Employees ‘put off’ by complexity of asset allocation choices

A report by James Choi of the Yale School of Management and the National Bureau of Economic Research looked at how individuals make decisions in their workplace-sponsored defined contribution plans to gauge how they make economic decisions in general.

In his white paper, Contributions to Defined Contribution Pension Plans, Choi points out that the U.S. has moved away from defined benefit pension plans, which offer a guaranteed amount of money every month in retirement, to defined contribution plans, in which participants have more of a say about how their money is invested.

Because most Americans are not savvy investors, he examined many factors introduced by employers to help break worker inertia when it comes to saving for their retirement. A recent report by the Investment Company Institute showed that in June 2014, U.S. assets in IRAs and employer-sponsored defined contribution plans totaled $13.8 trillion, far outstripping the $8.3 trillion still held in defined benefit plans.

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Only 16% of U.S. workers had access to a DB plan in 2014, while 42% of private industry workers participated in a workplace DC plan.

Choi looked at employer matching contributions as a way to encourage employees to save more in their retirement plans. The most common formula for a match, as reported by Vanguard, is a 50% match on 6% of the employee’s deferred contribution. Forty-five percent of Vanguard plans that offer a match vest these contributions immediately, according to the white paper.

“Employers usually adopt matches in order to encourage employees to save in the DC plan. They do this not only out of a sense of benevolent paternalism, but also because the IRS’ non-discrimination test on 401(k) plans limits the amount by which contributions of highly compensated employees may exceed those of non-highly compensated employees,” Choi said in the report.

Even with a hefty match, many employees still choose not to contribute to their 401(k) plan, although many of the studies cited in Choi’s paper come to the conclusion that a 10 percentage point increase in the employer match can increase participation in the plan by two to four percentage points.

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Inertia is a huge problem. Choi examined employee response to automatic enrollment, active choice enrollment, where they have a certain amount of time during open enrollment to determine which percentage of money they will contribute to their retirement plan, and choice overload.

He found that automatic enrollment does a better job of getting people to participate in their workplace retirement plan but that defaulting employees in at lower contribution rates has lowered the amount people are saving for retirement. Choi’s research found that raising the default contribution percentage to 6% from 3% and pairing it with an auto escalation feature dramatically increases the amount of money workers put into their plans and most won’t opt out of the auto escalation feature.

Choi found that “participation rates in auto-escalation rise dramatically from 27% to 83% when auto-escalation becomes the default.”

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He also found that allowing employees to choose their own contribution rate within 30 days of being hired encouraged a higher percentage of workers to participate in the plan than companies that switched to an opt-in enrollment regime for new hires.

Many studies have shown that offering employees too many investment options in their 401(k) plan can lead to inertia. “For every additional 10 funds, the participation rate is lower by 1.5 to 2 percentage points,” he found. That can be interpreted as “employees being put off by the complexity of the asset allocation choice they must make in order to opt into the plan.”

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