Effective 401(k) plan design features like auto-enrollment and auto-escalation have been shown to increase participation, boost deferral rates and improve investment diversification, but they can also bring unintended results, according to a new paper.
In their paper, “Best Intentions: The Unintended Consequences of Plan Design,” BlackRock executives Dagmar Nikles, Managing Director, Head of Defined Contribution Plan Strategy, and Mike Arak, Vice President, Plan Strategy, examines three real-world plan design case studies and the circumstances the plan sponsor hoped to manage, and the steps they took (or didn’t take).
They note that effective plan design, as inspired by behavioral economists such as Nobel laureate Richard Thaler, can help overcome a range of participant behaviors and biases by nudging them into appropriate choices. But at the same time, they write that, “The most well-intentioned and carefully considered plan design decisions may have unexpected results and even successful implementations occasionally reveal the limits of some baseline assumptions.”
Unintended Ceilings?
In a case study on auto-features, the plan sponsor worried that if the auto-enrollment and auto-escalation default rates were set too high, participants would opt out. But the analysis suggested that not only did many participants remain with the plan’s default rate and auto-escalation program, the rate could have been set even higher.
According to the findings, 43% of active participants chose well beyond the auto-escalation cap of 6%, while 60% of the passive participants remained within the 4-6% default range. As a result, active participants had a nearly 2% higher average deferral rate of 6.8% versus 4.9% for those considered passive.
“Passive participants trailed their active colleagues by a considerable amount across all age groups, suggesting that anchoring and inertia remained in effect even as income increased as participants moved throughout their careers,” Nikles and Arak explain.
Citing data that the majority of participants will accept higher defaults and escalation caps, as well as reenrollments and other actions, the authors suggest that plan sponsors should consider:
- increasing the auto-enrollment default rate to 6% or 8%;
- increasing the cap on auto-escalation to at least 10%;
- back-sweeping all participants currently below the default savings rate into the higher rate on an opt-out basis; and
- backsweeping all participants into auto-escalation on an opt-out basis, including those who previously opted out.
They also suggest that plan sponsors should consider restructuring their employee match to provide an added incentive for participants to save more, while keeping down the additional matching costs for the employer.
Loyal Employees Left Behind?
In a second study, a U.S. technology company updated its qualified default investment alternative (QDIA) for new hires from a stable value fund to a target date fund, but legacy employees were not reenrolled. Subsequently, the company acquired 10,000 new employees through an acquisition, where all were reenrolled into the TDF, creating two distinct participant populations with different return profiles.
Nikles and Arak note that the opportunity cost for the company’s longest-tenured employees may be significant. As illustrated in the report, higher returns from a TDF compared with a stable value fund compounded over a career can result in a nest egg that’s nearly 60% higher and would potentially require a participant to save 7% more annually to make up the difference.
The study further found that the participants who were reenrolled tended to accept the reenrollment and appreciated the recommendation even if they opted out. The authors submit that reenrolling the original legacy population is a “reasonable and easily justifiable option,” but they also caution that there are unique challenges to reenrolling out of stable value, including liquidity and wrap restrictions.
Who Really Holds Company Stock?
A third study looked at the level of exposure among plan participants to company stock. According to the scenario, the company match for a large U.S. health care company was previously made in company stock. The plan also offered company stock as an investment option along with a balanced fund QDIA and a core menu of six equity and fixed income funds. Due to the legacy match, the plan had a sizable overall allocation to company stock. The company later decided to update the plan’s QDIA by replacing it with a TDF.
The assumption of the plan sponsor was that senior managers and executives, who were required to hold a percentage of their assets in company stock, were particularly exposed to company stock. However, the study found that was not necessarily the case. BlackRock’s assessment shows that, as a percentage of their overall portfolio mix, it was the lower income participants who held significantly more company stock than higher income participants.
Research into company stock in 401(k) plans suggests that employees underestimate the risk of owning company stock, the authors note. “Should a market shock occur as they approach retirement they may need to remain in the workforce longer than they planned to either make up the loss or wait for a hoped-for market rebound,” Nikles and Arak warn.
They suggest that plan sponsors may be well served to consider various steps to manage and mitigate the exposure, such as:
- conducting a communications campaign targeted at participants with high company stock allocations;
- working with the recordkeeper to offer an auto-diversification service; and
- establishing a cap for company stock allocations or freezing the purchase of additional company stock.
- Log in to post comments