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With the continuing closures of defined benefit plans, retirement risks are being transferred from those who were unable to manage them to those who do not understand them. In all pension markets, defined contribution plans are gaining traction. Their members are enjoined to work longer, save earlier, save more and spend less – and leave the rest to “nudge economics”.
It makes a virtue of members’ two well-known behavioural traits: inertia and procrastination. This new approach helps, but it is not enough – as revealed in a US study from Principal Financial Group, the US insurer, and Create Research, the fund consultancy.
Currently, 401(k) plans – the cornerstone of retirement planning in the US – hold nearly $10tn in assets. They have long been dogged by low enrolment, inadequate contribution and poor investment choices. The Pension Protection Act of 2006 aimed to improve matters by giving birth to an autopilot version of 401(k) via three innovations in plan design: automatic enrolment of all eligible employees, automatic rises in contribution rates over time and a selection of default investment options. While participants retain the right to opt out, few do for want of better alternatives.
Notably, by providing a haven for life-cycle funds via a qualified default investment alternative (QDIA), the act has also promoted a whole-life approach to retirement planning. Unsurprisingly, the proportion of private sector employers offering a 401(k) has risen from 72 per cent in 2007 to 82 per cent in 2012. QDIA has been adopted by 74 per cent of sponsors.
However, there is also a more nuanced view: the act has achieved more than expected but less than needed. The “set it, forget it” features of the autopilot version create the context for the right behaviours on the part of plan members at the outset. But the necessary behavioural change needs to be reinforced and sustained throughout the retirement planning phase. Key decisions are not single events like buying a house. New decisions are often forced by changes in job, family, health or market situations.
The revised model of 401(k) continues to envisage the employee as a planner: a proactively engaged individual capable of accessing the right information and making informed decisions.
This ideal is at odds with reality. Plan members often stick to their initial asset allocation, even when their circumstances change. They overrate their own ability, yet blindly rely on the wisdom of the crowd. They follow the path of least resistance, display strong inertia, dislike choice overload and find it hard to cut their losses.
About 35 years after their introduction, 401(k) plan balances have averaged roughly $60,000 for all members and around $225,000 for those approaching retirement. Average contribution rates have stayed in the 6-8 per cent range, instead of the 17 per cent consistent with a decent retirement nest egg. Only 4 per cent of plan sponsors use income replacement ratio or income projections as the metric to track retirement readiness. Enrolment rate remains a significant yardstick of success.
No wonder then that, over the past 10 years, more than 60 per cent of plan members have consistently remained “very concerned” about their long-term financial future. In 2012, the difference between what they saved for retirement and what they should have saved was $6.6tn.
The answer is a 360-degree approach that goes beyond autopilot architectures and aims to improve the quality of retirement products and the guidance framework around them. The approach involves four sets of stakeholders: asset managers, plan members, plan sponsors and financial advisers.
Asset managers need to understand the needs and risk tolerances of their end clients and improve the design features of life-cycle funds such that they have an explicit retirement income benchmark.
Plan members need to develop personal retirement plans with the help of their advisers, adopt a contribution rate that can deliver the targeted nest egg and above all engage in educational activities. In the industrial age, it was hard to get by without basic literacy: the ability to read and write. In this age of personal responsibility, it is just as hard to get by without financial literacy: the ability to plan and prioritise.
Financial advisers need to help plan members craft a retirement strategy that sets goals, provides tips on how to save more, performs regular reality checks, provides basic education on investing, and copes with untoward contingencies such as job loss, illness, family crisis or early retirement.
Finally, plan sponsors need not only to implement the autopilot features but also improve their outcomes. Specifically, they need to re-point their educational offering towards investment matters, and initiate annual retirement readiness check-ups.
Without this holistic approach, DC plans in countries such as the UK and US face the same fate as the DB plans that preceded them.
Amin Rajan is chief executive of Create Research