HISTORICALLY, 401(k) plans were viewed as supplemental, or savings, plans. However, 401(k) plans are now the primary retirement vehicles for most employees. Unfortunately, the laws have not changed so that 401(k)s can be effective, or successful, retirement plans-—at least not until now.
Based on surveys, only about two-thirds of eligible employees actually are deferring into their 401(k) plans. On the other hand, many automatically enrolled plans are achieving participation levels greater than 90%. Depending on the survey you read, the switch to automatic enrollment increases participation by 14% to 22%.
To use round numbers, if approximately 70% of the employees participate in traditional 401(k) plans, and 90% participate in automatically enrolled plans, that means that 70% of the employees know how to get into a plan and 10% of the employees know how to get out of a plan-—but 20% of the employees will stay where they are put.
We can assume safely that Congress was aware of those statistics. To improve participation, Congress made a number of changes to enhance the attractiveness of automatically enrolled plans in the Pension Protection Act (PPA). Those included the preemption of conflicting state laws, creation of a new safe harbor (so that discrimination testing would be satisfied automatically), directing the Department of Labor to provide fiduciary safe harbor guidance for investing participant default accounts, and permitting employers to return money to automatically enrolled employees within 90 days, if the employee complains. Through these changes, Congress has removed all of the major barriers to automatic enrollment and has, in effect, endorsed the use of automatic enrollment to increase participation.
Levels of Deferrals In an interesting and unusual move, Congress did not simply require that participants be enrolled at a specified level in the new auto-enrollment safe harbor plan. Instead, the new law requires that, at a minimum, participants be enrolled at a 3% automatic deferral, going to 4% in the second year, 5% in the third year, and 6% thereafter. By increasing the minimum level of deferrals each year, Congress signaled both that employees need to be deferring more and that one way to get there is through increasing the rates each year.
Unfortunately, the new deferral rates, even including the matching or profit-sharing contributions, are still inadequate—-e.g., a 6% deferral, together with the 3.5% safe harbor match or the 3% safe harbor profit sharing contribution, would only result in a total annual contribution of 9% to 9.5%. Based on calculations by the Vanguard Group, the total contributions must be much higher, perhaps twice as much. Nonetheless, these changes will cause plan sponsors, participants, and providers to focus more on the amounts needed to fund retirement benefits adequately.
Quality of Investing On September 27, the DOL released a proposed regulation describing the qualifying investments and explaining the conditions for obtaining the fiduciary protections. Based on the proposed regulation, the following types of investments satisfy the rule: risk-based lifestyle funds, age-based (or target maturity) lifecycle funds, managed accounts, and balanced funds.
That is a significant change from current thinking. Based on various studies, it appears that many, and perhaps most, plans have been defaulting participants into riskfree investments, such as money market accounts and stable value. If they continue that practice, the fiduciaries will not receive the protection of the safe harbor. Instead, they will need to put the employees at some risk by using investments that contain equities and bonds, which can fluctuate in value.
My belief is that, once the final regulation is issued, plan sponsors quickly will embrace these multi-asset-class vehicles as default investments. I believe also that this implied “endorsement” by the government will increase significantly the use of multi-asset-class vehicles in 401(k)s. As a result, the quality of participant investing should improve significantly over the next few years.
If the new law is successful in increasing levels of participation, rates of deferral, and quality of investing, the results can only be good: increased retirement benefits for participants. I believe the law has the right focus, and I believe it will work.