July 1, 2008

The Future Is Here

In its survey of large 401(k) plans (with median plan assets of $248 million), Hewitt found that, between 2005 and 2007, there had been a dramatic shift in the way that plan sponsors­ were measuring the success of their 401(k) plans (See More Plan Sponsors Worrying about Retirement Nest Egg Size).

In 2005, 43% of the plan sponsors reported that a high participation­ rate was the primary metric for that purpose, while only 14% reported that the primary measurement was whether the plan properly helped participants accumulate adequate retirement income. By 2007, the two were almost even, with a high participation­ rate receiving 25% of the "votes," while 24% of the plan ­sponsors focused on retirement adequacy. That is an extraordinary­ change in a relatively short period of time.

While Hewitt did not ask about the reasons for the change, I suspect that two of the reasons were the Pension Protection Act, with its provisions on automatic enrollment, and the aging of the Baby Boomer generation—with its first members reaching age 60 in 2006.

In other words, the prospect of retirement became more real, and the government provided plan sponsors with the tools for making necessary changes to their plans. At least part of my assumption is supported by other data in the survey. Hewitt reports that the percentage of plan sponsors that were auto-enrolling increased significantly, as did the percentage of plans that allowed employees to have their contribution rates automatically increased from year to year.

The increased focus on benefit adequacy also appears to be resulting in a better understanding that employees need to defer more in order to have adequate retirement income. For example, a few years ago, most plans automatically enrolled with a deferral rate of 2% or 3% of pay. However, those initial deferral rates are increasing.

In our practice, we are commonly­ seeing initial deferral rates of 4% to 6%, and some employers­ have adopted initial rates as high as 8%. The Hewitt study confirms that change: "Further, 83% of employers set their default ­contribution rates at 3% or higher compared to just 66% two years ago. In addition, almost three out of 10 employers (28%) use contribution escalation in conjunction with automatic enrollment, with more than 40% of employers escalating employees to ­target rates between 8% and 15%."

I believe that the Hewitt study confirms that we are at the early stage of a major shift in perspective by plan sponsors. I say that for two reasons. The first is that the study covers only very large plan sponsors but, typically, the largest plan sponsors are the first to embrace fundamental changes in 401(k) plans.

Second, I believe that we are in the early stages of the shift because much of the thinking still appears to be defined contribution­-based. That is, the focus is on getting employees­ into plans, deferring at a specified rate, increasing those deferrals­ to another specified rate, and investing prudently.

While it is almost absolutely certain that those steps will add up to meaningful benefits, it is not clear that they will result in adequate benefits.

As a result, I believe that the next wave of change—after this one—will be to apply defined benefit thinking. That is, both plan sponsors and employees will begin to think in terms of the amount of retirement income that is needed, which will lead to the amount of the lump sum that is required at retirement to produce that income, which will lead to the amounts that need to be contributed each year along the way. In other words, basic financial planning and actuarial concepts­ will be applied to the funding of 401(k) accounts.

The future of 401(k) plans has begun. Attentive plan sponsors and fiduciaries will want to embrace these changes to show their compassion for their employees and to help those employees achieve retirement security.


Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.

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