Modern plan designs are giving employees a 401(k) option their grandfathers didn’t have: A way to participate without participating.
This fact represents a victory not only for today’s workers, but for science.
You see, before the 401(k) concept entered its teenage years, service providers and plan sponsors (at least the astute ones), recognized three critical problems with the retirement vehicle.
First, not enough employees were participating. Second, even among those who did participate, savings rates were too low to meet projected retirement needs. Finally, those that did save, whether or not they saved enough, tended to put their savings into conservative investments (like stable income funds) rather than the more appropriate long term options.
Fortunately, a relatively young branch of science known as behavioral finance was just then blossoming. In combining the psychology of decision making with the psychology (and mathematics) of money, researchers sought opportunities to study large groups of people making financial decisions. The 401(k) environment proved a fertile – and immediately practical – environment for such study. They quickly discovered what elements led to inappropriate decision making (see, “How Poor Plan Design Damages Retirement Readiness,” FiduciaryNews.com, Sept. 30, 2014).
Today, many large companies have absorbed these lessons and have incorporated them into their 401(k) plans. We call these the “auto” features, and it’s not just because they drive employees towards the land of retirement readiness. While there are many other features – both traditional and novel – that help encourage employees to save (see, “Steps the 401k Fiduciary Can Take to Avoid Poor Plan Design,” FiduciaryNews.com, Oct. 2, 2014), it is these three auto features that have garnered the most attention:
Auto-Enrollment: This is the grand-daddy of them all. Researchers found employees had a certain inertia when it came to decision-making regarding their 401(k) – they preferred to make no decision at all. Originally, 401(k) plans required employees to opt-in, i.e., make a positive decision to enroll in the plan. The inertia of “no decision” left many, if not most, employees on the sidelines. Auto-enrollment takes this inertia and performs a jujitsu on it. By flipping the decision-making 180 degrees and requiring employees to opt-out rather than opt-in, plan participation skyrocketed. Companies were initially reluctant to add this feature due to the potential fiduciary liability associated with it. Congress removed the liability in the 2006 Pension Protection Act.
Auto-Escalation: This is the sister of auto-enrollment. It addresses a similar problem and is based on the same no-decision inertia outlined above. It’s one thing to get employees to start saving, but those salary deferrals generally are not high enough to best prepare the employee for retirement. As before, in the past, the employee had to opt-in – or make a positive decision – in order to increase his savings rate. Industry statistics showed this inertia was holding people back from doing the right thing. Auto-escalation, like auto-enrollment, requires the employee to opt-out. This takes advantage of the no-decision inertia and allows the employees to get to the contribution rate best suited for their retirement needs.
Auto-Asset Allocation: Okay, I admit this term is far less used than the other two, but it makes the point. Research in the psychology of decision making has long shown people tend to freeze when confronted with a multitude of choice. When applied to the 401(k) world, this paralysis adds to the anxiety of decision making, giving employees further reason to simply not participate. At first, the evolution from a single portfolio profit sharing plan to a menu of a few distinct choices in a 401(k) plan seemed attractive. But as those choices proliferated to the tens and even hundreds, this paralysis phenomenon took hold. The same 2006 PPA mentioned earlier outlined a way for plan sponsors to protect their fiduciary interests by giving what a majority of employees appeared to want: a single portfolio managed to their own needs. Whether target date funds, lifestyle funds, or even managed models, this “one” option has indeed drawn an enormous interest from retirement investors.
Is it time to put your 401(k) on “auto”?