How to help employees avoid the ‘average participant’ retirement trap
Behavioral finance helps retirement experts understand that everyone, including participants, sometimes behave irrationally. Investment practices is one of the best examples:
Most people fear loss more than they delight in gain — and as a result, they invest too conservatively even though they have 40 years before retirement.
Most people prefer the status quo over change — and as a result, they fail to participate in 401(k) plans even though they want to save more for retirement.
Most people become overwhelmed by too many options — and as a result, they decide not to participate even though they want to pick the investment options that best meets their savings objectives.
These insights and many others have helped create what we now think of as retirement plan best practices: automatically enroll employees to improve participation, default employees into a target-date fund to improve investing behaviors and simplify the menu to limit choice and minimize confusion.
Without question, these plan features and practices have helped countless participants, particularly those who are early in their savings journey. It is an important focus given that millennials (ages 20-36 in 2017) now outnumber every other generation in the workforce, according to Pew Research. The sooner employees begin saving, the more prepared they are for retirement.
We have best practices for the majority, maybe even the “average” participant, but is it enough?
Morningstar states, “A problem with focusing on the average participant is that doing so ignores the potentially significant, and unique differences that exist among participants.”
A range of investors
For many reasons, investors are not always the undereducated, unaware and overconfident investors our industry believed they once were. Indeed, those participants still exist and may even comprise the majority of participants. According to DCIIA, 60% of all plans have now implemented auto enrollment and that will likely increase. With auto enrollment being a way to segment your participants, what needs to be considered for the minority who specifically opt-out of defaulted automatic features to build their own retirement portfolios?
Engaged participants, specifically those who are near retirement, deserve an appropriate spectrum of risk options. These near-retirees will likely look to their employer-sponsored plan for help. For those employees, simple investment menus are not always better. In fact, simple may be worse.
One of the biggest criticisms of a diversified investment menu with multiple options is the risk that participants will inappropriately allocate among riskier asset classes. For example, if a specialized option with predictably more risk is available on the menu, there is a chance the participant could allocate the majority of their assets into that option.
Also see: “How to measure retirement plan success.”
Most often, this concern is not borne out by utilization data. Emerging Market funds, for
example, are prevalent in 15.5% of plans, but only account for 2% of total defined contribution assets. Similarly, Specialty Equity funds are prevalent in 4.4% of plans, but only has 1.2% of plan assets, according to Callan.
These asset classes can provide participants great opportunities for diversification and can be important elements of a participant’s retirement portfolio, especially after considering the bigger picture.
The bottom line is employer-sponsored plans may not be the entire participant’s financial situation – quite frequently it is only a snapshot. To start, near-retirees may be a portion of participants to begin expanding the menu for based on their demographics, engagement and other related needs.
Indeed, this must mean stronger trust in engaged participants.
For those participants with the interest, the assets, and the opportunity to actively select investments through their employer-sponsored plan, they need the tools – i.e. investment options – that give them a spectrum of risk options.