Over the past 20 years, the 401(k) plan has gradually replaced the traditional pension plan as a primary source of retirement income for many American workers. This trend has shifted the responsibility for accumulating a source of retirement income from the employer to the employee.
Julie Stone, CIMA®, Vice-President and Senior Investment Management Consultant with the Denver office of Morgan Stanley Smith Barney LLC, member SIPC, says “unfortunately, not all American workers with access to a 401(k) plan participate in it – and when they do, many are overwhelmed by the decisions they are forced to make.” Between low participation rates and uninformed investment choices, Stone says many Americans are expected to reach retirement age with a nest egg that may fall woefully short of what they will need to maintain their preretirement standard of living.
Addressing the Shortfall
Enter the Pension Protection Act of 2006 (PPA). Some of the PPA’s most significant provisions were crafted in response to the perception that American workers were not preparing adequately for their retirement years—and that American employers needed better tools to help employees do so. The PPA clarified and standardized automatic enrollment to give plan sponsors protection from potential violations of state laws when choosing to automatically enroll employees in their 401(k) plan. The PPA also addressed the issue of how to invest the assets of automatically enrolled employees by creating a “safe harbor” for the selection of a qualified default investment alternative (QDIA) by employers. With this measure, employers generally bear no additional responsibility for investment selection if they choose a default option that meets the safe-harbor criteria, and if certain notices and other information are given to participants. Together, automatic enrollment and QDIAs are becoming powerful solutions for the challenge of employee inaction.
Turning Inertia to Advantage
Stone says with automatic enrollment, “employees are enrolled in the plan as soon as they become eligible. When an existing plan adds an automatic enrollment feature, the employer can choose to include only new hires as they become eligible, or it can also include previously eligible employees who have not yet joined the plan.” Upon enrollment, the employee has 90 days to opt out of the plan and have any money that may have already been deferred returned. If the employee does not elect to opt out, a percentage of his or her salary—typically starting at a minimum of 3%—will be contributed to the plan from each paycheck. Effectively, automatic enrollment takes advantage of the same inertia that prevents many employees from participating in a plan.
An Opportunity to Grow
Once an employee has been automatically enrolled, the next question is how to invest the employee’s contributions. “While employers have had to resort to default investments in the past, in many cases those investments were aimed at preserving capital, not growing it,” according to Stone. “But with the PPA’s safe-harbor provision for QDIAs, plan sponsors can now select default investments that will give participants an opportunity to grow their assets at a rate necessary to fund their retirement without creating more liability for the plan sponsor.”
“The PPA’s most significant provisions are beginning to weave their way through the fabric of our retirement landscape, as more plans automatically enroll more employees into diversified investments, which in turn provide greater opportunity for capital appreciation,” says Stone. “While there has been much progress, there is still a long way to go. Given the tremendous shortfall in retirement savings and the loss of guaranteed retirement income from pension plans for millions of people, only time will tell if the PPA’s provisions are enough to help American workers adequately fund their retirement.”
Retirement Savings Need Work
According to the 2007 Retirement Confidence Survey from the Employee Benefit Research Institute and Mathew Greenwald & Associates, Inc., only 20% of respondents age 55 or older have saved more than $100,000 for retirement. Stone points out some other sobering findings from this study:
- Nearly one-third of respondents over age 55 said they have less than $25,000 in retirement savings
- 43% of all respondents said they have not done a retirement-needs calculation
- Approximately four in 10 respondents were forced to retire before they intended to retire
- 75% of respondents underestimated their estimated lifespan
Different Types of QDIAs
Qualified default investment alternatives (QDIAs) are investment strategies or services that can take a number of different forms. Stone says here are three of the most popular:
1) A combination of investments that takes into account the individual’s age or retirement date (example: a life-cycle or targeted-retirement-date portfolio)
2) A mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (example: a balanced portfolio)
3) An allocation of contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (example: a professionally managed account)
Julie Stone, CIMA® is a Financial Advisor with the Global Wealth Management Division of Morgan Stanley Smith Barney in Denver. She has been building solid portfolios for over 22 years.
The information in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their personal tax or legal advisors to understand the tax and related consequences of any actions or investments described herein.