Defined contribution plans are practically ubiquitous. But like most things that are common, the mere fact that they are does not necessarily mean that comprehension of investing the funds they contain is. A recently released research paper discusses the problem posed by poor financial literacy and how it may be improved.
Research Paper No. 19-22, “Defined Contribution Plans and the Challenge of Financial Illiteracy,” presents the work of three researchers: Jill Fisch of the University of Pennsylvania Law School and Andrea Hasler and Annamaria Lusardi of the George Washington University School of Business. They analyze data from the 2015 National Financial Capability Study to show that one cannot expect that people can make sound investment decisions simply because they participate in an employer-sponsored 401(k).
Fisch, Hasler and Lusardi argue that investing retirement plan funds is complicated, and that typical 401(k)s and the way workplace investing has evolved exacerbate that by offering products they say many participants don’t understand and requiring them to exercise functions for which they are “particularly ill-suited.” With DC plans, the researchers write, individual employees’ retirement benefits are determined by the decisions they make regarding how much to save and how to invest those funds. “The challenge with this system,” they write, “is that U.S. employees are poorly equipped to make decisions about how to invest for retirement.” And they add the sobering assessment that employees “suffer from higher levels of financial illiteracy than other investors.” And they call this deficit of literacy “critical” because participants’ choices:
- have financial consequences for individuals; and
- are what limits the fiduciary obligations of the employer regarding the structure and options the retirement plan provides.
Further, they say, effectively investing those funds requires participants who may not grasp it in the first place and are susceptible to making mistakes in handling investments to evaluate their portfolios throughout their careers and then manage the funds after retirement. Not only that, say the researchers, people who are not financially literate are less likely to plan for retirement at all. And that, they warn, renders those who most need retirement planning most at risk.
The researchers suggest that one possible approach to correcting the situation may be to amend ERISA in order to require more of plan sponsors in making participants financially literate. However, they admit that such an approach has limitations and could have the counterproductive result of making employers less likely to offer retirement plans at all. A better option, they suggest, would be to mandate that employers provide employees with financial education. They suggest that financial education programs incorporate:
- minimum substantive components;
- and timing.
“Formalizing the employer role in evaluating and increasing financial literacy among plan participants is a key step in providing retirement plan participants with the resources necessary to manage important decisions regarding retirement planning and, ultimately, for enhancing the financial security of American workers,” they write.