PROspective Vol II No II February 2011
In a study published by Northern Trust last fall titled Designing the Ideal Defined Contribution Plan*, Sr. Vice President Jim Danaher said the “ideal” plan would be simple, automatic, and cost-effective.
“An ideal defined contribution structure should possess each of these three traits to satisfy the requirements of the different constituencies that are relying on saving efficiently in defined contribution plans.”
What are the characteristics of an “ideal” DC plan? Did the study reveal anything that surprised you? How did consultants and plan sponsors agree, and how did they differ? These were the questions Chuck Miller recently asked Jim Danaher.
Chuck Miller: Why did Northern Trust undertake this study?
Jim Danaher: We wanted to identify ways for plan sponsors to improve the effectiveness of defined contribution (DC) plans. DC plans have become the primary retirement savings vehicle for many U.S. workers and this structure will only grow in importance as other sources traditionally relied upon by U.S. workers for retirement funding come under increased pressure or disappear entirely. That share of the overall retirement plan market is sure to grow rapidly in coming years as:
• Companies respond to mounting pension costs and tougher accounting rules by closing their defined benefit (DB) plan to new employees, and
• Plan sponsors eventually come to grips with the unsustainable current DB model. Employers have frozen DB plans for one in five private industry workers that had access to these plans.
With cracks already appearing, failings in DC plan structures will take on huge significance if, as expected, these plans become the cornerstone component of the nation’s retirement system. Thus, plan sponsors and policy-makers alike should review improving the DC structure as an essential task.
CM: What were the significant findings?
JD: Our conversations with survey participants focused on perspectives regarding the key areas of plan design and features, investments, employee education and advice, administration and fees. These conversations revealed the ten key characteristics in designing the ideal DC plan:
Key Characteristics & Why This Makes Sense
1. Mandatory participation for all employees.
Employees are automatically enrolled into the plan on their first day of employment, thereby ensuring immediate savings.
2. Initial default employee contributions of 5-6% of salary.
This contribution rate automatically increases on an annual basis until it reaches 11% − 12% of salary, the contribution level commonly recommended for retirement security.
3. No limit on post-tax employee contributions.
Though limits on employer matching contributions and government-sponsored tax deferral are acceptable, unlimited post-tax employee contributions encourage higher levels of saving.
4. Immediate vesting of employer contributions.
Immediate vesting allows today’s more mobile workforce to recognize immediate benefit from plan participation.
5. Participant loans are not permitted, unless under duress.
Prohibiting loans removes participant temptation from drawing upon balances for non-retirement related expenses. Hardship withdrawals are the exception to this rule.
6. Continuation of shared decision-making between plan sponsor and participants.
Participants are responsible for investments and asset allocations within guidelines established by sponsors, which enables participants to control their money while ensuring adherence to prudent investment practices.
7. Optimized investment menus.
Investment lineups are required to include asset allocation funds like target date or other managed options, but can also include more flexible options for more informed or active participants.
8. Broad-based advice for participants.
Participants have access to advice that not only focuses on investment products, but also long-term financial planning, offered in an environment of reduced concern about potential liability.
9. High levels of fee transparency.
Participants receive clear and concise information regarding administration expenses, investment management fees and participant-initiated transaction fees.
10. Unbundled service structures.
Unbundling enables utilization of “best of breed” providers.
CM: Were there any findings that surprised you, or were different from usual practices?
JD: Considering that DC plans, particularly 401(k)s, proliferated on the premise of “choice” it was interesting that 63% of plan sponsors and four of five consultants thought participation in DC plans should not be optional for employees; in essence, almost a contract of employment.
It is somewhat surprising that while three-quarters of plan sponsors support another key automatic feature, auto-escalation of participant contributions, there is still concern about excessive paternalism or infringement on employee freedom. The average pre-tax deferral rate for non-highly compensated employees is 6.8%. That rate is far from ideal considering the amount participants need to save to meet expected post-retirement spending needs.
Finally, as we know, one of the key drivers in getting employees to save in DC plans like a 401(k) was access to their money. As a result, participant loans and in-service withdrawals became core features in the plan design process. This has lead to leakage in the retention of retirement benefits. Two-thirds of all plan sponsors and 100% of consultants participating in the study believe participants should not be allowed to take loans against their DC account balances.
CM: Were there any differences in the responses of plan sponsors and consultants?
JD: Plan sponsors and consultants had differing views regarding enrollment, contribution levels and investment options.
• Most plan sponsors seemed to agree that simple is best when it comes to investment options, however they still suggest broader investment line-ups;
• Consultants promote greater levels of corporate paternalism regarding participation and investment decision-making. They prefer fewer investment options than plan sponsors would, on average.
The differing views on the number of investment options offered are compelling, considering the studies that have shown the impact the number of investments offered may have on participant behavior in fund selection and how much they save.