Pity the prospective retiree. Social Security is projected to become insolvent in 2041, according to its trustees. Traditional pension plans are terminated, frozen, or underfunded with increasing regularity.
That leaves the 401(k) plan to carry the bulk of the retirement load. The trouble is, though, plenty of research suggests that 401(k) plans, as they are designed at most companies, do a poor job of providing for an adequate retirement on their own. A study by Hewitt Associates found that at companies that provide a 401(k) plan as the only source of retirement benefits, even employees who actively contribute to the plan could face a retirement-income shortfall of nearly 27 percentage points.
"You're going to see a lot of companies that have employees who can't afford to retire," predicts Melodee Webb, vice president of compensation and benefits at Rockwell Collins Inc., an aerospace-design company in Cedar Rapids, Iowa.
Hence the quest for the perfect plan. Smart companies know that if they are going to rely more on 401(k) plans to provide the bulk of retirement savings, they have to make them work better. They are searching for ways to take the muss and fuss out of their plans and encourage more employees to participate.
To be sure, the right plan characteristics depend on the individual company's goals. But widespread agreement on a number of best practices is emerging, regardless of the individual plan. The most often mentioned qualities are the presence of hefty employer matches, the right choice and number of funds, and helpful education and advice for employees.
Other best practices include using automatic enrollment, in which workers can choose to opt out of a 401(k) only after they've been dealt in; automatically hiking contribution rates on a yearly basis or when a raise occurs; and automating investment rebalancing to keep portfolios on target to meet retirement goals. "The best 401(k)s are often those with the simplest design features, both for the plan sponsor and for the participant," says Karen Sanchez, a partner at Sikich Group LLC, a professional services firm in Aurora, Illinois.
Less Is More
During the late-1990s boom, many employers assumed that the way to get employees to put money into their 401(k) accounts was to offer them an ever-expanding array of mutual funds. The stock market's upward spiral, they reasoned, would whet workers' appetites for variety. Fund companies even began to offer brokerage accounts, enabling participants to bet portions of their retirements on any high-flying stock they desired.
Yet when the tech-infused bubble burst, that freedom turned out to be a curse for many plan participants as those risky stocks plummeted. And for others, a plurality of options just led to confusion. Indeed, research has shown that having too many options can actually deter employees from saving for retirement. What happens, according to Columbia University Business School researchers Sheena Iyengar and Wei Jiang, is that employees fall prey to "choice overload."
Faced with a glittering array of alternatives, it seems, consumers go numb. Poring over Vanguard Group records of 647 defined-contribution plans spanning nearly 800,000 employees, Iyengar and Jiang found that for every 10 funds added to a plan's menu, the probability that an employee will take part in a retirement savings plan drops 2 percent. Further, variety might not spice up asset-allocation strategies. The boost in funds apparently made employees more risk-averse, leading them to bump up their contributions to money-market and bond funds by five percentage points and lower their allocations to stock funds by seven to nine percentage points.
Many plan sponsors appear to be getting the message. A consensus seems to be emerging that offering about 12 to 15 core funds is more than enough, and offering "lifestyle" funds — portfolios built to establish sound investment diversification for participants of different ages — might be even better. Thinning the list of funds also eases the compliance burden. "Fulfilling your fiduciary duty can be a daunting and expensive task if you offer 200 funds," says Susan Alford, an executive vice president in the benefits group at Aon Consulting.
Retirement experts generally discourage companies from offering brokerage accounts, which enable participants to trade individual stocks and bonds as well as a broad range of mutual funds. Tom Dunn, CFO of Southwest Power Pool Inc. in Little Rock, Arkansas, doesn't see much benefit to balance what he considers the "tremendous risk" of investing via a brokerage account. Some participants who embark on a round of day trading "may not have the foresight to diversify their holdings," he says. "You could have someone [in a situation in which] when they retire, they have nothing."
While simplified investment choices can boost participation, nothing meets that goal as well as a robust employer cash or stock contribution that matches part of what the employee saves. "The existence of a match is the number-one driver for participation," says Alford.
While there are many variations in matching formulas, an employer pay-in of 50 percent up to the first 6 percent of salary that the employee contributes is increasingly considered to be the standard. Matches should be stretched out across as big a percentage of pay as possible to encourage workers to allot higher percentages of their paychecks to their 401(k)s, says Michael Weddell, a Watson Wyatt Worldwide consultant in Detroit. For instance, 50 percent on the first 6 percent of pay is better than a full match on the first 3 percent.
Whatever the formula, some kind of match is better than none. The absence of one can convey the impression that it's OK not to save at all, "instead of it being a necessary part of one's retirement planning," according to Weddell. By supplying a percentage match, an employer can cue employees about the proper level to contribute. Weddell says a 6 percent match might cause the employee to think, "It seems to me that the design of match tells me that 6 percent is the right number."
Matches can also be shaped to make up for the demise of a traditional pension. When Rockwell Collins freezes its defined-benefit plan later this year, senior management wants its 401(k) to remind workers of a traditional defined-benefit plan and be more attractive to midcareer hires. Just after employees stop earning new pension benefits in September, the company will start making payments to its workers' 401(k) accounts amounting to 0.5 percent to 6 percent of their salaries, divided into six ranges.
To mimic the structure of the frozen pension plan, the company has designed a point system under which the amounts paid in will be based on the employee's age and length of service. The new contributions, piled on top of the 75 percent match in company stock of the first 8 percent of salary that Rockwell has provided for years, are an attempt to replace some of the funding lost to the pension freeze and to prompt employees to save more, say Rockwell managers.
Linking a match to corporate profits can provide an incentive for employees to stay with a strong-performing employer, say advocates. Because Call 4 Health, a medical answering-service firm in Boca Raton, Florida, pays percentages of its net profits into workers' 401(k) accounts, employees can get a sense of taking part in the company's growth, says CFO Nicholas Koutrakos. Net profits have burgeoned 20 percent per year for the past five years, according to Koutrakos.
But a profit-sharing match at a company with more-volatile results can create months of uncertainty for participants. Such plans force employees to choose their contributions before they know what their employers will contribute, according to Weddell. Informing employees that a match will be determined by year-end profits "sounds like a pretty weasely promise," he contends.
One alternative is simply to inject cash into the plan, with no strings attached. RLI Insurance Co., a Peoria, Illinois-based property-casualty insurer that is terminating its defined-benefit plan, contributes an automatic 3 percent of salary to every employee's 401(k) plan, even if the employee contributes nothing. (The company has an additional profit-sharing portion that last year amounted to about 2 percent.) "A match penalizes those least able to contribute to retirement," contends Jeff Fick, the company's vice president for human resources. "If employees can't participate, they lose the contribution."
Along with simplifying their plans and improving funding, companies are also seeing a need to provide more education and advice. With the move to automatic enrollment, for example, plan sponsors — required by the Employee Retirement Income Security Act of 1974 (ERISA) to operate solely in the participant's best interest — "want to make sure employees understand what money is coming out of their paycheck and how it's invested," says Sanchez.
The loss of the guaranteed income triggered by pension freezes is also driving the need for education. "This becomes a little more important, since the safety net of the defined-benefit plan [is gone]," says Denny Popovec, vice president of human-resources delivery at Rockwell Collins.
Furthermore, the bar for employee training is rising. "We're seeing education move from [training in] overall plan design to much more individualized and personalized education," says Alford. "We're also finding that what participants want is not education, but advice."
In light of such changes, CFOs are rethinking the quality of their education efforts. Some can be quite self-critical. Southwest Power Pool's Dunn, for instance, gives his organization high marks for its match — 75 cents on the dollar up to the first 6 percent of salary deferred — and its range of 19 investment options. But he feels that his company hasn't always been up to snuff in terms of education.
As evidence of that, Dunn says, the average age of company employees is 40, and 20 percent of the plan's assets are invested in cash and cash options. When he looks at such figures, the CFO feels that participants might not end up with enough to retire on. To remedy the situation, the company has brought in a registered investment adviser to meet with employees one on one and review their investments, retirement goals, and risk profiles. Many employers have long been wary of providing such a service because of fears that poor advice might lead to poor investment performance, and, in employee lawsuits. Indeed, under ERISA, workers can sue employers for providing a poor range of investment choices, as well as for conflicts of interest on the part of the adviser. But a 2001 Department of Labor advisory letter enabled sponsors to offer advice based on third-party analyses. Bills currently before Congress could also protect employers from liability incurred by investment advisers they hire for their plans.
Less-than-stellar participation rates can also lead to second thoughts about 401(k) education efforts. While an 80 percent rate at Arrow Electronics appears decent, the participants are heavily concentrated among white-collar workers, says Paul Reilly, CFO of the Melville, New York–based distributor of electronic components and computer products. To gain more-equitable participation, Arrow sends fund managers and its benefits teams to its distribution centers so that hourly employees can learn directly about 401(k) investing. "The biggest challenge we have is educating people in our hourly employee base who don't have as much disposable income," the finance chief says.
Of course, no list of best practices would be complete without a reminder to measure everything. The best metrics underlying 401(k)s are straightforward: the percentage of participants, the size of their accounts, and the growth potential of their investments. Practically all the features in today's top-performing plans are aimed at driving toward a 100 percent employee participation rate and a rate of income replacement for employees at retirement in the range of 70 to 85 percent, according to CFOs and benefits experts.
David M. Katz is deputy editor of CFO.com.