January 2008

The Truth

AS A LAWYER, I have been trained to think in terms of the truth, the whole truth, and nothing but the truth. As a lawyer, I also have learned that truth is a risk management tool—in the sense that, if the truth is fully explained to people, both up front and along the way, there is almost never litigation or other claims of wrongdoing. In fact, lawsuits and government enforcement are much more likely to occur where the truth is left unspoken or where facts are concealed.

In my opinion, there is a fundamental truth that every employer should tell its employees. However, there are others who disagree; they believe it is a case of too much truth. The truth is, most employees are not, by and large, deferring enough to replace their income at retirement. That is bad news, and most employers are reluctant to communicate bad news—even if it is the truth. Also, some employers and adviser are concerned that, if employees become aware of how much they need to save for retirement, they will give up trying because they will feel it is hopeless. However, unless we deal with the truth openly and honestly, behavior is unlikely to change, and behavior needs to change in order for employees to have a good chance of retiring with enough income.

Beyond those general principles, there are specific reasons for communicating with employees about the need to increase deferrals. A rule of thumb that is often used in the 401(k) industry is that participants need to add at least 15% per year to their accounts—through deferrals, matching contributions, and profit-sharing contributions. For example, if the employer is putting in 3% profit-sharing contribution, the employee needs to defer at least 12% of pay. For an employee who is under age 35, and who wants to retire at 65, that is a good goal. However, for an employee older than 35, that is probably not high enough—unless the employee is willing to work past age 65 to make up for the shortfall.

A few years ago, the Vanguard Center for Research analyzed the contributions and deferrals needed for a 35-year-old participant to retire at 65. It defined retirement adequacy as replacement of 75% of the employee’s final pay, counting both the 401(k) benefits and Social Security. If the employee’s compensation at 35 is $50,000, and if it reasonably increased over the years, the employee would need to defer 17% of pay per year to her account, reduced by the employer’s contributions. According to surveys, the average employer contribution is about 3%, so the typical 35-year-old participant would need to be deferring 14% of pay each year from age 35 to age 65, though if that same participant made $100,000, the numbers were worse.

Regardless of whether those numbers are exactly right, the point is that employees—who, on average, are deferring about 7% or 8% of pay—need to increase their deferrals significantly, plan or retiring later than 65, or understand that their standard of living in retirement will be lower. However, they cannot make those decision unless they know that they need to—and, of course, they won’t know without being given the right information.

It is time for plan sponsors, providers, and consultants to offer the “truth”: education to alert employees to the issue, and information and tools to make decisions.

While the law does not require most of the services and information discussed in this article (at least not yet; remember, the prudent man rule is based on prevailing circumstances—that is, it evolves), my experience as a lawyer is that, where situations are well-managed and the results are positive, there is little to fear. Fiduciaries will do well while doing good.

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