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Automating the 401(k) Plan: Providers Say It May Be the Key to Success

For much of the past two decades, defined contribution retirement savings plans have been trying to transform American workers into de facto investment professionals. To a large degree, they've failed. While assets in defined contribution plans have grown mightily-from $1.4 trillion in 1994 to $3.2 trillion by year-end 2004, according to the Investment Company Institute-the average 401(k) plan account balance at year-end 2004 remained a paltry $57,000. That is hardly enough to make a meaningful dent in the average retiree's standard of living. Retirement plan providers believe they've come up with product and plan features that will make 401(k)s and other defined contribution plans work, even for investors who can't or won't make smart retirement savings decisions for themselves.

The need for better results is undeniable. Speaking at the Stable Value Investment Association's 2006 Spring Seminar in Henderson, Nevada, Doris Fritz, a Vice President in Fidelity Investment's FIRSCo Investment Consulting Services group, highlighted participation and contribution rates among the 8.6 million participants in the nearly 11,000 defined contribution plans administered by Fidelity. Based on 1994 plan data, about 34 percent of the eligible workers don't participate in their plans, Fritz said. A whopping 91 percent don't contribute the legal maximum amount ($15,000 in 2006), and many don't even contribute enough to take full advantage of their employers' matching contributions. Finally, 21 percent of participants stash all of their retirement savings in a single investment option, which suggests that their portfolios are probably not adequately diversified.

Better results are possible, Fritz said, and one way to get them is to automate the defined contribution plan experience. In recent years, about 10 percent of Fidelity's plan sponsor clients have introduced an automatic enrollment feature to their plans, meaning that eligible employees are automatically enrolled and can opt out only if they take specific action to do so. Based on studies by the Investment Company Institute and the Employee Benefit Research Institute done in July 2005, 66 percent of eligible employees were participating prior to automatic enrollment. The figure increased to 92 percent with automatic enrollment.

Of course, getting people into their retirement savings plan is only part of the battle to assure they enjoy a financially secure retirement. Another key requirement is getting them to save at an appropriate rate, using an appropriately diversified asset allocation strategy. One way to do that, Fritz said, is to offer participants the chance to enroll in an automatic deferral increase program, in which the percentage of their pay shunted into their retirement savings plan goes up automatically each year until it reaches a predetermined ceiling. About 6,700 Fidelity-run plans have introduced this feature, she says. Where plan participants use it, the average deferral rate grows from 4 percent of salary to 14 percent, according to "Save More Tomorrow: Using Behaviorial Economics to Increase Employee Savings," by Richard M. Thaler and Schlomo Benartiz.

John Doyle, Vice President and Director of Marketing and Communications for plan provider T. Rowe Price Retirement Plan Services, says 22 percent of his firm's plan sponsor clients have adopted automatic enrollment for their plans, about twice the percentage that had done so just two years ago. Some plan sponsors are now taking this approach a step further by annually re-enrolling participants who have opted out of their plans in the past. They re-enroll them either on the plan's anniversary date or the individual's eligibility date. "We call that auto harassment," Doyle quipped at the Spring Seminar. "When I first heard about this, it seemed to strike me as a difficult hurdle for participants and an issue of liability for plan sponsors. But if you think about it, this is what employers do with health plans and other benefits. So why not try to push people to participate in their plan, and get them to proactively say 'no' on an annual basis if they really don't want to do it?" Doyle said the first plan to add this option was a law firm, suggesting that it was comfortable with any potential legal ramifications of its decision.

About 11 percent of T. Rowe Price's plan sponsor clients have adopted automatic deferral increase programs for their retirement savings plans, Doyle said. The increases really are automatic, too. Under the T. Rowe Price model, they take effect unless the participant takes specific action to opt out of the program. "The only true success in this area seems to come from defaulting participants into the (deferral increase) option," Doyle explained. He compared it to organ donor programs in Europe, where participation rates leapt to about 85 percent from 15 percent or less once people were required to opt out of the program rather than into it.

Where employers use automatic enrollment, Doyle encourages them to set the beginning deferral rate at 5 percent or 6 percent of salary, rather than the 3 percent that is more commonly used. A 3 percent deferral rate isn't adequate for the vast majority of plan participants, he says, and T. Rowe Price has found that setting the rate twice as high doesn't have any significant impact on the number of new hires who opt out of the plan.

Doyle also noted that however helpful automatic enrollment and deferral increase features may be in bringing new employees into a retirement plan, they do nothing for existing employees. That oversight, he suggested, needs to be corrected. "If we don't look at employees who are already participating in these plans, and address some of their issues, we're not going to have a real impact on the retirement system for 30 years," Doyle warned. "That is where our challenge is."

To get things rolling, Doyle said T. Rowe Price has been talking to its clients about extending automatic features to cover all plan participants. One way to do that would be to perform a plan "conversion" in which all employees would be "re-enrolled" in the plan. Existing employees who don't bother to re-enroll proactively would then be defaulted into an age-appropriate lifecycle fund, or, as T. Rowe Price calls them, retirement date funds.

"What we're suggesting as a best practice is to look at some reason to re-enroll participants on an interval basis, and to default their portfolios to an age-based investment option," Doyle says.

To help make sure investors put their money to use wisely, an increasing number of plan sponsors are offering age-based or target-date lifecycle funds as an investment option in their plans. Typically offered in a series, each lifecycle fund provides a diversified portfolio of stocks and bonds targeted to when an investor plans to retire. The closer the targeted retirement date, the more conservatively the portfolio is structured. Plan participants simply pick the fund with the retirement date closest to their own.

T. Rowe Price has found plan sponsors receptive to offering lifecycle funds as investment options; about 25 percent to 30 percent of the company's clients do so, and where they are offered the funds have captured about 11 percent of plan assets. A smattering of plans-21 at last count-have introduced an "all or nothing" policy for those funds, meaning that if participants choose one of them, they can't invest any of their assets in other funds. The intent, Doyle said, is to help people realize that the funds are designed as a one-stop source for an appropriately diversified investment portfolio.

Taken together, automatic plan features and lifecycle funds promise to help millions of American workers come closer to fulfilling their retirement savings goals.

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