Knowledge@SMU

English

Institutional Knowledge at Singapore Management University

Singapore Management UniversityInstitutional Knowledge at Singapore Management UniversityKnowledge@SMU Office of Research10-2006How Can Employers Improve DefinedContribution Plans?Knowledge@SMUFollow this and additional works at:http://ink.library.smu.edu.sg/ksmuPart of theInsurance CommonsThis Journal Article is brought to you for free and open access by the Office of Research at Institutional Knowledge at Singapore ManagementUniversity. It has been accepted for inclusion in Knowledge@SMU by an authorized administrator of Institutional Knowledge at SingaporeManagement University. For more information, please emaillibIR@smu.edu.sg.CitationKnowledge@SMU, "How Can Employers Improve Defined Contribution Plans?" (2006).Knowledge@SMU.Paper 188.http://ink.library.smu.edu.sg/ksmu/1887/21/12 How Can Employers Improve Defined Contribution Plans? - Knowledge@SMU1/3 knowledge.smu.edu.sg/article.cfm?articleid=1035   (http://knowledge.smu.edu.sg)How Can Employers Improve Defined Contribution Plans?Published: October 18, 2006 in Knowledge@SMU In 1980, more than 60% of American workers who had retirement plans at work enjoyed traditional pensions, withthe employer providing fixed monthly payments throughout the former employee's retirement. Most other employeeshad "defined contribution" plans such as 401(k)s, which leave retirement investing to the employee.Today, the numbers are reversed, with more and more companies scrapping traditional pensions and shifting theinvesting risk to their workers. But numerous studies have found that the typical worker saves too little, ofteninvests too conservatively and doesn't manage the nest egg well after retiring. Millions could end up with too little tolive on as they grow old.If 401(k)s and similar plans are the main way Americans invest for retirement, how can employers improve them? Bymaking enrollment automatic, minimizing the use of the employer's stock, expanding use of annuities and improvingemployees' financial knowledge, according to the Financial Economists Roundtable, a 13-year-old group of about 50prominent economists. "As a social policy, we want people to have enough to live on when they are retired," saysWharton finance professor Marshall E. Blume (http://www.wharton.upenn.edu/faculty/blume.html). Unless theseproblems are remedied, Blume says, many 401(k) participants will run out of money and become burdens on society."Currently, many employees do not participate in these plans, even when there's an employer match [to employeecontributions]," he adds.To address these problems, members of the FER met in Breton Woods, NH, in July. The result is a set ofrecommendations titled, "Best Practices for the Design of Defined Contribution Plans."The FER was founded in 1993 and meets every year to address a key economic issue. Recent annual statementshave dealt with subjects such as risks related to hedge funds, better accounting for corporate pensions and highexecutive compensation. Statements must be approved by a majority of members attending the annual meeting. The52-member Roundtable includes three Wharton professors besides Blume: Richard Herring(http://www.wharton.upenn.edu/faculty/herring.html), Jeremy Siegel(http://www.wharton.upenn.edu/faculty/siegel.html) and Robert Stambaugh(http://www.wharton.upenn.edu/faculty/stambaur.html), all of whom were among the 33 members who signed thelatest statement.The paper endorses key provisions in the federal Pension Protection Act of 2006 passed last summer, such as thevalue of allowing employers to automatically enroll employees in 401(k)s. It also envisions further steps not includedin that law, such as the development of low-cost annuities that 401(k) participants can buy to get steadyretirement income guaranteed for life."The defined benefit plans were great," Blume says. "They removed investment risk. They removed longevity risk.People just got a lump sum every year for the rest of their lives. But that assumes you work for one companyforever and ever. It also assumes the company is going to be around to make the payment."Traditional pensions, or defined benefit plans, typically figure an individual's pension with a formula that multiplies theemployee's years with the company times his final salary, or an average salary over the final few years. The result ismultiplied by a percentage figure to calculate the annual pension payment. Thus, a $75,000-a-year employee with30 years on the job would get a $36,000 annual pension, assuming the percentage was 1.6.To get the most out of a pension, the employee must stay with the company many years and still be with thecompany when he or she retires. If he leaves earlier, he may still get a pension, but the formula would use feweryears, and it would use his salary upon leaving, rather than the higher one he might make just before retiring manyyears later.In a defined contribution plan such as a 401(k), the employee can choose to contribute a portion of his salary, andhe can choose from among a variety of investments offered by the plan trustee selected by the employer -- usuallya mutual fund company. Many employers also match a portion of the employee's contribution, though they typicallyput in less than employers put into the average pension plan. Employee contributions are subtracted from theemployee's taxable income, reducing federal income tax. There also is no tax on investment gains until the money iswithdrawn in retirement, when all withdrawals are taxed as income. Generally, the employee cannot withdraw moneyfrom a 401(k) until turning 59.5 years, or else there is a 10% penalty on top of taxes.Defined contribution plans are good for employees who change jobs, because they can take their 401(k) assets with7/21/12 How Can Employers Improve Defined Contribution Plans? - Knowledge@SMU2/3 knowledge.smu.edu.sg/article.cfm?articleid=1035them and don't have to worry about the health of the employer's pension plan. But their income in retirementdepends on how much they choose to put into the plans and whether the investments they choose do well. Thetypical 401(k) offers no more than a dozen mutual funds.Poor InvestorsThe problem is that too many employees are poor investors.In 2006, federal rules allow participants to put as much as $15,000 into their 401(k)s, or $20,000 if they are over50. Many plans allow employees to put up to 20% of their salary into the plans as long as they don't exceed thefederal limits. But a recent study by Fidelity Investments, which operates plans for 12,000 employers and nine millionparticipants, found the average employee put in only 6.9% of annual salary. In many cases, that's not enough toget the entire match offered by the employer. Just over a third of eligible employees don't participate at all, andamong those who do, the average account balance is only $62,500. Nearly half had balances of less than $20,000.About 72% of assets in the Fidelity plans were in stocks, showing that participants do understand these are moreprofitable long-term investments than bonds or cash. But about 14% of all holdings are in the employer's stock,which many experts think is too many eggs in one basket."Defined contribution plans are designed for well-informed people who take active interest in planning for theirretirement and who can evaluate longevity risks, portfolio allocation, and saving decisions," the FER statement said."But the large number of people who are prone to error, including spouses who can suffer from their partner's errors,is of social concern."One remedy: automatic enrollment. That means automatically signing new employees up to participate in the 401(k).Employees would have the right to opt out, but studies have shown that they tend to stick with plans once theydiscover the payroll deductions are not so onerous. "If they're in, they tend not to get out," says Blume. "If they'reout, they tend not to get in."Fidelity found that with automatic enrollment, 76% of eligible employees participated in their plans, compared to 54%for plans that did not have automatic enrollment. People in automatic-enrollment plans also contributed more. Amongplans that did have automatic enrollment, the most common "default deferral rate" -- the percentage of income putinto the plan unless the employee changed it -- was 3%.While many automatic enrollment plans put the employee's contribution into a money market fund unless he or shedesignates something else, the FER suggested plans use low-cost, low-risk diversified portfolios that include stocksand bonds. One option is the life-cycle fund that puts most of a young employee's contributions into stocks, andthen gradually shifts to bonds as the employee approaches retirement age.Don't Rely on Company StockMany states have long had laws that prevented automatic enrollment by requiring that employees approve anypayroll deductions. But the Pension Protection Act of 2006 lifted this barrier and protects employers from lawsuits ifautomatic investments do poorly, so long as those investments are prudently diversified.In the Enron collapse of 2001, many employees saw their retirement savings virtually wiped out because they wereheavily invested in the company's stock. Although many experts subsequently warned about the dangers of havingboth one's paycheck and retirement savings dependent on one company, about 14% of all 401(k) assets are inemployer stock, according to the Fidelity study.One reason is that many companies use their own stock to match employee contributions. "Company stock exposesan employee to a lot of additional risk," Blume says. "If the company does poorly, it may well be that the employeeloses his or her job and at the same time sees the stock go down." While not suggesting that this be banned, theFER statement noted that a good defined contribution plan should avoid use of employer stock.One of the biggest problems retirees face is "longevity risk" -- outliving one's money. Even a substantial nest eggcan be built through a 401(k); however, many people do not know how much they can withdraw each year while stillassuring there's enough left to last them well into their 80s or 90s.The FER said that good plans should therefore offer annuities, using the plan's bargaining clout to reduce fees. Onetype is the immediate annuity which guarantees a fixed income for life in exchange for a lump-sum payment. Uponretiring, for example, an employee might pay $150,000 to get an income of $1,000 a month. By paying more, theemployee could get an income that rises with inflation and continues after the former employee dies, providingincome for a spouse. The disadvantage: The money paid for an annuity is gone forever, even if the employee diesafter receiving only a few payments."The FER concluded that annuities can play a major role in eliminating longevity risk, and employers should offer atretirement the default option of joint life annuities that protect both employees and spouses," the statement said."An employer can obtain annuities at group rates and may be in a better position than an individual employee to7/21/12 How Can Employers Improve Defined Contribution Plans? - Knowledge@SMU3/3 knowledge.smu.edu.sg/article.cfm?articleid=1035A ll materials copyright of Singapore Management University (http://www.smu.edu.sg) and the Wharton School (http://www.wharton.upenn.edu) of theUniversity of Pennsylvania (http://www.upenn.edu), Privacy Policy (http://knowledge.smu.edu.sg/privacy.cfm).evaluate different annuities." The Pension Protection Act makes it easier for employers to offer various types ofannuities, Blume says.Even if employers adopt automatic enrollment, eliminate use of their own stock and provide annuities and otherinnovative investing options, the employee remains in control of the defined contribution plan. So improvingemployees' financial education is key to making these plans work better, the FER said.Many employers have been reluctant to offer employee education, fearing lawsuits if employees have poorinvestment results. The Pension Protection Act protects employers from liability so long as their investment advicerelies on accepted principals, such as the need to diversify among various types of holdings. Although manyemployers are likely to turn employee education over to subcontractors, the FER noted potential conflicts of interestif education is done by the fund companies or brokerages that manage their plans. Employers therefore should stillbear "primary responsibility" fsor the content of any investor education programs they provide, the FER statementsaid."You want people to understand the risks and rewards of different investment strategies," Blume says. "At this point,people with large amounts of money can obtain this education through financial advisors. The problem is how toprovide this understanding to people with a limited amount of money, and to do it cheaply." (#top) (#top)

How Can Employers Improve Defined Contribution Plans?

Abstract

Similar works

Full text

Available Versions

Institutional Knowledge at Singapore Management University

Institutional Knowledge at Singapore Management University