Steps the 401k Fiduciary Can Take to Avoid Poor Plan Design
(This is the third installment in a series of four articles.)
A poorly designed 401k plan, rather than promoting employee savings, actually dampens it. Plans like these fail the retirement readiness test. In return, this places more pressure on the demand for often controversial, if not questionable, public policy decisions. Poor plan design – specifically, leakage and weak savings – is the main villain in this drama. We’ve already identified which fiduciary drives plan design. The question is “What can the 401k plan sponsor due to mitigate poor plan design?
“A good way to improve plan design is to adopt a fully automatic approach that applies to all of a firm’s workers, not just new hires,” says 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. “Workers would be automatically enrolled with an initial default contribution rate set at a meaningful level. They would then have their contributions automatically increased over time until the combined employer-employee contribution rate reached at least 12 percent of pay.”
The 2006 Pension Protection Act insulated plan sponsors from certain fiduciary liabilities when incorporating automatic enrollment with one or more Qualified Default Investment Alternatives (QDIAs). Since then, the number of plans electing this option has skyrocketed – and for a very good reason. Alan Hahn, a Partner in the Benefits & Compensation Group at Davis & Gilbert LLP in New York City, says, “Automatic enrollment remains the most effective way to help employees save for retirement. Also, plan sponsors should consider an automatic escalation feature with automatic enrollment, so that employee contributions automatically increase year over year.”
Automatic enrollment takes advantage of the “no action” inertia common among employees. By requiring savers to actively “opt out” of contributing to the plan, we’ve seen participation rates nearing 100%. What’s more, once the employees see how little impact a seemingly “large” deferral percentage has, they are motivated to stay in the plan. Seth Deitchman, Financial Advisor at Morgan Stanley in Atlanta, Georgia says, “There is usually a 90 day look back and the employee who was automatically enrolled can get their funds back if they choose not to participate. What has happened is that employees see that it is not a big chunk taken out of their pay check.”
Sponsors can design plans with a wide assortment of automated alternatives beyond enrollment. Richard Rausser, Senior Vice President of Client Services at Pentegra Retirement Services in White Plains, New York says, “Automatic features are one of the best ways to improve plan design. These features can include automatic enrollment, automatic escalation of salary deferrals, auto rebalancing and utilization of QDIAs. These features help plan participants set a reasonable level of salary savings, increase their contributions over time, achieve proper investment diversification, and make better use of a plan’s investment alternatives. Placing participants in an appropriate investment option at a pre-selected contribution rate that increases annually essentially replaces some of the most important features of a defined benefit plan such as automatic coverage and professional investment management.”
While these new twists have been a boon to employee saving, we shouldn’t dismiss the continued importance of the traditional incentives. Ozeme J. Bonnette, a Financial Coach at Tri-Quest Investment Advisors in Fresno, California and Torrance, California says, “Poor plan design happens in more than one way. One area of poor plan design is the lack of a match. Employees want to feel valued and appreciated. A match is a value-add that an employer can write off. Another issue is that of the platform and its investments. Some employers set it and forget it. That does not work. Investments change over time, and a plan should adjust for that. Poor quality funds should be replaced. If funds shift styles, the employer should ensure that other options are available to meet the need for diversification. Another issue is the expense. Some expenses are a part of the normal cost of doing business, but some plans are never revisited over the years. Is there a better option, or a better way to design the plan? Have asset levels increased to a point that fees can be reduced due to economies of scale?”
Even leakage, a traditional feature much maligned in Munnel’s “401(K)/IRA Holdings in 2013: An Update from the SCF” report, may actually help encourage saving. Robert M. Richter, vice president at SunGard’s Relius in Jacksonville, Florida says, “I think the benefits of permitting loans, hardship distributions, and distributions upon termination of employment outweigh the detriment of leakage. I would, however, like to see loan provisions that do not accelerate on severance of employment. Improvements on the investment aspects of plan design have been embraced by most providers.”
It turns out one of the most “popular” features in the early years of the 401k era – that of picking from an almost unlimited bounty of mutual fund investment options – produced the biggest obstacle towards retirement savings. Paralyzed by the overwhelming number of choices, many employees chose not to participate. Changes to the approach towards investment options has greatly improved participation levels. Robert C. Lawton, President of Lawton Retirement Plan Consultants in Milwaukee, Wisconsin says, “Many plan sponsors have evolved their plan designs to include features that either guide participants to ‘best’ choices or make choices for them. The proliferation of ‘auto’ features and target date investment options are excellent examples. The addition of these features will result in participants who will have much higher 401k plan balances at retirement. Without question the addition of ‘auto’ features will have a significant impact upon the group of participants that needed the most help – those who were least connected to the plan. Similarly, the addition of QDIA’s that feature some exposure to equity will result in much higher 401k retirement balances for this least connected group.”
The QDIA allows the act of “deciding to not decide.” In return, employees are now free to focus on saving. Yet some would like to have better confidence in how their money is invested. Plan design addresses this specifically through the Investment Policy Statement and the service providers selected. Nathaniel C. Propes, Chief Investment Strategist at Capital Management Advisors in Atlanta, Georgia says, “The use of an ERISA 3(38) fiduciary managed models helps many participants to feel more comfortable knowing that a professional adviser is looking over their allocation and acting in their best interest.”
Yet, there remains one old-fashioned feature many plan sponsors insist on including in their plan design. It is meant to address an “issue” that, by its very pervasiveness, can no longer be considered an issue. It is the norm. We’re talking about employee turnover. While the outmoded vesting feature is all but extinct, the “probation period” whereby hires must wait before participating continues to survive. Christopher Hobaica, co-founder and principal of HNP Capital LLC in Pittsford, New York says, “Giving new employees the opportunity to participate immediately in a company sponsored retirement plan is the first step. The second step is to give them incentives, such as a safe harbor match to increase their contributions. A Profit Sharing contribution, if affordable, is a great way to incentivize participants to work harder towards a common company goal. Also, having a QDIA will help the financially uneducated employee from hurting themselves in the long run by unintentionally allocating their contributions to a money market.”
As we’ve come to accept a new standard, a new ideal, in plan design, thought leaders persist in the effort of continuous improvement. We reveal hints are what the next generation in plan design might be in our fourth and final installment, “Beyond Auto-Mania: The Future of 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!