by John Richards, CFA, Bronfman E.L. Rothschild
and Marc McDowell, CRPS®, AIFA®, Bronfman E.L. Rothschild
Designing a 401(k) plan to serve your company and its employees is more than just selecting the right investments.
With 17 years of experience in focusing our attention on helping plan sponsors structure and administer their retirement plans, we’ve identified five principles that we believe contribute to success. This whitepaper will explore these principles and offer a framework for plan sponsors to design and manage an effective retirement plan.
Our approach to retirement plans is based on these 5 principles:
1. Incorporate behavioral finance fundamentals to help improve participant and plan results
2. Deliver participant advice on a one to one basis
3. Include plan design features to make enrollment and investment selection easy for participants
4. Provide financial wellness services to improve the financial health of your employees
5. Have a sound investment process
Let’s explore each of these separately.
Principle 1: Incorporate behavioral finance fundamentals to help improve participant and plan results
Numerous studies have identified that individuals often fail to act rationally when it comes to investing. This often leads to inertia and reluctance to change the status quo. Participants who tell themselves, “I’ll get around to that tomorrow,” or “I don’t know how to sign up” delay getting started. Those who tell themselves “I’ll start saving when I’m older,” or “I have more important expenses now,” have a detrimental focus on the short-term and can undermine their long-term success by failing to save early.
Yet when many participants approach retirement, they later regret this behavior. According to a study by American Century Investments, 8 out of 10 pre-retirees feel they did not save enough early in their career. Eighty two percent wished they could encourage their younger self to save more, and 76% felt they underestimated when they were young how much they would need to save for retirement.1
To avoid this, it is important to try to eliminate the behavioral hurdles of getting started and having a disciplined savings plan. Studies conducted by behavioral finance experts prove that you can harness potentially negative forces such as procrastination and inertia in a positive way.2 The landmark “Save More Tomorrow” study revealed that automatically enrolling employees in their retirement plan dramatically increased participation rates and automatically increasing saving rates helped employees save more. The first hurdle is inertia and a preference for the status quo. Many employees are comfortable today and want to keep things the way they are. The challenge is a focus on the short-term only and an inability to consider the future. Some won’t save now because they can’t picture what they are going to need in the future.
Plans need to get past these hurdles to encourage savings and participation. One way to do this is with your plan design. Automatic enrollment, the subject of the “Save More Tomorrow” study and which we will discuss more below, is an excellent way to start the savings process and help young participants realize it is relatively painless. Creating the opportunity to engage participants on a face to face level to help them picture what they are going to need to retire is critical. While many plans offer great content for participants online, it still requires time and energy to go to the website and find the relevant information. We find that taking a more individualized approach is more effective.
Principle 2: Deliver participant advice on a one to one basis
In our experience, participants in retirement plans fall into three broad groups:
Self-Directed – Do It Yourselfers or “DIY” Participants
This is the engaged participant who does the research and has some understanding of investments and their options. We encourage these individuals to work one-on-one with and an advisor to review their selections and follow up to make sure the participant adjusts the portfolio and rebalances to stay on track. These participants are engaged in the investment process, not intimidated or overwhelmed by it and seek guidance to meet their specific needs.
Advice Seeking - “Help Me” Participants
This is a participant that does not want to be defaulted into a target date fund or some automated selection that might not suit their needs. Instead, these individuals are looking to better understand their options and seek customized advice on their portfolios. Being able to work with an advisor one-on-one is critical for this type of participant. They want to understand their options, what will work best for their situation and will take the time to engage with a knowledgeable professional.
Target Date Alternative - “Do It For Me” Participants
When we can’t get individuals to engage and participate in the planning process, we generally encourage a target date fund approach. Target date funds are funds that take age and the projected retirement date into consideration. Most target date funds do not take an individual’s risk appetite into consideration, however. Target date funds, while not ideal, are appropriate for those participants who need a simple and effective way to save. Target date funds simplify the investment process. We believe an age-based option is better than not participating at all because investment selection is too overwhelming.
In our experience—and the studies support it—participants in the advice seeking group do the best over time. Studies show that retirement plan participants who work with an advisor post returns in excess of 2% higher than those who don’t.3
Why? The self-directed group while seemingly more aware of their investment selections, tends to buy or sell at the wrong time. Many try to time the market which, for most individuals, is unsuccessful. Often, these investors shift into a fund after it has done well or sell after a fund hits a rough patch. The timing of making changes is difficult.
Offering one-on-one advice and getting more people into the “advice seeking group” can help boost plan results.
Since there is a varying degree of investment engagement and need by your participants, you should offer a full array of investment advice services, ranging from traditional on-site education meetings with risk assessment tools, sample risk-based portfolios with rebalancing advice and full one-on-one advisor support. Saving for retirement is not one size fits all.
Principle 3: Include plan design features to make enrollment and investment selection easy for participants
Making the investment selection process for participants as easy as possible is important. If participants feel their retirement plan options are too complicated or difficult to understand, they may end up not making any decision and declining to participate. So signing up for their retirement plan and selecting investments must be easy. One-on-one advice, mentioned in principle 2 above, can help this. But plan features such as auto enrollment and an automatic deferral increase can help as well.
In 2006, the Pension Protection Act (PPA) encouraged the adoption of auto provisions in qualified retirement plans. The passage of this legislation removed barriers that had prevented some employers from automatically enrolling their employees. The PPA defined appropriate default investment options, deferral percentage amounts and offered other guidance for plan sponsors. In our view, this was positive and pro-participant.
Auto enrollment occurs when employee/participants are automatically enrolled in their retirement plan unless they opt out. Those who sign up through auto enrollment are generally placed into a target date or balanced investment option. Plan sponsors who adopt these plans find their enrollment rates soar. More importantly, employee/participants like and support the auto enrollment feature.4
While most employers will find significant benefit from auto enrollment, we generally encourage plans to also institute an automatic increase as well. For example, an auto enrollment plan may start with 3% deferrals and bump that up each year until the employee reaches the maximum deferral. It is a painless way to encourage participants to start saving more. We encourage employers to implement increases around the time of their normal pay raises so participants don’t feel the impact of a reduction in take home pay.
We have also found that the majority of employees don’t opt out of the plan or the increased savings mechanism; most find it an easy way to save.
Principle 4: Provide Financial Wellness Services to Improve the Financial Health of Your Employees
While many companies have wellness programs focused on your health, we encourage companies to offer financial wellness services in conjunction with a retirement plan. Financial wellness services include proactive financial planning such as budgeting or credit counseling to address shorter term issues and retirement planning to address longer issues. We also provide a retirement gap analysis, a projection of where a participant thinks retirement savings need to be in order to retire compared to current savings, can be very helpful.
Financial wellness services are critical and go hand in hand with principal 2 above—the need to sit down and identify each person’s personal financial situation on a one-on-one basis.
Principle 5. Have a Sound Investment Process
How you select investments for your plan is important to its long-term success. We encourage plans we work with to develop an investment policy statement that governs the investment selection process for the plan. It is important to review and adhere to this statement, including quarterly monitoring.
Plans should include investments that cover the broad asset classes—fixed income, U.S. stock, and international stock. Plans should offer a mix of both index and actively managed funds, and we generally encourage the inclusion of an alternative or low correlation selection as well.
We encourage plans to select managers with an established investment strategy that have produced consistent results over time. Plans should also put an emphasis on funds that steward their resources well and charge low expenses. It is also important to avoid any conflicts of interest when selecting investment options and thoroughly vet any proprietary investments offered in the plan. When selecting investment options keep your employees in mind—the three main types of investors discussed in principle 2 above. Your investment options should address each type of investor.
1 American Century Investments, Through the Rearview Mirror: A Retrospective as Pre-Retirees Express Regret; Offer Words of Wisdom to Younger Workers and Employers
2 Save More Tomorrow: Using Behavioral Economics to Increase Employee Savings, Richard H. Thaler and Schlomo Benartz, August 2001.
3 Help in Defined Contribution Plans: Is it Working and for Whom? , January 25, 2010, by Hewitt Associates and Financial Engines
4 Harris Interactive Poll http://www.retirementmadesimpler.org/Library/FINAL%20RMS%20Topline%20Report%2011-5-07.pdf