Shortly after passage of the Pension Protection Act of 2006, I had a memorable conversation with a company treasurer. After I suggested that he take advantage of the act's fiduciary protections to enhance his defined contribution plan participation, savings rates and potential investment returns, he curtly informed me that improving employee retirement outcomes was not a priority. His company had closed its defined benefit plan, and his marching orders were to minimize effort by offering a basic 401(k) plan. “Dick, you just don't get it, do you?” the treasurer fumed. “I'm not trying to run the best 401(k) in America — it just has to be good enough.”
I've come to observe that “good enough” is good enough for many companies. But will good enough cut it, given the rising chorus of criticism of the 401(k) system? We live in a nation in which 69% of private-sector workers with some type of workplace program are totally dependent on their DC plan — plus Social Security — for retirement. Corporate America needs to decide: Is it serious about maintaining control of its workplace retirement programs?
Much of current industry criticism laments the decline of a DB system in which workers stayed with employers for their entire careers and retired to a comfortable pension. But this golden age of retirement is an urban legend. Worker mobility has been high since World War II. At the peak in 1991, only 38% of private-sector retirees enjoyed a DB benefit, declining to 34% by 2010. Retirees now drawing a private-sector benefit receive a median annual payment of $7,600, in real terms only slightly greater than 30 years ago and about half the sum provided by Social Security. So the bar the 401(k) system has to beat is not that high. But we should not be satisfied.
Most consultants agree workers must consistently save 15% of income to support themselves in retirement. However, record keeper statistics indicate participation rates have been hovering around 75%; a quarter of eligible workers do not enroll in their plan. Average savings have been stable around 7% — add in a typical company match and we get to about 11%. But averages are misleading. Roughly a quarter of participants are saving less than 4% before the match. And most participants are poor investors. Using target-date fund design as an appropriate allocation target, it would not be unusual for 70% of participants to have an inappropriate mix of stocks and bonds in their portfolios.
The good news is that the system is working well for the top quartile of lifetime income earners who are saving well. Analysis conducted by the Employee Benefit Research Institute indicates that for high-income employees, a system that allows them to take balances from job to job should do as well and possibly even better in generating retirement income than the defined benefit program it replaced. Lower-income workers, who are less likely to participate — and save at low rates when they do, present the real problem. In the current opt-in system, their prospects for a comfortable retirement are far lower than in the former DB world.
The solution to address this segment is quite straightforward, and the Pension Protection Act provides a road map:
- Auto-enroll new employees and all non-participants every year — and not at the typically cautious 2% to 3% contribution levels, but at 5% to 6%. Admittedly, this will mean some additional expense.
- Auto-escalate employee contributions from initial rates by two percentage points per year to 10% or higher. Stretch the company match formula if necessary to support higher savings. For example, instead of a dollar-for-dollar match on the first 5% of contributions, match 50% on the first 10%.
- Encourage participants to move their assets into the default portfolios blessed by the PPA — typically target-date funds. Education alone will not do it — re-enroll participants using a negative consent process.
Following these steps, “best-in-class” plans have boosted participation rates to between 95% and 98%, seen total savings (participant plus company match) for the majority of participants approach 15%, and moved 80% of assets into professionally managed portfolios, with these gains largely benefiting workers of low and moderate income.
These actions can be taken within our current system. Fortunately, few participants will opt out. Some companies view these steps as too paternalistic for their cultures. But the evidence is that while participants object to mandatory participation and government intervention, they trust their employers to make more informed decisions on these retirement matters than they can on their own. They like our 401(k) system, even if it is serving some of them poorly.
If corporate America fails to act, others are more than willing to replace the current voluntary employer-based system with a second public-sector retirement program. Elements of Australian and U.K. systems are held up as models, but proponents want to go even further to include mandatory contributions and annuitization coupled with government investment control. Sponsors satisfied with their “good enough” plans today might find a future filled with new government programs far from their liking. This fear of the unknown might finally coax them into taking aggressive steps now to maintain private sector control of the second pillar of our retirement system while better serving American workers.
Richard Davies is managing director, defined contribution, Russell Investments, New York.