In its fifth and final issue brief in a series about retirement policy and principles, the American Academy of Actuaries separates plan provisions or features that affect retirement plan outcomes into four categories.
The first is where no choice is provided. The paper explains that not all aspects of plan design allow individual choice. For example, a plan could require that a portion of a participant’s account balance be used to provide lifetime income. Though this is not common in defined contribution plans subject to the Employee Retirement Income Security Act, it is a possible approach to improving lifetime income. The academy says that because each person’s circumstances differ, plan provisions that do not allow for choice could provide favorable outcomes for most participants but might lead to less favorable outcomes for others.
The second plan design category is where some level of choice is provided and a range of options is offered. While a wide range of options can add tremendous flexibility and customization of plan benefits to fit employee preferences and circumstances, the inclusion of too many options can potentially confuse some plan participants, the paper warns. In addition, more choices could increase the need for education to assist individuals in making selections that are appropriate for them. The use of only low-cost, well-designed target-date funds is an example of a restriction of investment choices that can benefit some plan participants.
The third plan design category is the use of defaults, for which options exist but, if no action is taken, a selection is automatically made according to the terms of the plan. This approach is the cornerstone of automatic enrollment and default automatic contribution arrangements. This approach is also used for default investment choices when participants fail to select an investment option. For example, the academy says, the use of a well-designed TDF as a plan’s qualified default investment alternative, or QDIA, has the potential to improve retirement outcomes.
The last category of plan design is where incentives (or disincentives where penalties apply) are used, where certain decisions are encouraged or rewarded (or penalized). The academy notes that participant decisions can be influenced by incentives. An example is the use of employer matching contributions to encourage plan participation and certain savings rates. On the other hand, a penalty tax on early withdrawals discourages the use of retirement savings for nonretirement purposes.
The academy says these plan design methods might not improve outcomes for all individuals. For example, a participant might be automatically enrolled into a plan, reducing his salary his, but then be in a financial position where he has to take a hardship withdrawal from the plan. That withdrawal could be subject to taxes and a penalty, which would not be a desired outcome.
Plan sponsors should also consider that younger individuals may be interested in different types of investment options than older ones. Plan designs that offer alternatives might thereby increase plan participation. In making such decisions—for example, to include environmental, social and governance investments on the fund menu—plan sponsors must make sure they are satisfying their fiduciary obligations, which might necessitate additional due diligence.
“Plan sponsors might consider the impact their plan design can have on different demographic groups covered by the plan and whether there are specific features or communications that may be appropriate,” the academy says. “For example, while encouraging positive saving behavior, employer contributions that rely on matching employee contributions negatively impact those who do not contribute. Each employee has unique financial circumstances that may inhibit their ability or willingness to contribute to the plan and obtain the full match. While matching contributions provide a strong incentive for first-dollar savings to go to the retirement plan, other uses may be a higher priority for any particular individual. In contrast, non-matching contributions do not provide a direct incentive for employee contributions but guarantee some level of contribution to all participants, regardless of an individual’s circumstances.”