How Poor Plan Design Damages Retirement Readiness
(This is the first installment in a series of four articles.)
By now, you’ve probably read all the reports about retirement plans missing $273,000 from their hypothetical value. The report, titled “401(K)/IRA Holdings in 2013: An Update from the SCF,” was written by Alicia H. Munnell, the director of the Center for Retirement Research at Boston College and the Peter F. Drucker Professor of Management Sciences at Boston College’s Carroll School of Management. It analyzes the data from the Federal Reserve’s 2013 Survey of Consumer Finances (SCF). Although it features a number of interesting finding, the “missing $273,000” appears to have most caught the eye of the media.
More intriguing than the number are the components that go into it. Surprisingly, high fees were not the worst culprit when it comes to siphoning value out of retirement accounts. In fact, of the four identified sources of the $273,000 loss, fees contributed the least. And these aren’t even high fees. Munnell used the average fee as provided by the Investment Company Institute (ICI). The ICI reports only mutual fund expense ratios, and there are other (i.e., service provider) fees that may have a greater impact. Using just the ICI data, Munnell estimated the toll from fees was only $59,000. Leakages ate up $78,000 while poor savings habits resulted in losses of $136,000 ($71,000 from “Intermittent Contributions” and $65,000 from “Immature System,” i.e., the failure to save early).
Still, Munnell tells FiduciaryNews.com, “Fees are really important. Many plan sponsors clearly have room for improvement in this area as fees can often be reduced significantly in a way that boosts net-of-fee returns for the plan participant.” Certainly, as FiduciaryNews.com has previously reported, few could argue with this statement. But the data shows the bulk of the missing $273,000 stems from poor plan design. (Investment due diligence – where the fee issue can be most readily remedied – is addressed in the plan’s Investment Policy Statement, which, arguably, may or may not be considered part of “plan design” proper).
Munnell sees the negative impact coming from a mix of poor plan design and public policy. “For example,” she says, “leakages are primarily a result of federal law on pre-retirement distributions (involving hardship withdrawals, post-59 and 1/2 withdrawals, loans, and cash-outs upon job change).”
Alan Hahn, a Partner in the Benefits & Compensation Group at Davis & Gilbert LLP in New York City doesn’t agree the problem can be blamed solely on poor plan design. He says, “It’s important to note there are very few plan designs that should be called ‘poor.’ Oftentimes, an unimaginative 401k plan design is really the victim of a poor employee communication effort. Think about the most important thing that helps employees save for retirement. It’s the simple act of getting enrolled in the plan and starting to save. So, with that in mind, even a plan with a 401k-only feature without a match or non-elective contribution can help employees reach their retirement goals. What’s missing is the education piece. Getting employees engaged so they understand the value of saving, and then giving them the tools to get there.”
It’s possible that poor plan design is a function of the economic realities of the plan sponsor. When this is the case, though, the impact may be limited to company owners and other high-paid executives. “Poor plan design really only effects those who want to save at or near maximum levels,” says Andy Bush, Partner at Horizon Wealth Management in Baton Rouge, Louisiana. “A plan sponsor has the liberty to design the plan in a variety of ways, but he must have the wherewithal to make matching contributions, non-elective contributions (Safe Harbor) or profit sharing in order to maximize the effectiveness of the plan and minimize the restrictions (ie. Top-Heavy plans sending contributions back). Some small businesses simply can’t commit to those options every year.”
Many others feel plan design is the critical first step towards improving retirement readiness. Richard Rausser, Senior Vice President of Client Services at Pentegra Retirement Services in White Plains, New York says, “The industry has learned that education alone does not drive participant behavior. Ensuring successful participant outcomes begins with progressive plan design that maximizes positive participant behaviors. Progressive redesign of the 401k plan can only help participants achieve higher levels of retirement readiness and success. Poor plan design can directly impact an employee’s motivation to save through a retirement savings plan. Today, 401k plans have become the sole retirement plan for many employees. We need to focus on improving defined contribution plan outcomes to ease the loss of the traditional defined benefit plan that may have been closed, frozen or cut back.”
Poor plan design can actually work against the need for employees to save. Indeed, traditional plan designs – those created around investment products rather than savings strategies – may often send the wrong message regarding the priority of saving. Ozeme J. Bonnette, a Financial Coach at Tri-Quest Investment Advisors in Fresno, California and Torrance, California says, “Poor plan design can discourage employees from saving. They simply don’t see any value in doing so. They may also not be informed enough about the importance of saving and how this plan will benefit them. The expenses can be so great that it results in too large an impact on net returns, especially if employees are sitting in cash or money market type investments.”
Worse, poor plan design relies too heavily on employee education to overcome the savings obstacle it represents. Nathaniel C. Propes, Chief Investment Strategist at Capital Management Advisors in Atlanta, Georgia says, “Poor plan design can significantly detract from an employee’s willingness to participate in the plan. Employees who are not educated and don’t understand the plan are significantly less likely to participate or contribute at a high enough rate if they do.”
The potential for plan sponsor fiduciary liability regarding investment selection may have been one reason why traditional 401k plans emphasized investing over saving. Employees, who previously had the comfort of merely “counting their money” with profit sharing plans that were professionally managed portfolios tailored specifically to company demographics, now found themselves as deer thrust into the headlights of making their own investment decisions. It was a responsibility few were confident enough to undertake and fewer still were competent enough to take on. Robert C. Lawton, President of Lawton Retirement Plan Consultants in Milwaukee, Wisconsin, says, “Many legacy plan designs assumed participants were interested in being heavily involved in making choices regarding participation, contributions and investment elections. The result was, for many plans, low participation (both in joining the plan and contributing) and inappropriate investment elections.”
The numbers don’t lie. In truth, different plan designs can favor or harm different specific demographic groups. Christopher Hobaica, co-founder and principal of HNP Capital LLC in Pittsford, New York says, “Poor plan design characteristics such as a longer wait time before being able to participate, no safe harbor contribution, match or Profit Sharing component, lack of Qualified Default Investment Alternative (QDIA) or lack of auto-enrollment tends to hurt employees’ ability to save for retirement. As an example, if a 21 year old employee, didn’t have to wait for one year of service and was able to contribute $5,000 in his/her first year of employment, assuming a 7% compounded rate of return, over the 45 year span until retirement, just that first year contribution would grow to $105,000. An annual safe harbor match of 3% on a $50,000 salary, following the previous assumptions would grow to an additional $460,000. These are just two simplistic examples of how lack of a flexible plan design can hurt an employees’ ability to save for retirement.”
Robert M. Richter, vice president at SunGard’s Relius in Jacksonville, Florida, cites two general categories of poor plan design. The first is the plan’s features. Poor designed features are readily seen discouraging savings. The second – the number of options on the plan’s menu of investments – is the more subtle and, for a long time, was viewed as a positive. Richter says, “Regarding plan features, you have the obvious – including a matching contribution as an effective way to increase participation. There is an argument that including loan features, hardship distribution features, and distributions upon severance of employment help with participation because employee deferrals are not locked up until retirement. Asking someone to contribute to a plan where there is no access to the funds for decades down the road is a tough sell. Yet these features come at a cost – they lead to leakage of assets prior to retirement. Loan provisions that provide for the acceleration of loans on termination of employment are also a popular but poor design. This is a particularly harsh result as a participant may not have funds to repay the loan in its entirety, thereby forcing leakage. Plan investments are also cited as hurting the ability of employees to save for retirement. Studies have shown that too many investments can overwhelm employees to the point that they will not participate in the plan.”
A 401k plan is supposed to represent a bridge to the employee’s retirement future. Poor plan design often makes the plan a bridge to nowhere. Munnell’s work shows the dollar cost of poor plan design, specifically by identifying the impact of leakage and lack of savings. Industry practitioners see first-hand and even name the suspects responsible for these negative results. This same hands-on experience compliments Munnell’s theoretical perspective and can offer testimony as to what plan sponsors can do to avoid poor plan design. But first, we should take a look at exactly who is responsible for plan design in general.
We’ll take up that topic in the next installment, “Which Retirement Plan Fiduciary Most Drives 401k Plan Design.”
Interested in learning more about important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. He will be speaking at CFDD ’14 on the subject of “Using Proven Psychological Techniques to Motivate Plan Sponsors & Participants to Implement Your Recommendations.” The session will feature a unique but highly effective presentation style and feature tools mentioned in his new book Hey! What’s My Number? – The One Thing Every Retirement Investor Wants and Needs to Know!