A workable prescription for redefining retirement plans

As traditional defined benefit pension plans continue to fade from existence, the retirement security of millions of American workers increasingly rests squarely on the shoulders of their 401(k) or other workplace-provided defined contribution (DC) program

This decades-long transition has been marked by weak plan participation rates, anemic contribution levels, and meager accumulations.  And together, these issues have prompted the Center for Retirement Research at Boston College in 2010 to characterize the movement toward participant-directed retirement planning as the single most dramatic factor behind the negative trend in its National Retirement Risk Index over the past quarter century.
   
Some of the shortcomings in the DC-based retirement-planning environment have begun to be addressed through the Pension Protection Act of 2006 (PPA), which will make it easier for plan sponsors to adopt a number of “auto-pilot” features for their retirement programs, such as automatic enrollment and automatic contribution escalation.

Bur even with these important “steps in the right direction,” it’s become increasingly clear that the PPA is really just a good beginning … and that the retirement security of millions of working men and women demands a more cohesive, broad-based, and far-reaching approach.

In fact, this need amounts to nothing less than a mandate, because—based on current trends—failure to act may potentially lead to:

•    A retirement for a majority of Americans that will fall far short of their expectations; and
•    Increased taxation for all to support the retirement-savings shortfall.

The following proposals are designed to keep these unwelcome consequences at bay. 

Automatic Enrollment

•    Automatically enroll all eligible individuals not currently participating in the plan.  Even before passage of the PPA made automatic enrollment easier for sponsors, this practice was on the rise, according to the Profit Sharing/401(k) Council of America (PSCA), and with good reason. It reverses the impact of one of the greatest impediments to more-effective retirement saving: inertia, or the simple fact that if someone doesn’t join their plan when they first become eligible, chances are they never will.
•    Revisit enrollment with non participants on an annual basis.
•    Make contribution acceleration a default feature of automatic enrollment. Automatic escalation is a key best practice recommended by the Retirement Security Project, and its ability to drive substantial increases in contribution rates over time has been demonstrated in both practice and theory.

Default Savings Rate

•    Set automatic enrollment default savings rates at either six percent or at the plan’s maximum match percentage.  Current contribution rates are often too low to provide adequate retirement income for participants. Research by the National Bureau of Economic Research found that once a plan’s default rate is raised to six percent from an existing lower default rate, virtually no new hires select a lower contribution rate.

Asset Allocation

•    Default participants into age-appropriate investments offering professional asset allocation.  To overcome the tendency to remain invested in “first choices”—or help participants who suffer from a real or perceived lack of expertise to make investment choices—individuals may choose to default into age appropriate “target retirement-date funds,” or at the very least provided with professionally guided asset-allocation tools.

Contribution Escalation

•    Make contribution acceleration automatic for both new and existing participants. Automatic escalation of contribution rates in defined contribution plans is a key best practice recommended by the Retirement Security Project to counter participants’ tendency to passively maintain the same contribution rate over time—again, inertia.
•    Add a contribution-escalation feature to plans that already include the automatic-enrollment feature.
•    Structure plans with an automatic contribution-accelerator feature as an opt-out or default option.
•    Increase the deferral rate in contribution-accelerator programs by two percent a year.
•    Set the plan’s maximum deferral as the cap for a contribution-increase feature.

Lifetime Income

The wealth-accumulation phase of retirement planning has dominated most discussions about retirement security.  But we should never lose sight of the ultimate goal, which is guaranteed lifetime income in retirement.  Lack of effective planning in this area can result in the same devastating outcome as inadequate wealth accumulation during the participant’s working years: insufficient income in retirement. This inevitably leads to the need for plans to:
•    Offer an in-plan guaranteed retirement-income solution that does not require annuitization but still provides a guaranteed income stream, asset control and flexibility, an optional spousal benefit, the ability to take advantage of market upswings, and protection from market downturns. 

Badly Needed Prescription

Resistance to change is endemic in human nature, but there comes a time when failure to change becomes a more perilous route.  If DC plans are to serve as the primary source of lifetime retirement income for millions of American workers, they must evolve … and they must address the two biggest obstacles to better retirement planning: inertia and risk avoidance.

Behavioral finance experts tell us that most individuals tend to make one decision and stick to it.  They either join their plan or they don’t.  And, once in, they generally never change their investment elections or contribution rates … unless faced with a short-term loss.

Instead of trying to change behaviors, it’s time to change the structure of the plans; to create a “glide path” that carries individuals not only to retirement, but through retirement.  And that’s what these modest proposals are designed to do—to make behavioral finance work for individuals rather than against them.

The time for discussion and debate over whether to change DC plans is long past, and a prescription for what ails them is long overdue.  Even in a DC environment—even in an era of personal responsibility for retirement preparedness—everyone, with a little help, has the potential to achieve a secure retirement. 

Retirement products and services are provided by Prudential Retirement Insurance and Annuity Company, Hartford, CT, or its affiliates.

Guarantees are based on the claims paying ability of the issuing company.

Keep in mind that application of asset allocation and diversification concepts does not ensure safety of principal and interest, it should also be noted that diversification does not assure a profit or protect against loss in a declining market. It is possible to lose money by investing in securities.
The target date is the approximate date when investors plan to start withdrawing their money.

The asset allocation of target date funds will become more conservative as the target date approaches by lessening your equity exposure and increasing your exposure in fixed income type investments.

The principal value of an investment in a target date fund is not guaranteed at any time, including the target date.

Neither Prudential Financial nor any of its representatives are tax or legal advisors and encourage you to consult your individual legal or tax advisor with any specific questions.

This material is for informational purposes only. It is not an offer or solicitation for any product or service.