As one 401(k) advisor recently noted, “Income is the outcome in retirement planning.”
It’s something Northern Trust Asset Management realizes.
“A decade after the Pension Protection Act (PPA) ushered in an era of reform for the U.S. retirement system, defined contribution plans are still falling short in promoting savings and offering investments that manage risks and provide retirement income,” according to a new study by Northern Trust Asset Management.
The Path Forward: Defined Contribution Plans Can Achieve More tallies the successes of the PPA and proposes solutions to improve the performance of defined contribution (DC) plans.
Improve implementation of automatic features
The PPA was the catalyst for DC plans to include elements such as automatic enrollment of employees into the plan, and automatic escalation of savings over time. Industry leaders interviewed for the Path Forward said these automatic features have helped combat participant inertia, a view supported by the plan sponsor and participant surveys.
Asked to identify the single biggest benefit of the PPA, the response cited the most by plan sponsors was increased plan participation as a result of auto enrollment. Similarly, participants indicated the ability to save painlessly through automatic deductions is the 401(k) feature they value most.
Despite the benefits offered by auto enrollment, Northern Trust’s survey shows that plan sponsors could challenge participants to save more:
- While a majority (52 percent) of plan sponsors auto enroll new hires, just 32 percent implement auto escalation to increase participant contributions.
- Nearly two-thirds (63 percent) of participants think they could contribute 10 percent or more of their income to retirement savings, but about the same percentage said their plan’s deferral rate was below 10 percent. Additionally, 65 percent said they wish they could go back and contribute a higher proportion of their salary to their 401(k) plan.
“The benefit of using both auto features in tandem is clear,” said Gaobo Pang, Ph.D., head of investor analytics for Retirement Solutions at Northern Trust Asset Management. “Among plan sponsors using auto enrollment and/or auto escalation, 64 percent think that participants using these features are better prepared for retirement.”
Understand and embrace risk in default options
The PPA enables plan sponsors to determine the default investment for their participants. Of auto enrolled participants, 72 percent keep their assets in the default option, demonstrating that the plan sponsor’s choice can have a powerful impact on participant outcomes.
Risk is a key factor in the selection of the default investment. While both plan participants (53 percent) and plan sponsors (46 percent) cited market risk as a key concern, they also mention a variety of other risks, such as inflation, longevity and concentration risk. In fact, 79 percent of plan participants are concerned about taking the right type of risk at the right time.
Over three-quarters of plan sponsors (79 percent) cite market volatility as a key risk for participants over the next five years, and 74 percent say inflation is another serious risk that will continue in the next five years.
“Risks evolve over time, so it is crucial that plan sponsors select a default investment option that can help plan participants appropriately deal with a variety of risks,” said Susan Czochara, managing director of Retirement Solutions at Northern Trust Asset Management. “By constructing a robust default option, such as a target date fund that adjusts in line with investment goals, sponsors can help participants manage risk exposures.”
Address retirement income needs
Industry leaders interviewed for the Path Forward said one major shortcoming of the PPA is a lack of a provision for retirement income. Plan sponsors and participants agree this is a crucial issue:
- 84 percent of participants surveyed are concerned about outliving their resources, and 84 percent of plan sponsors cited longevity risk – the risk that participants will outlive their assets – as a serious risk facing participants in the future.
- 86 percent of plan sponsors and 87 percent of plan participants think it is important for a 401(k) plan to include investment options specifically designed for retirees.
“Although default options work well for most participants during the accumulation phase, people’s needs, circumstances and priorities tend to be very different when they retire,” Czochara concluded. “In designing a menu of options, plan sponsors need to consider three primary concerns – efficiency, safety and flexibility – to address a variety of retirement income needs.”