Taking a fresh look at 401(k) design

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At this point in its evolution, the 401(k) plan has cemented its place as a critical tool for helping workers prepare for retirement. In fact, most workers say that a 401(k) is their largest or only source of retirement income, according to a recent survey from Schwab Retirement Plan Services. Still, one of the primary challenges of the current 401(k) system is that many plan participants are not saving enough to afford a comfortable retirement, often because they are confused, overwhelmed or even unaware of how much they need to save.

Plan sponsors want to help employees make the most out of this crucial retirement savings vehicle, but despite their best efforts, they can’t control participant behavior. What they can control, however, is how they design their 401(k) plan with a focus on helping employees work toward their retirement savings goals.

Modern plan design can take a number of features into account, layering them with the goal of maximizing the potential benefit to participants while remaining cost-efficient. Several of these, such as automatic features and managed account services, have emerged in recent years and are already making an impact on participant behaviors and outcomes. Whether an employer includes auto features or professional advice or both, these design elements don’t exist in a vacuum but can instead be “stacked” to potentially achieve specific outcomes.

Get participants off on the right foot with auto features
Using certain automated features, employers can leverage participants’ inertia to help them get off to a good start with the goal of simplifying the decision-making process. These include auto-enrollment, which gets employees into the plan and saving for their retirement; auto-increase, which increases participants’ contribution levels at regular intervals; and auto-advice, which enrolls participants into managed accounts based on data available on each participant. Historically, some plan sponsors have raised concerns that participants might perceive auto features as overreach, but these concerns are misplaced, and we know participants appreciate the help. In fact, a study from the Transamerica Center for Retirement Studies found that 71%of workers find the idea of being automatically enrolled in a 401(k) plan to be appealing.

For one, auto-enrollment gets workers participating in the plan, and when it comes to saving for retirement, the sooner, the better. Some workers might assume that the default rate is sufficient, and employers will do them a disservice by setting the default rate too low. At a minimum, plan sponsors should consider moving from the common default rate of 3% up to 5%.

Furthermore, an automatic savings increase bumps up participants’ contribution rates by a percentage or two at regular intervals or milestones, such as after salary increases or at work anniversaries. This may help participants gradually move their way up to a higher contribution rate as they work toward their longer-term retirement goals. For companies that also pay bonuses, it may make sense to automatically assign them the same default contribution rate as workers’ regular paychecks, eliminating the guesswork for participants and helping them get closer to contributing the yearly maximum.

Another option is automatic enrollment into professional advice/managed account services as a Qualified Default Investment Alternative for the plan. Managed account services have become increasingly popular in recent years, so new employees may benefit from being automatically enrolled. To give longer-term employees the same potential benefit as new workers, plan sponsors can introduce re-enrollment, effectively placing all employees into the plan’s QDIA with the choice to opt out. When plan sponsors re-enroll all participants into the plan’s managed account QDIA, 86% of plan participants have stayed with the QDIA choice, according to a study of 147 plans by Schwab Retirement Plan Services, Inc

Auto-enrollment is often the first auto feature that comes to mind for plan sponsors, and those unwilling or unable to implement it — due to costs or other concerns — should keep in mind that auto features are not an all-or-nothing proposition. For example, implementing automatic savings increases without automatic enrollment may still be effective for participants who have proactively signed up for the plan. Likewise, a plan re-enrollment into the QDIA may help to address asset allocation issues for existing participants.

Find an ideal match
Most employers offer some matching dollars as part of their 401(k) plan — and that match can be a key incentive to getting workers to participate. From what I’ve observed, when participants act on their own — that is, without the help of a financial professional —they tend to contribute at or near the match level. This means, if an employer offers a match of 50 cents on the dollar up to 6% of salary, then workers commonly cluster around a 6% savings rate. For most Americans, that’s simply not enough to meet long-term retirement savings goals.

For the reason above, a dollar-for-dollar match up to 3% and a 50-cents-on-the-dollar match up to 6% are equivalent to the employer, but the latter structure will likely get most participants contributing closer to 6%. A match of 25 cents on the dollar up to 10% or 12% will likewise give participants incentives to contribute even more. This is what’s known as a “stretch match,” and it takes advantage of participants’ inclination to contribute at the match level without increasing plan costs.

Another option is auto-enrolling participants at the match level. This way, they’re not missing out on matching dollars.

Give participants a helping hand
While saving enough for retirement is important, asset allocation can also have a significant impact on retirement saving outcomes. Target-date funds have long been a popular choice because they are designed to take much of the guesswork out of choosing 401(k) investments by determining an investment strategy based on an individual’s anticipated date of retirement. But a personalized investment plan created with the help of a financial professional may be even more useful, since it takes multiple data points about the individual into account. These data points include everything from other sources of retirement income to current salary and savings rate to marital status and more.

At Schwab Retirement Plan Services, we’ve observed managed account services lead to a number of positive participant behaviors, like electing higher contribution rates, better diversifying investments and staying the course during times of market volatility.

Most participants in the aforementioned survey, some 70%, say they want help managing their 401(k). Roughly three-quarters (74%) say they’d feel very or extremely confident making 401(k) decisions with the help of a financial professional, while only 44% would feel that same level of confidence on their own. By making professional 401(k) advice available, plan sponsors may help their participants feel more confident about their investments decisions.

Time for a design refresh?
The same survey found that saving enough for a comfortable retirement is actually the No. 1 source of financial stress for most workers. A plan sponsor’s thoughtful choices about plan features may go a long way toward easing that burden. As we look to the future, plan sponsors should continue evaluating ways to help their employees stress less and save more for their retirement through effective 401(k) plan design.

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