In 2006, Congress passed the Pension Protection Act. Can leaders do it again?
At times, it seems like nothing much good comes from the policymakers in Washington, D.C. Efforts to rein in long-term entitlement spending have mostly foundered. In recent years, plans to expand access to workplace retirement plans have gone nowhere. In the current environment in Washington, D.C., even a task as simple as raising the debt ceiling— to pay for appropriations that Congress has already approved—has proved difficult, with the country coming to the brink of default on numerous occasions.
But it is worth remembering that the federal government sometimes gets things right. We have reached the 10-year anniversary of one of the largest achievements in recent policymaking, the Pension Protection Act of 2006 (hereafter referred to as the PPA). Thanks to its provisions relating to 401(k) accounts, the PPA will ultimately help tens of millions of Americans achieve better-funded retirements.
What Is the PPA, Anyway?
Much of the PPA focused on shoring up financially troubled defined-benefit plans— and especially their insurer, the Pension Benefit Guaranty Corp., or PBGC—but the legislation also had incredibly important provisions relating to defined-contribution plans, including 401(k)s.
Broadly speaking, the PPA was probably the first major piece of legislation that relied heavily on learnings from behavioral economics, according to Doug Fisher, a senior vice president of Thought Leadership and Policy Development at Fidelity. Behavioral economists focus on providing the right “choice architecture,” or more colloquially, making it easier for people to make the right decisions. In short, in three key areas the PPA relied upon a human tendency toward inertia to help them achieve better retirement outcomes.
First, the PPA strongly encouraged the use of auto-enrollment by plan sponsors. Companies with 401(k)s typically need to conduct “fairness testing,” which is designed to ensure that the benefits of a defined-contribution plan do not flow disproportionately to upper-income employees. This testing can be cumbersome, and in certain circumstances, it can lead to the loss of certain tax benefits for 401(k) plans. With respect to fairness testing, the PPA established a “safe harbor” for sponsors that auto-enroll their employees, provide matching or unilateral retirement contributions, and meet a number of other criteria.
Second, the PPA promoted plan sponsors’ use of auto-escalation features in their plans. Again, the legislation provided a safe harbor for those employers who meet certain criteria, including auto-escalation. Academic research shows that a lot of people know they need to save more for retirement and plan to do so in the future— and yet never get around to doing it. The PPA intended to use people’s inertia to their advantage, by automating future increasing in retirement savings (with an opt-out, of course).
Third, the PPA provided for much better default options for plan sponsors that auto-enroll their employees in 401(k)s. Before the PPA, many of the relatively few companies that offered autoenrollment tended to invest participants’ contributions in money market funds or other extremely safe investments that are poor long-term holdings. Plan sponsors feared that if they invested the money more aggressively, they might expose themselves to participant lawsuits in the event of a market downturn that caused losses to participant accounts. The PPA gave plan sponsors protections if they selected an appropriate “qualified default investment alternative,” such as a target-date fund or a managed account.
The PPA 10 Years Later
By most relevant metrics, the PPA has been a tremendous success that “people should feel really, really good about,” says Ann Combs, head of government relations at Vanguard. Data from Vanguard and Fidelity, two of the nation’s largest 401(k) providers, confirm that the PPA has successfully increased the number of workers saving for retirement.
First, the PPA has greatly increased the number of plan sponsors that use auto-enrollment features. In 2006, just 12% of employees hired into Vanguard-administered plans had access to auto-enrollment. By 2015, that proportion had increased to 63%. At Fidelity in early 2006, just 13.1% of participants were hired into plans offering auto-enrollment; by the first quarter of 2016, that percentage had nearly quintupled.
Second, that greater adoption of autoenrollment has predictably increased the number of workers participating in their retirement plans. At Vanguard, for example, in 2015 about 75% of eligible employees participated in their retirement plans, up from roughly two thirds a decade earlier. Much of that growth can be directly attributed to the greater use of auto-enrollment programs. Across time, Fidelity and Vanguard say that generally about 85% to 90% of auto-enrolled workers continue to participate in their retirement plans (i.e., they do not opt out). By contrast, Vanguard reported that in 2015, retirement plans that lacked auto-enrollment had a participation rate south of 60%.
Third, most firms now use very suitable default investment options for retirement plan participants. At both Fidelity and Vanguard, more than 95% of plans using auto-enrollment now designate as the default option a target-date fund, managed account, or other similarly diversified investment option.
In addition to providing superior long-term returns to money market funds, which offer an inflation-adjusted return of less than zero, these managed investment options are easier for investors to use. Russel Kinnel, a director in Morningstar’s fund ratings group, publishes an annual study examining which types of funds tend to have the best “investor returns”— that is that smallest gap between funds’ published returns and those actually enjoyed by investors, taking into account the timing of their purchases and sales. Kinnel has consistently found that owners of target-date funds enjoy better investor returns than those who invest in many other categories. Similarly, David Blanchett, Morningstar’s head of retirement research, has found that managed-account investors earn higher longer-term returns than those who do not use a broadly diversified investment option. Fourth, over time the number of plan sponsors using auto-escalation in their retirement plans has increased over time. In early 2006, no Fidelity-administered retirement plans offered auto-escalation provisions. Ten years later, about one in seven plans offer auto-escalation.
Drawbacks of the PPA and Next Steps
Still, it would be wrong to suggest that the PPA was perfect. Many plan sponsors auto-enroll their employees at just a 3% contribution level and do not offer auto-escalation. That is unlikely to be an adequate savings rate to provide an adequate retirement for many American workers. Combs, an official in the Department of Labor in 2006, said that a decade ago, there were fears that a higher default contribution rate—say, 6%— would have prompted many workers to opt out of saving for retirement. Recent scholarship has shown that opt-out rates are no higher at a 6% default rate than at a 3% rate, so future legislation should encourage higher initial default rates, as well as greater availability of auto-escalation.
Both Combs and Fisher point to the “coverage gap” as another big issue that retirement-focused policymakers should address. Somewhere between one third and one half of private-sector employees lack access to a workplace retirement plan. If behavioral research teaches us anything, it is that more people will save for a distant goal—like retirement—if it is easy and simple for them to do so. Sure, these employees without workplace retirement plans could theoretically fund individual retirement accounts on their own, but few do so. If a workplace retirement plan is available, more than 70% of people in the $30,000 to $50,000 income range will participate. However, in that same income bracket, less than 5% will fund an IRA.
Is it reasonable to expect Congress to act to close this coverage gap? Despite the seemingly endless dysfunction in Washington, D.C., both Combs and Fisher, a former tax counsel for the Senate Finance Committee, believe that congressional action is possible.
Both note that major retirement-related legislation tends to make its way through Congress once per decade. Combs said that a crisis in the retirement system often prompts congressional legislation that can serve as a vehicle to which other retirement legislation can be attached.
For example, in 2006 the impending insolvency of the PBGC led to legislation that not only restored it to (short-term) financial viability, but also provided an opportunity for new policymaking related to defined-contribution plans. With the PBGC again on the ropes financially, perhaps 2017 will feature new retirement legislation.
If there is additional retirement legislation, Combs and Fisher both said that making it easier to form multiple employer plans, or MEPs, will be part of it. MEPs, which allow smaller companies to band together to form a single retirement plan, ease the regulatory burden on any individual employer. Moreover, small-company retirement plans typically feature high costs for participants; MEPs should provide some economies of scale. Right now, the Department of Labor allows only closely related companies to form MEPs, while pending legislation—offered by members of both parties—would make it easier for unrelated firms to form MEPs.
A number of states have also enacted legislation intended to enhance access to workplace retirement plans. For example, starting in 2017 or 2018, Illinois will mandate that most companies without a workplace retirement plan must auto-enroll their workers in a Roth IRA. This legislation has flaws—the auto-contribution rate of 3% is too low, employers cannot make a matching contribution, and there are no auto-escalation requirements—but this initiative does speak to policymakers’ widespread concern about the retirement gap.
Many of these retirement initiatives seek to build on the PPA, or at least to use learnings provided by the legislation to enhance retirement outcomes. What will happen in Washington, D.C., is anyone’s guess, but if the next piece of retirement legislation is even half as good as the PPA, it will be a major step forward for Americans’ retirement security.