Employers and policymakers need to recognize that there is no such thing as a neutral menu of options for a 401(k) plan but rather that how the decisions are framed will affect the choices that employees make.
Enron's collapse has put company-sponsored 401(k) retirement plans under the spotlight. As well as losing their jobs, Enron employees lost most of their investment in 401(k) plans that was concentrated overwhelmingly in Enron stock. The Enron example highlights two important issues: the power employers have over their employees' 401(k) accounts and the importance of encouraging appropriate investment decisions. These are addressed in two timely NBER Working Papers by James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick.
The common theme in these studies is that employees tend to be "passive decisionmakers" taking the path of least resistance. This means that employers have a great degree of control over savings and investment decisions employees make in 401(k) plans. Employers and policymakers need to recognize that there is no such thing as a neutral menu of options for a 401(k) plan but rather that how the decisions are framed will affect the choices that employees make. Of particular importance are the default options that apply to enrollment in the 401(k) plan, the default options that apply to plan balances when employment is terminated, the threshold at which employers match 401(k) contributions, and the menu of fund options that are available to employees.
Although there are some limits, companies have broad discretion over the design of the 401(k) plans they offer. One plan design feature that has been increasing in popularity over the past few years is automatic enrollment. Standard economic theory suggests that automatic enrollment should make no difference to employee savings outcomes because it does not change the savings options faced by employees. In For Better or for Worse: Default Effects and 401(k) Savings Behavior (NBER Working Paper No. 8651), Choi and his coauthors show that this presumption could not be farther from the truth.
Using administrative data from three companies, the researchers conduct a detailed study on the impact of automatic enrollment on 401(k) savings outcomes. Although employees subject to automatic enrollment can opt out of the 401(k) plan at any time, few choose to do so. As a result, automatic enrollment has a dramatic impact on retirement savings behavior: 401(k) participation rates at all three companies exceed 85 percent, regardless of the tenure of the employee. Prior to automatic enrollment, 401(k) participation rates ranged from 26-43 percent after six months of tenure at the three firms and 57-69 percent after three years. The researchers also find that the participation increases are most important for those least likely to participate in standard retirement savings plans: the young, lower-paid, black, and Hispanic employees.
Although automatic enrollment results in substantially higher 401(k) participation rates, employees hired under automatic enrollment tend to follow the path of least resistance when it comes to how they participate in the 401(k) plan -- they tend to stick with the low company-specified default contribution rate (2 or 3 percent for the three companies studied) and to remain in the default (conservative) investment fund chosen by the company (either a stable value or a money market fund). In the three companies, 65-87 percent of plan participants save at the default contribution rate and they invest exclusively in the default fund. While this percentage declines slowly over time, after two years of tenure 40-54 percent of participants are still at the default.
What impact will automatic enrollment have on long-run asset accumulation? While automatic enrollment encourages 401(k) participation, it anchors participants at a low savings rate and in a conservative investment vehicle. Higher participation rates promote wealth accumulation but the low default savings rate and the conservative default investment fund may actually lower employee wealth accumulation over a long period. In their investigation of the employees in the three companies studied, the NBER researchers find that the two effects are roughly offsetting on average. Although automatic enrollment has little impact on average long-run wealth accumulation, it does reduce the overall variance in wealth accumulation across employees. This is in part because automatic enrollment increases 401(k) participation among lower-paid employees and in part because some employees who would have participated in the plan without automatic enrollment do not bother to select an alternative to the automatic enrollment defaults and thus have a lower contribution rate and a lower return asset allocation than they would otherwise have.
In Defined Contribution Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance (NBER Working Paper No. 8655), Choi and his co-authors suggest that automatic enrollment is only one example of the many ways in which employees follow the path of least resistance when it comes to 401(k) savings outcomes. After examining the administrative records of several anonymous U.S. corporations, the authors find that employees tend to do whatever requires the least effort. Though surveys suggest that workers often feel that they save too little, and intend to raise their contribution rates, few ever do so unless employers offer a low-effort opportunity, such as signing up for an automatic schedule of increases in their contribution rate.
When employees leave a job, the default treatment of 401(k) balances of terminated employees largely determines what happens to their accumulated savings. When balances are small (less than $5000), employers can send employees a check for the value of the balances whether the employee requests it or not, and such cash distributions tend to be consumed rather then saved. When balances are large (more than $5000), employers cannot legally force a cash distribution on terminated employees. In this case, the balances by default remain at the previous employer, and only a small percentage of employees elect some other action for their accumulated balances, for example a cash distribution or a roll-over to another 401(k) plan. When employers offer a match in the 401(k) plan, many employees elect to contribute at the threshold at which the employer ceases to match employee contributions because the match threshold provides a convenient focal point.
Even in the case of savings decisions over which employees are required to exert some effort, such as investment allocation choices in the absence of automatic enrollment, the plan's design also can influence savings outcomes. For example, employees tend to have asset allocations that are more heavily weighted toward equities when the plan offers more equity choices to its employees.
While many individuals have advocated financial education as a way to promote better savings outcomes for employees, the NBER researchers suggest that in the presence of the employee behaviors just described, financial education cannot be viewed as a panacea. They examine the effectiveness of financial education in one company by linking attendance data from financial education seminars to subsequent data on actual savings outcomes. They find that individuals who receive financial education are both more likely to enroll in the 401(k) plan if not already participating and more likely to diversify their asset holdings than employees who do not receive financial education. However, they also find that less than one-third of the employees who say they intend to make changes to their 401(k) savings plan actually do so. Thus, while financial education does motivate changes in savings behavior, its effects are limited at best.
On the basis of this research, the authors conclude that employers can exert a strong influence on the savings and investment choices of their employees through their design of retirement savings plans. Whatever savings plan an employer creates will favor certain passive or nearly passive choices over other choices that require more effort. The researchers suggest that employers seeking to increase employee savings could adopt automatic enrollment with more aggressive defaults, including defaults that slowly raise the employee's contribution rates over time. They also could automatically roll over the 401(k) balances of terminated employees into an IRA rather than compelling a cash distribution if account balances are small. They could choose a higher match threshold to motivate higher savings rates, and they could offer employees well thought-out investment options.
Policymakers also should recognize that the government can affect economic outcomes, with laws and regulations, through the use of defaults. For example, firms may be wary of increasing the aggressiveness of the default investment fund under automatic enrollment, since choosing a fund that includes equity exposure may leave the company vulnerable to employee lawsuits when volatile asset classes suffer capital losses. Policymakers could address this concern by giving companies legal protections to encourage them to pick higher return default investments, like the S&P 500, rather than the money market and stable value funds that are the choice of most employers who have automatic enrollment.
-- Andrew Balls