Making 401(k)s Work for Retirement

Jason Stipp: I'm Jason Stipp for Morningstar. The 401(k) plan was perhaps never intended to be the centerpiece of Americans' retirement financial planning, but it is so for an increasing number of Americans. So how are we making these plans work for retirement investors?

Joining me today is Nathan Voris from Morningstar Investment Management to discuss some of the ways that 401(k) plans are making it work for investors.

Thanks for joining me, Nathan.

Nathan Voris: Thank you. Glad to be here.

Stipp: You have a lot of knowledge and work with a lot of large plans, and you understand some of the things that are making plans work well for investors.

One of the main things with these plans is, they are voluntary plans. People don't have to contribute to a 401(k) plan. One of the things that plans have started to do to get more enrollment is something called auto-enroll. How does that work and what is the effect?

Voris: Auto-enroll is a program where the plan sponsor, meaning the employer, decides that at some point every new employee that enters the firm is automatically in the plan. So, when they become eligible they are auto-enrolled, and typically that auto-enrollment puts someone into the default investment option. And often there's an auto-savings rate feature as well. So if they don't choose their own savings rate, they are put into a base savings rate. That feature happens as a new employee. And then some other plan sponsors have actually re-enrolled all of their employees and sort of reset the clock, if you will, making everybody eligible for the plan and enrolling every employee that they have in the plan.

Stipp: So in other words, if I opted out after I was auto-enrolled, I might get re-enrolled maybe at the beginning of the next year in some of these plans?

Voris: That's right. So let's say you were hired seven years ago before the auto-enroll feature occurred. Often many employers will re-enroll the entire population to put everybody in the plan again and have a fresh start.

Stipp: Do we have a sense of the effectiveness of this auto-enroll as far as percentage of people participating in 401(k) plans?

Voris: It has been very effective. For plan sponsors that do this, we see a stick rate of around 90%. So it can be from 85% to 95% of participants actually staying in the plan. And the same holds true for the auto-savings rate, what we call auto-escalation feature. We have about the same take rate after that auto approach is implemented.

Stipp: You mentioned auto-escalate. That's something where it might start you at a lower rate but over time it'll escalate the amount that you're contributing automatically. You don't have to go in and say, now I want 4%, now I want 5%.

Voris: That's correct. It's a feature where you have a starting savings rate, and then every year your savings rate would be increased by either 1% or 2%--most often it is 1%. That is a program that has been successful as well.

Stipp: You mentioned that if you don't make a particular election for what kind of investments [you want], these auto-enrolls might put you in a designated investment. So talk a little bit about how some of the investment choices in 401(k) plans, especially for the auto-enroll or the default investment option has changed?

Voris: In 2006, the Pension Protection Act was passed and it gave plan sponsors the ability to adopt a QDIA, a Qualified Default Investment Alternative. It gave some safe harbor around those choices. So since that happened, the default has become much more popular, and nearly universal, in many ways in retirement plans.

There are really three options. The first is a balanced fund or a risk-based model. The second is a target-date fund, which has a glide path and adjusts its riskiness over time, based upon age. And then third is a managed account, which is a more discretionary program where it provides a savings recommendation, investment allocation recommendation. It's more of a financial-planning tool than just an investment program.

Stipp: Part of the purpose of this legislation is to make sure that people can get defaulted into an option that's probably pretty good for them, or at least in the right ballpark?

Voris: That's right. It gave the employers a little bit of leeway into doing what was right for their participants in providing a highly diversified, quality default option, because we know investment choices are tough. And the average participant has a hard time doing that. So providing these defaults solves that part of the equation for the participant.

Stipp: And with these qualified defaults, I think maybe we have seen more target-date fund adoption in 401(k) plans. In general, though, do you think lineups of 401(k) plans, the options that are available to investors have improved over time? That even if an investor is making their own choices that they are probably having more quality options to invest in.

Voris: There has been some evolution in the investment menu design, particularly in the large and the mega market. We have seen a lot of streamlining, a lot of simplification. A lot of expenses have been going down. So there has been improvement over probably the last five to seven years. 30 years ago, when this started, the idea was to give participants everything that they wanted. So menus were 30 to 50 investment options. And over time we have realized that, that choice is actually harmful in many ways and paralyzing for some folks. And so we have slowly streamlined those investment options and provided a cleaner, more efficient choice, and that has, we believe, improved outcomes.

Stipp: It seems like 401(k)s have addressed the voluntary aspect with this auto-enroll and the auto-escalate. It seems like the choice aspect of putting too many decisions in the hands of folks who aren't investment experts, is being solved with some of the default options, the target-date funds or the managed accounts.

What about when people retire and now they have this 401(k) account that they need to somehow transition into retirement? Are 401(k)s addressing that transition?

Voris: They are. I think that's probably the next phase. We have been talking about that for a number of years--retirement readiness and retirement income, those concepts. So there certainly are products that are out there to help solve for that. Many are sort of guarantee-based with annuity products inside of them that will provide a guaranteed or steady stream of income in retirement.

Those products are out there. The adoption has been slower than I think many of us anticipated. But we do see that as a trend. We have much of the accumulation side of things straightened out in some ways, as long as we get savings rates up and people don't spend their money when they change positions and those kinds of things. But that retirement income is sort of the next step of innovation, I believe, where investment professionals and asset managers will really start to come up with innovative solutions there.

Stipp: When people shift jobs, the portability of a 401(k) could be seen as one of the pros of that investment vehicle. But there's also the pitfall of someone cashing out of their 401(k) when they switch jobs. Is there a way that plans could make it easier to keep it in a retirement plan, so that people aren't making this bad mistakes of cashing out too soon?

Voris: Yes. I think so. There are certainly some plan design issues where you could remove the force-out provision or at least lower the force-out provision in your plan. But in general, I think it's a communication issue, more than a plan design issue. A 26-year-old has had a job for four years. They have accumulated hopefully a small balance, and the mentality is, it's small, so I'm going to cash it out and use it for some other purpose.

Making sure that those people know that that $7,000 they have accumulated is meaningful and will have real outcome and real value at age 65 is important. And so, if we can eliminate that leakage, which is the term that most folks use, that will go a long way. Because we know that folks now change jobs frequently. It's not the 35-year careers of our parents. And so making sure that money either goes to an IRA or stays in their plan or is rolled into their new plan is a very important step to improve retirement readiness and improve outcomes.

Stipp: Nathan it sounds like there have been some interesting and effective innovations in 401(k) plans. There is probably still a little bit more work to do to make sure that these are entirely working for investors. But it sounds like some of these things at least are getting some good traction. Thanks for joining me today and for your insights.

Voris: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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