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Rekenthaler Report

The British Show How to Improve 401(k)s

The imitators have outdone the originators.

A Big Step Forward
As with most developed nations, the United Kingdom has realized that without additional financial support, which the government itself did not wish to provide, many millions of its citizens would face precarious retirements. Consequently, in 2012, the United Kingdom mandated that all workers age 22 and over, earning at least 10,000 pounds annually, be automatically enrolled into the country’s equivalent of a 401(k) plan.

As with U.S. automatic-enrollment schemes, it ultimately is voluntary. Although all new employees who meet the program’s conditions are placed into the program, they may opt out within the first month of enrollment, without penalty. Every three years thereafter, they are re-enrolled, always with the opt-out provision. The government encourages, but it does not demand.

The legislation, it is fair to say, has been an unqualified success. Over the ensuing seven years, participation in workplace pension schemes has more than tripled, rising to 14 million from 4 million. As the U.K. possesses one fifth the population of the United States, this increase of 10 million participants is equivalent to adding 50 million American retirement savers in seven years. Nothing like that level of growth has ever occurred in the U.S.

Gratifyingly, the employee participation rate has held steady even as the contribution rates have risen. The auto-enrollment program began with a minimum 3% rate, was bumped to 5%, and then increased again to 8%. Throughout the process, the participation rate has been 91%. Those who recall the early days of 401(k) plans, when companies relied on enrollment meetings rather than automatic enrollments, will know that 91% was once considered an almost unreachable figure.

Once enrolled, workers have showed almost no desire to trade their accounts. The research paper, “Pension charging structures and beyond; an outcomes-focused analysis” (the source for this column’s facts), reports that an astonishing 99% of participants remain in their default funds. This surely also rates as a success, unless one believes that employee trades can improve on diversified, professionally managed portfolios.

In short, the British government achieved each of its desired goals, and then some. Its legislation quickly moved almost one third of the full-time workforce into retirement schemes, at a healthy 8% minimum contribution rate (a minimum--some companies have established even higher rates), into sensible, diversified portfolios that investors don’t turn over. The new rules led to the dream outcome.

An American Invention
It would be a dream outcome in the United States, too, and would go far in addressing the country’s “retirement crisis.” (The ironic quotes reflect this author’s disbelief that the outlook for upcoming retirees is any worse than for previous generations, but there is no doubt that, even if their future isn’t as grim as typically portrayed, it is not good.) Can the U.S. profit from the British experience?

To a large extent, of course, it already has. The U.S. private marketplace gave the United Kingdom its road map. Through Section 401(k) of the IRS tax code, entrepreneurs devised defined-contribution retirement plans, as opposed to the defined-benefit plans that then held sway. Twenty years after, in 2001, that invention became the British government’s blueprint when it launched portable, tax-advantaged employee retirement plans.

Similarly, the U.K.’s automatic-enrollment program came from observing U.S. trends. The British system started as fully voluntary, as with the first stage of 401(k) plans. However, when U.S. plan providers, in conjunction with academic researchers, launched auto-enrollment programs that boosted participation rates higher than what educational campaigns could achieve, the United Kingdom did the U.S. one better. It not only adopted the feature but made it a requirement.

Mandating that companies auto-enroll all eligible employees is one of five major changes that the British made to the U.S. system that it had studied and adopted. The other four were:

1) Requiring that all eligible companies establish a defined-contribution plan;

2) Simplifying the process by which companies join such plans;

3) Setting a (relatively high) minimum contribution rate;

4) Ensuring that all parties--participants, their employers, and the government itself--have skin in the game.

In Response
The United States should emulate Britain’s flattery by adopting the first three of those four features on the spot. They are clear and obvious improvements to the current U.S. system. The final item can and should be debated. It unquestionably improves retirement outcomes, but its adoption would be expensive.

First, the easy decisions--the free benefits. Requiring that all companies offer a 401(k) plan would cost no more than the time spent to draft, pass, and sign the legislation. True, that would place a burden on private enterprises under current laws, which demand various duties, including assuming fiduciary responsibility, from plan sponsors. Those regulations are ridiculous. They should be scrapped, as the British have done, so that rather than spin their wheels creating needless new plans, companies could simply and without cost join an existing national plan.

Addition by subtraction. Write a new law that saves time and money by eliminating the errors of the current laws. There is no good claim against doing so, unless one is in the business of filing lawsuits against 401(k) plan sponsors.

Requiring that all 401(k) plans automatically enroll new employees, at a minimum contribution rate, is similarly obvious. In fairness, the marketplace is already heading in that direction, as auto-enrollment programs are becoming standard features in new plans. But why wait? Automatic enrollment costs the government and companies nothing, and employees are under no obligation. They may decline the honor if they so choose. Few so choose. People like the nudge.

The tricky part is the skin in the game. The British government decided that workers would be happier about being in a retirement scheme if the contributions were not solely from their paychecks. Getting somebody else’s money would enhance the appeal. Thus, the U.K. minimum-contribution formula consists of 4% from employees, 3% from employers, and 1% from the government. Everybody pays.

As the U.S. is less enthusiastic than the British about government and corporate spending on social programs, I would not expect an identical formula. Perhaps neither the government nor companies would be expected to contribute at all. Having them do so would increase participation rates, which would reduce future social costs, so an argument can be made for that approach, but counters certainly exist. The matter is open for discussion.

What is not debatable is that the British have one-upped the United States at its own game. It is time that the Americans across the Atlantic return the favor.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.