RSM Resources

If CFOs seem a bit grouchy these days, it may be they’re losing sleep over their 401(k) plans.

A recent CFOmagazine survey of finance executives found their top concern about401(k) plans is that employees may not be able to retire comfortably.In less than 20 years since their creation, the number of 401(k) orsimilar defined contribution plans has nearly doubled to 683,000, whilethe number of traditional pension plans has declined by almosttwo-thirds. That decline coupled with the uncertain future of SocialSecurity has made employees increasingly reliant on 401(k) savings forretirement income.

Yet many workers are woefully unprepared forretirement. According to the Center for Retirement Research at BostonCollege, the median retirement account balance in 2004 for heads ofhousehold was only $40,000. The outlook is even worse for baby boomersnearing retirement. Another study found that more than half of today’s55-year-olds have less than $50,000 in their defined contributionplans. The meager savings levels result from a variety of factors,including low participation, inadequate contributions and poorinvestment diversification.

The shortcomings of the 401(k) planhave prompted some employers to rethink match levels and strategies inhopes of boosting both employee participation and contribution levels.However, increasing employer contribution matches beyond a certainpoint may be an ineffective and costly way to encourage savings. Theoptimum match, however, remains an elusive figure despite numerousstudies.

Generous matches don’t guarantee participation
Anearlier Boston College study determined that the employer match is themost important factor in employee contribution decisions. The typicalcompany match is 3 percent of pay, but research shows that the level ofemployer match is less important than the existence of the match.Increasing the match to 80 percent from 40 percent of employeecontributions yielded less than a half-percentage-point increase insavings levels.

The diminishing incremental returns onmore-generous employer matches may have more to do with procrastinationand inertia than the financial acumen of employees. A leading expert onbehavioral finance, Dr. Shlomo Benartzi of the University of CaliforniaLos Angeles, has observed that those who delay decisions or actionabout saving for retirement tend to do nothing about it.

Morethan 25 percent of eligible U.S. workers choose not to participate in acompany-sponsored retirement plan, even when employers match andimmediately vest their contributions, Benartzi reported in a recentarticle for AllianceBernstein Investments Inc. Benartzi believes thatbehavioral tendencies toward inaction can be powerfully negative. In aUnited Kingdom study of 26 defined benefit plans, which requireemployees to sign up even though the company fully funds the entirecontribution, only about half the employees enrolled.

The optimal match structure
Companiesmatching employee contributions may benefit from examining how theystructure their matches. Benartzi hypothesizes that employees oftenrely on "mental shortcuts" when choosing their savings rates.Contribution levels may be tied to a round number or, not surprisingly,to the maximum match, instead of actual savings needs.

Theimplication for employers is to provide incentives for employees tosave more by spreading the match over higher contribution rates. A 2003survey found that about 15 percent of companies use a graded match,such as a dollar-for-dollar match on the first 3 percent of pay and 50cents per dollar on the next 3 percent. In such a plan, many employeesmay limit their contributions to only 3 percent, whereas a fixed matchof 50 cents per dollar up to 8 percent may result in a higher savingsrate.

Contribution caps provide further evidence of employees’mental shortcuts. Before 2001, the maximum allowable contribution ratewas 16 percent. It is now 100 percent, which intuitively seems likegood news for employees. However, one study reported the number ofemployees opting for the maximum deferral rate fell to 12 percent from21 percent once the cap was removed. Benartzi speculates that the newmaximum rate was too high, prompting many employees to choose a roundnumber.

Remove obstacles to participation
Evencompanies offering an attractive match structured to maximizecontributions likely will find that employees are still not savingenough. Behavioral tendencies are again to blame, and many employeesrealize it. More than two-thirds of employees in one study (andthree-fourths in another) believe they should be saving more for retirement. In other words, procrastination and loss aversion trump good intentions.

Expertsrecommend a multifaceted strategy to remove obstacles to planparticipation and higher contribution levels. By making enrollment,investment and other decisions easy — or even automatic — employees maybe more inclined to boost their retirement savings.

Automatic enrollment.Signing up all employees automatically in the 401(k) plan turnsprocrastination and inertia into a positive for retirement savings.Once enrolled, employees have the option to drop out, but few do.Studies show that automatic enrollment increases participation as muchas 35 percent.

Loan provisions. After employer matches,the ability to borrow against 401(k) savings is the second-mostimportant plan feature for boosting employee participation, accordingto Boston College researchers.

Simplified investment choices.When it comes to offering employees investment options, less may bemore. Research shows that, for every 10 funds a plan adds, investorsincrease their allocation to money-market and bond funds by 5.4percent. Too many choices spur migration to low-risk (and lower-return)investment options. One popular option is the "one-fund solution,"which provides a mix of stocks and bonds based on the participant’s ageand risk profile.

Managed accounts. Because employeeeducation has had limited results, some companies are turning tomanaged accounts, in which professional money managers relieveemployees from making investment decisions.

Automatic rollovers.Historically, employees cashed out 87 percent of all 401(k) balances ofless than $5,000 upon leaving a company. Last year the U.S. governmentbegan requiring employers to roll over any 401(k) plan balances valuedbetween $1,000 and $5,000 into an IRA or the 401(k) plan at theemployee’s new company.

The 401(k) plan has become a vitalsavings vehicle for many Americans. Although plan improvements over theyears have increased both participation and saving rates, most 401(k)plans are still leaving employees short of the resources they’ll needin retirement. Unfortunately, there is no single solution to ensureemployees will build an adequate nest egg for retirement. An employermatch is critical to attracting participation, but research shows thatit can be an expensive and ineffective way to encourage employees tosave adequately. A better strategy may be to take advantage of employeeprocrastination and inertia by creating a plan that requires action not to save adequately.

It’s a strategy that just might help CFOs sleep better.