Not only do workers fail to save enough in defined contribution plans, such as tax code Section 401(k) plans, many workers do not make the wisest investment choices and fail to get the most out of their assets, Watson Wyatt Worldwide said in an analysis of survey results on March 7th, 2007.
Many workers don’t start saving soon enough, don’t save enough, and don’t follow sound investment principles in managing their retirement assets.
Additionally, many defined contribution plan participants do not properly diversify their investments, it said. Even those whose investment allocations reflect a rational assessment of their risk tolerances and investment goals often fail to periodically rebalance their portfolios when asset returns reshuffle their allocations, it said.
The first responsibility for wise investment choices by participants lies with the plan sponsor. Sufficient and clear information should be provided so that average participants are not overwhelmed by myriad possibilities, but can make reasonable choices reflecting broadly their own tolerance for risk and personal economic situation.
The report also found that while participation rates are consistent with previous findings that not every employee participates in the plan, especially younger employees. It also found that even at the highest earnings levels, some workers do not participate. It suggested that the automatic enrollment provisions of the Pension Protection Act will result in greater plan participation. The report also found a total of 39.6 percent of plan participants aged 50 through 64 had accumulated less than their annual pay. Many workers spend their lump-sum payouts from their defined contribution plans, and to some extent, from their defined benefit plan as well.
Defined Benefit Plans More Effective
According to Watson Wyatt, studies have shown that assets are more effectively managed in defined benefit plans. Defined benefit plan sponsors generally work with consultants and professional asset managers to set investment policy and goals and their asset managers actively implement investment plans to attain those goals, the report said.
If plan managers decide to invest 50 percent of assets in equities, they allocate their contributions accordingly and periodically rebalance the portfolio to stay on course, it added. Swings in equity holdings in defined contribution plans are much wider than those for defined benefit plans, the report said. The wider swings in defined contribution plans are driven by market momentum rather than active management, it said.
By failing to rebalance their portfolios during the latter part of the 1990s when rising share prices ballooned the equity share in 401(k) portfolios, plan participants set themselves up to be “clobbered” by plunging stock prices from 2000 to 2002, the report said. It provided an example of assets worth $1,000 at the end of 1999 being worth about $880 at the end of 2002 in a defined benefit plan, compared to $780 for a defined contribution plan at the end of 2002.
To encourage appropriate investing, some employers have been introducing lifecycle funds as investment options in their savings plans, the report said. These balanced funds divide assets between fixed income investments and equities, it said.
Plan Participation and Automatic Enrollment
While younger employees are less likely to participate in 401(k) plans than older employees, some workers at the highest earning levels do not participate in such plans, the report said. Voluntary participation clearly does not work well for everyone.
Some employers have started automatically enrolling workers in their 401(k) plans unless the employee opts out, according to the report. In these automatic enrollment plans, participation tends to be 10 percent to 15 percent higher than in plans where the employee must make the first move to enroll, it said. Some employers also automatically increase the savings rate whenever an employee receives a raise, the report said.
However, many employers have hesitated to take this automatic approach because of concerns about their fiduciary responsibility for investment results, the report said. But it noted that the automatic enrollment provision of the PPA , enacted in 2006, should ease this concern and encourage more employers to adopt such arrangements in the future.
Asset Balances of Older Employees
Lower earners tend to be disproportionately represented among the groups with relatively low accumulations, while higher earners tend toward the high end of accumulations, referred to as the “balance-to-pay scale,” the report said. Still, many lower earning employees have accumulated large balances and some very high earner employees have little to show for the opportunity to save for retirement on a pretax basis, the report said.
The total balances suggest that workers following a reasonable path toward a comfortable retirement are a minority. Sixty-six percent of lower pay employees aged 50 to 64 have less than one year’s pay in their accounts. In the $45,000 to $60,000 range, 34.6 percent have less than a year’s pay in retirement savings.
Even in the $75,000 to $100,000 pay class, nearly 27 percent come up short of one year’s pay. It noted that these employees have been with their current employer for 20 years or longer, plenty of time to have accumulated substantial balances. This is shocking.
Lump-Sum Benefit Payouts
Another problem with defined contribution plans and, to a growing extent, with defined benefit plans that provide lump- sum payouts, is that many workers spend the money rather than save it. When workers switch jobs, most of them withdraw their money from their defined contribution plan. While roughly 75 percent of these assets are rolled over into another tax qualified retirement savings account, 55 percent of workers, especially younger and lower wage workers, withdraw their entire account for immediate use.
As you have just read through the general results above you can probably see some information we have known for a while. That people are not saving enough and many of those who do are not investing the money properly. This isn’t news, but some of the actual statistics are shocking. For instance the number of higher income earners having less than one year’s worth of salary saved up and they have been employed for over 20 years.
There is one part of the study that I have to partially disagree with, and that is in regards to the claim that defined benefit plans are better than defined contribution plans. Now, I do agree that given the investment knowledge of most people and the lack of willingness to participate in a defined contribution plan, yes, a defined benefit will suit these people better. But all things considered, an employee who is saving into a DC plan and investing appropriately along with regular rebalancing will be far better than the DB plan.
Of course until employees become educated enough to utilize their DC plan effectively it may still seem as if a DB plan will provide the most benefit. Unfortunately these plans are disappearing rapidly and people will need to rely on a DC plan for the bulk of their retirement. I think this study does a great job at illustrating the severe situation many people are in and hopefully it sheds some light on changes that need to be made in order to properly educate people about their responsibility to save and invest for their own retirement.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
I agree that if the traditional pension is headed toward extinction there should be some sort of mandatory savings. I think a lot of people think that is what Social Security is but it isn't.
I know there are some places that have some sort of mandatory retirement savings in place. My wife for example, works for the local government. While they still offer a defined contribution plan they also have a "defined benefit" plan that is mandatory to contribute to. Essentially you don't have a choice and 5% of your pay has to go into the account, which in effect is your pension when you retire.
Of course the problem with this is that like Social Security these are pooled funds. So while you are contributing money each week into this account that money is in effect paying for current retirees benefits. So 20 or 30 years down the road you are relying on your benefits to be paid for by current employees... and you find yourself possibly facing another underfunded plan.
If there was a mandatory contribution required I think it should be tied to that individual. Your money goes into an account in YOUR name, not just a pool for everyone. Of course it is no replacement for some of the benefits provided by a national system but at least it is fair.
We should remember that roughly half of "all workers" will have an IQ of less than 100 - so expecting them to take an active interest in asset allocation, rebalancing and so on is a big ask.
Personally I think the US should move towards compulsory retirement savings like in Australia - we traded off some pay rises for a compulsory superannuation contribution by employers of 3% of gross salary back in the 80s. This was then slowly incremented over the following decade to it's current level of 9% of salary - which should provide an adequate retirement fund for employees who work full time from 20-65. This allows the government pension to be asset and means tested so it only goes to the most needy retirees (and is affordable to taxpayers). This sort of change would be a solution to the looming US social security funding crisis.
One problem with the current Australian system is that the available retirement fund providers all tend to have a fairly conservative "default" asset allocation which is really only appropriate for older and/or risk-averse investors. A default asset allocation based on members age, that was set by the government and similar to the "target date" allocations would be of greater benefit most workers.