Tuesday, September 28, 2010

Automatic Savings: A Case Study

Recently, Dan Ariely (author of The Upside of Irrationality) published an article in the Harvard Business Review. In this article, linked at the bottom, he describes a public pension system in the country of Chile that looks very familiar to a mandated version of the provisions the Pension Protection Act of 2006. It seems that Chile subscribes to the notion that if they can remove emotional bias from the equation, the net effect would ultimately be an increase in retirement income adequacy for their citizens.

....In Chile, by law, 11% of every employee’s salary is automatically transferred into a retirement account. Employees select their preferred level of risk, with the following restrictions: They may not choose either 100% equities or 100% bonds, and the percentage of equity that they can select diminishes as they age. When employees reach retirement, their savings are converted into annuities.....

That sounds a lot like Automatic Enrollment and QDIA usage. Good ideas, no doubt. Behaviorally, it recognizes that inertia in decision making regarding money is a very real problem. Forcing the savings and forcing the reduction of risk over time probably seems like a diminishing of freedom in the absence of an opt-out clause. However, in the U.S. over the past 25-30 years, the data on retirement readiness never changes. Participants covered by plans are on a path to failure (inadequate income replacement rates) to the tune of 4-1, that's a rough composite stat, but you get my drift. The article points out that people are not good at two aspects of financial planning for retirement:

1.) deciding to save and
2.) eliminating risk in later years

We think that participants in retirement plans have more challenges thant that. After deciding to save, it is difficult for them to determine how much is truly affordable and how much is truly necessary. Additionally, participants are challenged in general when it comes to investing even with a little (or more) education. Common mistakes range from investing 100% in cash (overwhelmed behavior) to overly aggressive investing (gamblers behavior, aka performance chasing). The Chilean system, however does something very smart. It acknowledges that people who enroll in retirement plans are reasonably good at managing their own risk. So, while the investment choices are left to the individual, the choices are limited exclusively to asset allocation portfolios with a fair degree of diversification.

I think I once heard someone say that the safest plan is one that is 100% invested in QDIAs. Now that was in the context of fiduciary safety, so perhaps not directly applicable, however, the elimination of fear based and gambling based decision making by limiting the options only to models is a terrific idea.

This type of design structure is available in the U.S. today inside of 401(k) Plans. At my firm, we call it The Success Pathway. But unlike in the Chilean system, the participants still will have the freedom to opt out of the plan or any of its auto provisions.

We applaud Chile for taking a strong position on embracing a plan design that shows it leads to better outcomes for the folks it serves.

Please click here to see the full text.

Friday, September 17, 2010

Senate Passes Roth 401(k) Rollover Provision!

Today, the Senate passed a small-business jobs bill, H.R. 5297, which among other things would allow employers to amend their 401(k) plans immediately to allow participants to roll over pre-tax account balances into Roth 401(k) plan accounts.

The House has not yet acted on the proposal, and it remains to be seen if this will make into law. However, this step by the Senate is a very encouraging sign that this feature will at some point make it into law whether attached to this bill or some other.

According to the bill, it would also allow for some spreading of immediate tax over several years. For example, if a participant were to convert their pre-tax deferrals to a Roth 401(k) this year, taxation could be elected to be paid in 2011 and 2012.

We see this as a big step in increasing tax flexibility to be in line with what is currently available in IRAs. Additionally, another very real benefit is that in 401(k)s, often times the institutional pricing structure of the underlying investments makes this a better deal than for those in IRAs where mutual funds and the like are generally retail priced and thus more expensive. If passed, this could be a strong incentive for investors to finance their retirement from their 401(k) Plans rather than rolling to IRAs and financing that way. Every bit helps especially with the coming wave of retiring baby boomes.