Retirement Savings Defaults: The Evolving US Experience OECD-IOPS Global Forum J. Mark Iwry United States Department of the Treasury

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1 Retirement Savings Defaults: The Evolving US Experience 2012 OECD-IOPS Global Forum J. Mark Iwry United States Department of the Treasury

2 The material contained in these slides has been provided at the request of the 2012 OECD Global Forum on Pensions. This material is not intended to, and does not, represent an official position or views of the United States Department of the Treasury or the United States Government. 2

3 US Private Pension Assets (in billions of US dollars - 2d qtr 2012) Private Sector DB Plans Private Sector DC Plans $2,281b $4,110b Individual Retirement Accts (IRA) $5,229b State/Local Govt Employee Plans $2,993b Federal Govt Employee Plans Total $16,130b = $16.1 trillion $1,517b (figures do not include $2.5 trillion pension fund annuity reserves of life insurance companies) 3

4 61 million participating workers Of 153 million US workers, an estimated 61 million participate in an employer-sponsored retirement plan (i.e., excluding IRAs) under the US private pension system ( 2d pillar ), which is voluntary for both employers and individuals This presentation does not address the first pillar US Social Security system (a mandatory universal pension system) Share of workers participating is greater than half if limited to workers who have greater connections to work force (full-time, full-year, etc.) 4

5 Taxpayer Investment in US Private Pension System -- EET (and some TEE) tax expenditures are estimated at more than $140b/year of forgone revenue -- These estimates based on ten-year time horizon -- Present value estimates are somewhat smaller than ten-year cash flow estimates and are viewed by many as more meaningful 5

6 Role of Automatic/Behavioral Strategies in Retirement Savings See generally, W. Gale, J. M. Iwry, D. John, L. Walker, Automatic: Changing the Way America Saves (Brookings institution Press, 2009) Governmental intervention to influence individual behavior given market failures, such as hyperbolic discount rates, myopia, etc. Role within spectrum of interventions to influence individual saving behavior Mandate (requiring individuals to save) Doing it for them (e.g., nonelective govt or ER contribution) Defaults and other behavioral strategies ( automatic ) Incentives/disincentives (tax treatment; ER match) Laissez faire (letting market work without intervention) 6

7 Role of Automatic/Behavioral Strategies in Retirement Savings Shift from DB to DC.... Really? Shift from employer to employee funding, risk-bearing, responsibility and initiative Instead of shift to employer-funded DC, increasing prevalence of voluntary salary reduction 401(k) model in US (employersponsored DC funded mainly by employee salary reduction with reduced employer or collective risk-bearing) US has not experienced an equal cost shift from volatile DBs to predictable, flexible DCs 7

8 401(k) 1.0 ( Do it yourself ) Early 1980s to late 1990s: Do it yourself style retirement saving (401(k) 1.0 ) 401(k) delivers power of payroll deduction saving (although does not help selfemployed, others without connection to payroll system) Employee salary reduction funds most of benefit; some employer match in 70% of plans 8

9 401(k) 1.0 ( Do It Yourself ) Employee must sign up to participate (must take initiative) Employee, not employer or other collective entity, is left to bear most responsibility for managing risks: Nonparticipation risk: not signing up underfunding/contribution inadequacy risk Investment risk: risk of suboptimal decisions and adverse investment experience inflation risk leakage risk: when to withdraw and where to invest withdrawals longevity risk: timing and amount of spending Employee must take initiative to decide contribution level, investments (unadvised, retail, employer stock), payouts 9

10 401(k) 2.0 Behavioral Strategies Early 1980s to late 1990s: 401(k) Treasury ruling permits/defines/promotes automatic enrollment and other automatic features to begin restoration of pension attributes in evolution of retirement savings plans in US to upgrade 401(k) 1.0 For employees: employer match gives high return on investment For employers: helps meet nondiscrimination requirements under US law For employers/financial providers: inefficient, nonprofitable small accounts? For policymakers: pros: expand participation and improve suboptimal individual investing via asset allocation/diversification, crowd out employer stock; cons: replace employer match? 401(k) 2.0 alternative develops, slowly at first : further regulatory encouragement from Treasury (auto enrollment) & Labor Dept (default investments) 2006: legislation (PPA) spurs further expansion of automatic 401(k)s (preemption of state law, 90-day unwind, illustration of escalation, default investments) 10

11 401(k) (k) 2.0 is rudimentary automatic plan Treasury 1998 ruling used illustration of 3%, balanced fund (no employer stock) auto enrollment of new employees only 3% default contribution no automatic contribution increases (no escalation) default investments emphasize principal preservation more than asset allocation no effect on payout phase 11

12 Early Lessons from Auto 401(k) 2.0 Automatic enrollment increases 401(k) participation from typical 2/3-3/4 range to 90% or more Automatic enrollment is powerful in raising participation of LMI and minorities, who participate less in US Default can hold some employees back at 3% (Madrian et al.) Start higher and/or escalate contributions over time (Thaler & Benartzi, Save More Tomorrow) Employer caution means illustrations tend to become ceilings: 3% default; 10% cap on escalation 5% or 6% defaults don t seem to materially increase opt-outs Financial education/literacy/capability still important: need for individual choices/planning remains even with automatic features 12

13 401(k) 3.0 Since late 2000s, many 401(k) plans have been gradually evolving from 2.0 model toward 3.0 model Automatic enrollment of existing nonparticipants as well as new employees Start at 5% or 6% default contribution level Ask employees who opt out about committing to begin participation next year (Benartzi) Allow auto-enrolled employees to exit retroactively Escalate contributions 1% or 2% a year while emphasizing net increase in takehome pay from raises Employer signal employee contribution target of 10% or more Life cycle/target date/managed account investment defaults prevalent and well accepted, crowding out employer stock Intelligent design of employer match: front-load and stretch 13

14 Limits of Defaults US DBs must offer joint & survivor annuity as default (single life annuity for singles) But more than half of DBs offer lump sum alternative, and annuity default is often declined In hybrid DB/DC plans, most employees elect against default annuity because benefit framed as account balance (putative lump sum) 14

15 Limits of Defaults: Lessons Power of default is fact-sensitive: depends on specific circumstances and timing, including Choice architecture (including dynamic on-line structuring of choices) Power of framing (e.g., hybrids frame benefit as account balance, implying endorsement effect for putative lump sum payout) Cultural factors and implementation details matter Stakes at the decision point accumulation phase easier: gradual contribution and investment of small amounts payout phase challenging: all-or-nothing, now-or-never decision re disposition of entire nest egg 15

16 Limits of Defaults: Lessons Desirability of default also depends on circumstances: blunt instrument except where one size fits all Beware high transaction costs if too high a percentage of individuals will decline Consider richer solution set: more nuanced behavioral strategies in conjunction with default (e.g., required response; easy enrollment; on-the-ground strategies) 16

17 Automatic/Behavioral Strategies for the Payout Phase Automatic preservation: When employee s employment terminates, default in US retirement plans is retention of assets in former employer s plan (until a specified retirement age), unless employee elects to take payment or have plan transfer benefit tax-free to another plan or IRA This is another weak default: employees commonly override this default to take or transfer their benefits 17

18 Payout Phase (cont d) Automatic Rollover: To encourage preservation of benefits in the tax-favored retirement plan system, a plan that receives no explicit election from departing employee who has benefits up to $5,000 can transfer the benefits to an IRA the plan sets up for the employee US DBs are required to offer annuities as default; DCs generally are not, and pay mostly lump sums 18

19 Payout Phase (cont d) Beginning national effort to encourage optional restoration of pensions in private pension system to counteract prevalence of 401(k) lump sums (facilitate life annuities or other predictable lifetime or managed payouts a pension paycheck to replace worker s wage/salary) Treasury Fact Sheet: Helping American Families Achieve Retirement Security by Expanding Lifetime Income Choices (February 2, 2012) 19

20 Payout Phase (cont d) US exploring methods of encouraging annuities, other lifetime retirement income Deferred annuities in DC plans and IRAs to overcome lack of employee demand and related behavioral impediments Get away from all-or-nothing framing by encouraging partial annuitization Choice architecture: instead of asking whether annuity or lump sum, ask how much of each Longevity annuities cover tail risk for perhaps 15-20% of account balance 20

21 Payout Phase (cont d) Possible accumulation annuities in plans to mitigate interest rate risk and encourage participation Embed deferred fixed annuity in default target date/life cycle fund as fixed income investment which pays income in retirement? Invest employer matching contributions in deferred annuities)? Consider 2-year trial or test drive annuities in plans with default continuation for life? 21

22 Expanding Coverage Using Defaults & Other Behavioral Strategies Proposal for automatic IRAs In President Obama s legislative proposals and in Congress as HR 4049 and S Extension of successful automatic enrollment strategy from 401(k)s to those who have no access to retirement plans at work Require employers that do not sponsor plans and have more than 10 employees to automatically enroll employees into payroll deduction saving through employer s payroll system (or require employees to respond) 22

23 Defaults and Other Behavioral Strategies to Expand Coverage Employer is only a conduit for employee s salary reduction contributions to employee s own portable, independent account Use IRAs (individual retirement accounts): universal, portable, personal, tax-favored, limited to $5,000/year, well established in US To avoid competing with or crowding out employer plan system, do not permit employer contributions Small tax credit for participating employers Some parallels to new UK automatic enrolment program, but without employer contributions 23

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