Default Rules for Retirement Plan Selection

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An employer can significantly influence its employees' choice of a pension plan by setting its default plan.

Over the past 30 years, corporate retirement plan offerings have been shifting from defined benefit (DB) plans to defined contribution (DC) plans. The DB plans provide retirement benefits through a set formula based on earnings and years of service to one company, but they also carry the risk of the employer defaulting on part of the pension obligation in the future or of the employee leaving the firm before reaching its designated retirement age. The DC plans provide benefits based on tax-advantaged contributions and subsequent investment performance, but they put the responsibility of enrollment, contribution, and investment decisions on the individual. Because DB and DC plans differ in their accrual patterns and risk characteristics, deciding which plan is best for an individual can be difficult.

Many employers who have been making the transition to DC plans still have their pre-existing DB plans, so in some instances they continue to offer employees a choice between the two. However, some of those employees fail to make a decision by enrollment deadlines. In Incorporating Employee Heterogeneity into Default Rules for Retirement Plan Selection (NBER Working Paper No. 16099), co-authors Gopi Shah Goda and Colleen Flaherty Manchester analyze the effect of incorporating differences among individuals into the default rules governing retirement plan selection.

Their data come from a large non-profit employer that in 2002 offered 925 of its union employees the option of switching from their existing DB plan to a DC plan. The employees, whose average age was 46, were given six months to decide. If they failed to make a choice, they were defaulted into a plan based on their age: those under age 45 were assigned to the DC plan while those 45 and older were kept in the DB plan. Of the employees eligible for the transition, just under half made an active choice and 70 percent of that group mimicked the company's default rule -- that is consistent with employee choices seen in similar default option circumstances.

The results of this study suggest that an employer can significantly influence its employees' choice of a pension plan by setting its default plan. In this instance, the employees who were subject to a DC plan default were 60 percentage points more likely to enroll in a DC plan than a DB plan. "The default was an overwhelming determinant of plan enrollment," the authors conclude.

These researchers also examine what age-based default rule employers should select for pension plans if their goal is to maximize the aggregate risk-adjusted pension wealth of their workers. The rule will depend on employees' risk aversion as well as on the plans' characteristics. For example, the asset allocation strategy in the DC plan is important. When risk aversion is high, perhaps in volatile economic periods, the DB plan generally will be valued highly by more employees, which will translate into a decline in the optimal age at which the employer will set a default of DC participation.

-- Frank Byrt