DC Investment and Choice: Lessons from U.S. 401(k) Plans

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1 DC Investment and Choice: Lessons from U.S. 401(k) Plans Alicia H. Munnell Pension Finance and Economics Seminar Institute of Actuaries, London February 10, 2006 Pay-as-you-go pension costs are rising everywhere. Ratio of the Population age 65 and over to the Population Age 15-64, Belgium France Italy Netherlands Switzerland US Canada Germany Japan Sweden UK Source: United Nations Population Division World Population Prospects: The 2004 Revision Population Database. 1 Rising public pension costs reflect increasing life expectancy 24 Life Expectancy of Males at 65, Years Belgium Canada France Germany Italy Japan 12 Netherlands Sweden UK US Sources: Organisation for Economic Co-operation and Development Society at a Glance: OECD Social Indicators Edition. Table HE1. Life Expectancy; and United Nations Population Division World Population Prospects: The 2004 Revision. File 5, Obtained via

2 and very low fertility rates. Fertility Rates, Belgium France Italy Netherlands UK Canada Germany Japan Switzerland US Source: United Nations Population Division World Population Prospects: The 2004 Revision Population Database. 3 Problem is less serious in U.S. and U.K. because benefits are low. Gross Replacement Rate at Average Earnings, % 68% 65% 58% 53% 5 46% 43% 41% 39% 37% 2 Italy Netherlands Sweden Switzerland France Japan Germany Canada Belgium US UK Source: Organisation for Economic Co-operation and Development Ageing and Pension System Reform: Implication for Financial Markets and Economic Policies. 4 Rising pay-as-you-go costs have produced a shift to private funded plans. Percent Total Investments of Private Pension Funds as a Percent of GDP Switzerland Netherlands US UK Canada Japan Sweden Belgium Germany Italy Note: Switzerland data are 2002, not Sources: Ignazio Visco Ageing and Pension System Reform: Implications for Financial Markets and Economic Policies; and Jean- Marc Salou and Juan Yermo (Editors) Pension Markets in Focus. OECD Newsletter Issue

3 Within private plans, U.S. and Italy lead in shift to defined contribution. Percent of Pension Participants in DC Plans, Italy US Sweden France UK Canada Note: Canada data is for Data refers to RPP plans. Sources: Jean-Marc Salou and Juan Yermo "Pension Markets in Focus." OECD Newsletter Issue 1; and Silvana Pozzebon "The Future of Pensions in Canada." Pension Research Council Working Paper Japan Germany Netherlands Belgium 6 The U.S. provides a cautionary tale on how choice affects DC outcomes. 7 U.S. retirement income system is a threelegged stool. Retirement Income Social Security Private Pensions Individual Saving Defined Benefit Plans Defined Contribution - 401(k) - Plans 8 3

4 The private pension system plays an important role in the United States. Percent of Non-Earned Retirement Income of those 65 and older by Source, 2004 Assets, 17.2% Other, 3.4% Social Security, 52.2% Pensions, 27.2% Source: Bureau of Labor Statistics Current Population Survey and Author's calculations. 9 But private pensions have changed; most now rely on individual accounts 401(k) plans. Percent of Private Sector Wage and Salary Workers with Pension Coverage by Type of Plan from Form 5500, Defined Benefit Only Defined Contribution Only Both Source: U.S. Department of Labor Private Pension Plan Bulletin, Abstract of 1999 Form 5500 Annual Reports and author s updates. 10 Why did private pensions change? Shift away from large manufacturing firms Employees like them Benefits are portable Control over investments Employers like them Smaller contributions Employee bears risk Cheaper to administer 11 4

5 In theory, steady 401(k) contributions could produce a lot of wealth. Simulated Defined Benefit and 401(k) Plan Wealth at Age 62 $ 400,000 $ 350,000 $ 300,000 $ 303,560 $ 353,408 $ 250,000 $ 200,000 $ 150,000 $ 100,000 $ 50,000 $ 0 Defined benefit plan 401(k) plan Source: Alicia H. Munnell and Annika Sundén Coming Up Short: The Challenge of 401(k) Plans. Brookings Institution Press. 12 But, in practice, actual accumulations fall short. 401(k)/IRA Actual and Simulated Accumulations, by Age Group, to 44 $24,000 $58,503 Actual Simulated 45 to 54 $37,000 $155, to 64 $42,000 $289,073 $0 $50,000 $100,000 $150,000 $200,000 $250,000 $300,000 $350,000 Wealth Source: Alicia H. Munnell and Annika Sundén Coming Up Short: The Challenge of 401(k) Plans. Brookings Institution Press. 13 Why? Because 401(k) plans shift all decisions & risks to the individual. Participation Contributions Initial asset allocation Company stock Asset allocation over time Cashing out when changing jobs Withdrawing funds in retirement 14 5

6 Despite improvement, 26 percent of eligible workers fail to participate. Percent of Eligible Workers Not Participating in 401(k) Plans 5 45% 35% 25% 2 15% 5% 43% 35% 25% 26% Sources: Bureau of Labor Statistics Current Population Survey; and Board of Governors of the Federal Reserve System Survey of Consumer Finances. 15 Only 8 percent of 401(k) participants contribute the maximum. Percent of Participants Making Maximum Contributions, by Earnings % 12.6% 8.4% 2.5% 0.1% 0.5% Less than $ 20,000 to $ 40,000 to $ 60,000 to $ 80,000 to $ 100,000 and All $ 20,000 39,999 59,999 79,999 99,999 mo re Earnings Source: Authors calculations based on Board of Governors of the Federal Reserve System Survey of Consumer Finances. 16 More than half of 401(k) participants fail to diversify. Percent of Participants by Equity Holdings No equity, 31.6% Diversified, 47.4% Virtually all equity, 21. Source: Sarah Holden and Jack VanDerhei Employee Benefit Research Institute Issue Brief 285: 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in

7 401(k) participants over-invest in company stock. 35% 25% 2 15% 5% Company Stock as a Percent of Total Assets by Size of Plan, % 10.1% 1.2% Less than 1,000 1,000 to 4,999 5,000 or more Number of Employees Source: Profit Sharing/401(k) Council of America Forty-Eighth Annual Survey of Profit Sharing and 401(k) Plans. 18 Bad investment decisions could be result of too much choice. Experiment with Two Jam Tasting Booths % Booth with 24 flavors Percent of shoppers attracted Booth with 6 flavors Percent of attracted shoppers that bought jam Source: Sheena S. Iyengar and Mark R. Lepper When Choice is Demotivating: Can One Desire Too Much of a Good Thing? Journal of Personality and Social Psychology 79(6): (k) participants don t re-balance their accounts. Equity share Suggested and Actual Change in Equities as Percent of Plan Assets for TIAA- CREF Participants, % 5% -5% 9.2% - -15% -9. Rule of thumb Actual Source: John Ameriks and Stephen P. Zeldes "How Do Household Portfolio Shares Vary with Age?" Working Paper Employee Benefits, Compensation, and Pension Law 2 (22): November 29. TIAA-CREF Research Institute. 20 7

8 Most 401(k) participants cash out when they change jobs Percent of Participants Who Cashed Out Lump-Sum Distributions 55.2% Percent of Lump-Sum Dollars Cashed Out % 2 Source: Authors calculations based on Board of Governors of the Federal Reserve System Survey of Consumer Finances. 21 And people don t annuitize. Immediate Annuity Premiums as Percent of Total Annuity Premiums % 4.5% 4.3% 4.2% 4.6% 5.6% 5.1% 5.2% 5.2% Source: LIMRA International The 2001 Individual Annuity Market: Sales and Assets and updates from LIMRA International. 22 So how could these accounts work better? Limiting choice would help, but options increase. Median Number of Investment Options Offered, Source: Fidelity Investments Building Futures Volume VI: How Workplace Savings are Shaping the Future of Retirement. 23 8

9 Putting them on auto pilot is also important Participation Rate with and without Automatic Enrollment 85.9% 48.7% P articipation rate without automatic enrollment P articipation rate with automatic enrollment Source: Brigitte C. Madrian and Dennis F. Shea "The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior." Quarterly Journal of Economics 116(4). 24 To date, more than 30 percent of large plans have adopted automatic enrollment. Percentage of Plans with Automatic Enrollment by Plan Size (Plan size by number of participants) % % % 1,000-4, % 5, % All Plans 10.5% 5% 15% 2 25% 35% Source: Profit Sharing/401(k) Council of America th Annual Survey of Profit Sharing and 401(k) Plans. 25 But default contribution typically 3 percent and default investment typically low yielding. Default Deferral Percentage in Plans with Automatic Enrollment 1% 2% 3% 4% 5% >5% Default Investment Option for Automatic Deferrals Stable value fund Money market fund Balanced fund Professionally managed account Lifestyle fund Other Source: Profit Sharing/401(k) Council of America th Annual Survey of Profit Sharing and 401(k) Plans. 26 9

10 Need a comprehensive solution to improve 401(k) outcomes. Problem Too few participants Too low contributions Lack of diversification Too much company stock No re-balancing Too much cashing out Too little annuitization Default Automatic enrollment Automatic increase in default rate Automatic asset allocation Automatic allocation Life-cycle funds Automatic rollover Automatic annuitization 27 Conclusion: Rising public pension costs lead to search for alternatives. Funded individual accounts relieve government budget. U.S. experience shows too much choice produces too little retirement income