Would a cartographer be considered successful if only 25% of those using his maps arrived at their intended destination? Similarly, should we consider the current approach to 401(k) plan administration effective given that only a quarter of participants are on track to fund their retirements?
Plan success is currently measured by participation rates. This needs to change.
Retirement planning in the U.S. looks like a three-legged stool: Social Security, personal savings and retirement funds. This last component usually represents the strongest leg for supporting most Americans' post-work lifestyles. The problem, however, is that most plan participants have no idea how much they need to save in order to fund their retirement liability.
This problem has a fairly straightforward solution. A typical participant should be able meet their financial obligations in retirement with about 70% of their pre-retirement income each year. We can work backwards with their Social Security statements and out-of-plan savings to define with great accuracy what will be required in 401(k) assets to ensure a fully funded retirement.
Once we know how much each participant must save in order to maintain their standard of living in retirement, we can create a pathway for them to get there successfully. Our observations show that people tend toward inaction when faced with difficult choices. We call it behavioral inertia, and it is fair to suggest this phenomenon is a leading contributor to the underutilization of 401(k) plans as effective retirement tools.
Choices like whether to participate, how much to defer, which fund options to choose, deferral increases and allocation changes have traditionally been affirmative choices; they must be chosen or nothing happens.
Often - given that the participant knows neither how much they need to save nor what choices would ensure they save enough - nothing is exactly what happens. But what if the retirement plan was designed to account for behavioral inertia and harness it to the participant's advantage?
This is already being adopted on a fundamental level by many retirement plans in the form of automatic enrollment and default investments, which are steps in the right direction. The 401(k) plan could be a much more effective tool, though, if default options covered more ground and were married to an explicit goal of funding the participant's retirement liability.
The ideal plan should include automatic enrollment, a default model portfolio consistent with the participant's goals, progressive deferral escalation, and periodic reallocation and rebalancing. If these are offered with a negative opt out and tied to a stated retirement goal, behavioral inertia will likely prevent the participant from abstaining.
No explanation is required for why a fully funded retirement is important to participants, but what is the value to employers?
There is great merit in the concept of maximizing each employee's well-being simply because it promotes a more effective workforce. Reduced preoccupation over financial security and future uncertainty enables employees to focus on productivity. The defined contribution plan has become a mainstay in the employer-employee relationship, and plan improvements are a way for employers to demonstrate they care about staff well-being at the margin.
Employers can also leverage a superior plan in the competition for top talent, where benefits are a key consideration for potential hires. A plan that develops custom pathways for individuals and ensures they stay oriented without any commitment represents a point of differentiation.
The monetary value to employers is compelling too. The cost of success for a plan that guides participants to their goals is considerably lower than the costs associated with plans that leave them to their own devices. We can calculate the total cost per successful participant by dividing the total plan cost by the number of fully funded participants. Our observations and experience show a cost increase of 63% for plans that do not establish success pathways. In effect, participants who fall short of their retirement needs are failures attributable to plan design.
The basic business concept of prudent spending would suggest plan costs that do not achieve their true objective are a waste. Participation alone as a measuring stick ensures companies will miss the opportunity to commit those plan dollars to their highest and best use. It is time to measure retirement plans by the successful retirement outcomes they produce.
Topley is managing director of Unified Trust's retirement plan consulting group. He can be reached at (859) 514-8271 or firstname.lastname@example.org.
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