,000 for an individual or $4,000 for a married couple.
Pay for Life
A long-overlooked problem for 401(k) plan sponsors and participants is the question of what to do with retirement savings at retirement. Increasingly, plan sponsors are providing annuity options that allow employees to turn at least a portion of their savings into a guaranteed lifetime income in retirement.
A recent study by The Hartford reported that 86 percent of Americans who did not have access to a guaranteed income option within their defined contribution plan viewed the concept as either “very appealing” or “somewhat appealing.” The younger the plan participant, the greater the appeal of having a guaranteed income, the study found. That means younger employees may soon be asking for guaranteed income options.
Meanwhile, the U.S. Government Accountability Office (GAO), noting the growing risk of Americans outliving their assets as life expectancies increase, has encouraged the use of income products such as annuities in defined contribution plans. “With the declining availability of DB (defined benefit) plans and the lifetime retirement income they frequently provide, a default annuity in DC (defined contribution) plans could help to promote lifetime retirement income for more (plan) participants,” the GAO reported last year.
Retirement plan providers have stepped up to the challenge, introducing a broad spectrum of income options for retirement savings plans. The new income options typically come in one of three flavors: a fixed annuity, an annuity as part of a Target Date Fund, or a variable annuity investment option with a guaranteed minimum withdrawal benefit.
Ted Benna has said he barely recognizes his invention as today’s 401(k)s often come with a bewildering choice of investment options that he has complained often leave plan participants paralyzed. It’s time to make a few other changes in Ted’s brain child to make it more relevant for today’s retirement saving needs.
Some employers are starting to take a more proactive approach on promoting the importance of saving for retirement and making their defined contribution plans more effective and more relevant to the needs of today’s employees. Incorporating features such as automatic enrollment, automatic escalation, higher contribution limits for matching contributions, promoting the Savers Credit and offering lifetime guaranteed income options are a great starting point.
If everyone saved as much as they should for retirement, the $4.5 trillion now sitting in defined contribution plans would start to look like chicken feed. More Americans would be able to envision a more secure financial future, much like Jefferson did in expanding the nation’s border’s westward.
*The Employee Benefits Research Institute, 2011
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