T. Rowe Price Retirement Plan Services, Inc. Best Practices for a Better Retirement Plan: The Case for Automated Services About T. Rowe Price Retirement Plan Services, Inc. T. Rowe Price Retirement Plan Services, Inc., is a recognized industry leader, dedicated to helping employees prepare for a more financially secure retirement. With extensive research and development efforts, we anticipate emerging trends and innovate solutions that transform participant behavior. With worldclass service and award-winning technology and education, we seek to provide participants with the best possible plan experience. In short, our priority is the success of your participants. Defined contribution plans have become the central savings vehicle for millions of workers to achieve their retirement hopes and dreams. But are the plans up to the challenge? During their relatively brief existence, defined contribution plans have evolved to offer better tools and services including participant education, online technology, and investment options to help educate and engage participants. However, despite all the added features, most workers are still not saving enough, and will not have enough, for retirement. Sponsors and providers have the power to improve the situation. By properly implementing automated services, we can help those employees who are unable or unwilling to help themselves prepare for a more secure retirement. To help sponsors move forward, T. Rowe Price Retirement Plan Services, Inc., has developed best practices for automatic service implementation to overcome the hurdles standing between plan participants and sufficient retirement income. This paper is devoted to real solutions. And while we will briefly recap the savings challenges facing today s workers, our overwhelming focus is on the details of implementation necessary to bring about positive outcomes for participants. The problem: Participant savings is still falling short Plans now deliver comprehensive education and communications, providing investing 101 for employees, including guidance and advice services, retirement income replacement data, and savings calculators. Meanwhile, extensive lineups of investment choices and new, prediversified investment choices have evolved, appealing to a broad range of investors. Finally, online technology gives participants instant access to their accounts and simplifies transactions. These features and services were originally conceived to motivate all participants to get involved with their retirement plan and to make it easier for those not inclined toward planning and investing for retirement.
Ironically, however, these services have been most avidly consumed by self-directed employees while not benefiting the majority of the employee audience, the delegators. Flat: Participant salary deferral rates and savings According to the Profit Sharing Council of America, 1 the average participation rate of eligible employees with a balance for 401(k) plans is 81.9%. However, one of the more telling indicators of insufficient savings is the average salary deferral of participants. Sadly, deferral rates have not risen despite the steady dwindling of other sources (defined benefit plans, personal savings) of potential retirement income. Average percentage of pretax salary deferral Among non-highly compensated participants, 1994-2007 Pretax Deferral (Percentage of Pay) 10% 8 6 4 2 0 94 95 96 97 The spectrum of participant behavior: two extremes Financial experts understand that employees are not a homogeneous group. In fact there is a spectrum of participant behavior. At one end of the spectrum, there is the small but knowledgeable group we call self-directed investors. These motivated employees are willing to take time and effort to plan for retirement. They will respond to educational materials and communications. They will take advantage of tools and services. 98 At the other end of the spectrum are the delegators. Representing up to 80% of employees, delegators don t have the time, interest, or motivation to actively plan for retirement. In fact, 53% of workers have not tried to calculate how much they need to accumulate for retirement. 2 This silent majority needs do-it-for-me solutions or it simply is not going to get done. Automatic services help delegators by actually leveraging their inertia in order to create successful retirement outcomes. 99 02 03 04 05 06 07 1 Source: PSCA s 51st Annual Survey of Profit Sharing and 401(k) Plans (2008), reflecting the plan year 2007. 00 01 1 Meanwhile, participant account balances are insufficient. To put it simply, the vast majority of workers are not in a position to fund a lengthy retirement. According to the Employee Benefits Research Institute, 49% of workers saving for retirement report total savings and investments (not including the value of their primary residence or any defined benefit plans) of less than $50,000. 2 Longer lives: Projected years in retirement To put the problem in a more startling perspective, consider that people are living and will continue to live longer lives. Longevity reports indicate that a healthy 65-year old has a 50% or better chance of living past the age of 85, and a 25% chance of living past 92. Imagine trying to stretch the average account balance of $50,000 across potentially 30 years of retirement. The solution: Plans must incorporate automatic services During the past few years, automated services automatic enrollment, automatic contribution increases, and automatic investment have moved from early adoption to mainstream acceptance. And while most in our industry realize the potential impact of automatic services, fewer understand how the specifics of implementation can affect their success or failure. T. Rowe Price s best practices focus on the most critical areas of plan design and offer guidelines for implementing automatic services. We know our recommendations are realistic and achievable. And our experience tells us they are often met with gratitude by many employees. Our model can help sponsors optimize participant savings and potentially create more successful retirement outcomes for their participants. It consists of six practices: 1. Automate your plan get your employees enrolled. 2. Automatically enroll eligible employees at a 6% salary deferral rate. 3. Automatically increase salary deferrals by 2% annually, up to 20%. 4. Implement automated services as opt-out rather than opt-in services. 5. Make target-date funds the default investment for automatically enrolled delegators. 6. Reenroll your nonparticipants annually. 2 EBRI, 2008 Retirement Confidence Survey.
In the past, automated services were often implemented in an overly cautious manner, which may make some of our current recommendations seem bold. But our best practices are designed to help participants accumulate enough savings for a more comfortable lifestyle in retirement and that demands bold action. 1. AUTOMATE GET EMPLOYEES ENROLLED Our first recommendation is simple: automate your plan. Left to their own devices, the vast majority of employees will not meet their savings goals. Make no mistake, employee education is important, and it can lead to positive, incremental change. However, dramatic change is required to meet the challenge of the employee saving deficit. Automation offers that possibility. 2. AUTOMATICALLY ENROLL NEWLY ELIGIBLE EMPLOYEES AT A 6% SALARY DEFERRAL RATE The only way to move employees toward a more secure retirement is to ensure that they save. Automatic enrollment is the first, logical step. Employees are required to take action and make a negative election in order not to participate. Just as inertia often prevents employees from completing the initial paperwork to enroll in the plan, it also prevents employees from making a negative election. Automatic enrollment actually takes advantage of employee inertia. Automatically enrolled participants tend to stay in plans, too. Among plans record kept by T. Rowe Price that automatically enroll participants, over 90% stay in the plan. 3 Automatic enrollment is a great start. But automatic enrollment alone has not been as effective in helping employees save for retirement as sponsors and providers had hoped. Once automatically enrolled, the majority of participants tend to remain at their default salary deferral rate a rate that, if not regularly increased, is often too low for effective long-term retirement saving. Default deferral % in plans with automatic enrollment Percent of Plans 60% 50 40 30 20 10 0 5.8% 1% 13.7% 2% 53.2% Employees will accept a default deferral rate of 6% Historically, sponsors often chose to adopt a safe deferral percentage, such as 3% perhaps assuming that employees would react negatively to a greater percentage deducted from their paychecks. But T. Rowe Price research shows that this assumption is misguided. We surveyed participants to discover their tolerance threshold for being invested at various deferral rates. Our conclusion is that an initial deferral rate of 6% would be acceptable to most participants. Automatic enrollment: impact of default savings rate 3 Default Contribution Rate 6% 5 4 3 2 1 3% 9.4% 10.1% Source: PSCA s 51st Annual Survey of Profit Sharing and 401(k) Plans (2008), reflecting plan year 2007. As the chart above shows, employees will actually tolerate a significantly higher default rate than 3%. Setting a higher default percentage such as 6% does not mean that employees are more likely to opt out. While a small group may decide to decrease their deferral, most will remain at 6% and some may even increase their contributions. 4% Default Increased Decreased Opted Out 3 Source: T. Rowe Price, 9/30/08. 5% 7.9% 0% 20% 40% 60% 80% 100% Percent of Employees >5%
Stretch out the company match Most employees have good intentions to save but fail to follow through by actively choosing to have money taken out of their paychecks. Our research suggests that most employees will not resist if you do it for them. The same inertia that prevents employees from increasing their own salary deferral will also prevent them from choosing to reduce a salary deferral rate set by the employer. Company matching contributions are a powerful savings motivator for participants. Complicated matching formulas can actually discourage higher deferral rates. In addition, many employees save up to, and not beyond, the match. That is why it is important for companies to consider matching 50% of employee contributions up to 6%, rather than 100% of the first 3%. Matching only up to 3% can actually discourage participants from raising their deferral rate. 3. AUTOMATICALLY INCREASE SALARY DEFERRALS BY 2% ANNUALLY, UP TO 20% The single biggest determining factor for adequate retirement savings is how much you need to save. Automatic enrollment at a default 6% salary deferral is an excellent first step, but it is still no guarantee of success for plan participants. Financial experts recommend that employees should save at least 15% of their pretax salary annually in order for their investments to replace 50% or more of their current salary in retirement, adjusted for inflation. Once enrolled, however, inertia prevents employees from ever revisiting their deferral percentage. Working toward the lofty goal of at least 15% in pretax savings never even occurs to most employees. So even those who begin saving at a healthy 6% when automatically enrolled are not likely to meet their savings goals. That is why we strongly recommend regularly and automatically increasing salary deferral rates for employees. Eliminate the pain of deferral increases With an automatic increase service, participant deferral amounts are increased by a small percentage over time. The pain of increasing the deferral percentage is mitigated for participants by the fact that the increase usually happens at around the same time as annual salary increases. Most participants do not even notice the change in take-home pay. But, chances are, it can have a big impact on their account balance at retirement. Automatic increases can be set for any increment sponsors choose. Most choose a very conservative increase of only 1% annually. But T. Rowe Price actually surveyed participants on this topic. When presented with either 1% or 2% increases, it didn t make any significant difference. Virtually the same percentage of participants still intended to utilize the service. As a result, we strongly recommend 2%. Finally, sponsors often wonder at what point automatic increase should cease. Our research indicates that participants, when presented with automatic increases, are willing to save up to a threshold of 20%. 4. IMPLEMENT AUTOMATED SERVICES AS OPT-OUT Our proprietary plan research on auto-increase reveals a dramatic difference in participant adoption when the autoincrease service is offered as an opt-in service versus opt-out. When offered as opt-in, our findings shows that less than 5% of eligible participants sign up; however, when the service is offered as an opt-out approach, over 70% of eligible participants utilize the service. 4 As evidenced by this research, opt-out implementation can be an impactful way to put participants inertia to work for them. Also, our research shows that once defaulted into an investment allocation, such as a target-date fund, the vast majority of participants are likely to stay there and not select other investment options for example, switch to a more conservative but potentially ill-advised option such as a stable value fund. Most of these plan participants are content to have investment decisions made for them. 5. USE TARGET-DATE FUNDS FOR THE DEFAULT INVESTMENT Make the default investment option sensible Historically, automatic enrollment has been plagued by poor default investment choices. Automatically enrolled employees were invested in very conservative stable value or money market investments. Sponsors, fearing dramatic market loss, felt that this was a prudent default investment. 4 Source: T. Rowe Price, 9/30/08.
Ironically, stable value and money market investments may not be the most prudent choice. The risk of this type of investment is that earnings will most likely not keep pace with inflation. A participant invested in a stable value fund or money market fund for decades may be astonished at the small size of his or her nest egg, and then blame the sponsor for poor fiduciary oversight. Target-date investments help to avoid that pitfall. They provide professionally managed investment portfolios that rebalance the underlying investment allocations to a more conservative mix as the funds near their expected target dates and in the case of the target-date funds offered by T. Rowe Price beyond those dates. In general, the vast majority of participants would rather choose this type of premixed portfolio than a stable value or money market investment option traditionally used as a default investment choice by many plan sponsors. Sponsors should be aware when evaluating these investment products that not all target-date funds are the same. T. Rowe Price s Retirement Funds, for instance, feature a higher allocation in equities than many other target-date funds. These funds are managed based on life expectancy rather than a retirement date. Retirement Funds maintain an equity allocation based on a 30-year time period past the age of 65 (as demonstrated by the chart below). T. Rowe Price designed its target-date funds recognizing that life expectancy tables indicate many retirees will need money longer in retirement than in past years. Participants that use our Retirement Funds to save for retirement can also use these same funds while they are in retirement. Continue to serve self-directed investors Our best practice suggestions while focused on the majority of participants who are delegators do not discount the needs of self-directed participants. It s important for plans to offer a well-researched menu of stock, bond, and money market investments. Plans should also continue offering education and advice services for self-directed investors seeking validation or specific investment recommendations. Retirement Funds allocation adjustment More Conservative 100% Retire 100% 80 80 60 60 40 40 Stocks 20 30+ 25 20 15 10 5 5 10 15 20 25 30+ Years to Retirement Years Past Retirement 20 Bonds Short-term fixed income There are many important factors to consider when planning for retirement, including your expected expenses, sources of income, and available assets. Before investing in a Retirement Fund, be sure to weigh your objectives, time horizon, and risk tolerance. These funds invest in many underlying funds, which means that they are exposed to the risks of different areas of the market. Investors should note that the higher a fund s allocation to stocks, the greater the risk. Call 1-800-638-7890 to request a prospectus, which includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.
The cumulative effect: Automatic enrollment + automatic increase + automatic investment Automatic services should be implemented systematically, as a package, to generate maximum impact and effectiveness for participants. The following chart illustrates how automatic enrollment, automatic investment, and automatic increase can build on one another to help employees reach their retirement savings goals. Ultimately, automatically enrolling a participant at 6% in an investment option with an annual return rate of 8% and automatically increasing the default percentage annually by 2% up to 20% can produce nearly $2.2 million of retirement assets. The impact of automatic enrollment with varying deferral rates $2,500,000 $2,225,000 $2,208,045 $2,000,000 $1,750,000 $1,500,000 Line 1 Investment at 3% deferral rate, with annual return of 3% (4% replacement income) Assets $1,250,000 $1,000,000 $750,000 $775,752 Line 2 Line 3 Investment at 3% deferral rate, with annual return of 8% (11% replacement income) Investment at 6% deferral rate, with annual return of 8% (23% replacement income) $500,000 $250,000 $387,876 Line 4 Investment at 6% deferral rate, with annual return of 8% and with 2% automatic increases up to 20% (65% replacement income) 0 $147,728 30 35 40 45 Age 50 55 60 65 This chart is for illustrative purposes only and does not represent a particular investment in your plan. Assumptions: Salary of $50,000 annually adjusted to anticipate a 3% inflation rate. Line 1 illustrates a participant automatically invested at a default deferral rate of 3% in an investment with an annual return rate of 3%. Line 2 illustrates another participant invested in an investment option with an annual return rate of 8%. Now, compare these first two lines to Line 3 representing an employee automatically enrolled and invested in an investment option with an annual return rate of 8% at a 6% deferral rate. The resulting disparity is dramatic, representing a difference of approximately $625,000 dollars when compared to the traditional industry approach of defaulting participants at 3%. Finally, Line 4 represents the cumulative effect of our best practices. This example combines automatic enrollment at 6% and automatic deferral increases that boosts salary deferrals by 2% each year until topping out at 20%. Assuming the investment earns 8% a year, the cumulative effect of these services together is clearly more profound than the effect of each individually: This retiree could have over $2.2 million saved for retirement, representing over $88,000 in replacement income during the first year of retirement or approximately $31,000 in today s dollars. Assumes an inflation rate of 3% both for salary increases and to calculate the present value of the first year s retirement income. When a participant retires, it assumes his/her initial withdrawal amount will be 4% of the balance at that time and increases each year to offset the impact of inflation.
6. REENROLL ELIGIBLE NON- PARTICIPANTS ANNUALLY Enrolling in a retirement savings plan is usually emphasized at only two points: on an employee s first day of employment, or on the first day of eligibility. If the appropriate paperwork is not completed, or the employee does not enroll online, the subject is rarely revisited. Our recommendation represents a break with this traditional practice. Instead, retirement plans should be treated much like other benefits, such as health care, which employees must revisit once a year during an open enrollment period. Retirement benefits should not be any different. During this same period, nonparticipants should be automatically reenrolled. By encouraging employees to revisit the issue annually, sponsors will feel confident that they have made every effort to encourage all of their employees to confront the challenges of retirement savings. The guidelines for automatic reenrollment should be similar to those used for automatic enrollment. Those who do opt out will not be off the hook. They will be reenrolled annually and should continue to receive communications and education urging them to participate in the plan. The key is to keep the issue front and center. It is especially important to automatically reenroll younger employees those who have the most to gain from the power of time and compounding. These employees often choose not to participate for fear of diminishing their take-home pay. Automatic reenrollment could boost their participation and put them on track. DO WHAT IS BEST FOR ALL PARTICIPANTS To truly move the needle for participant savings, defined contribution plans must be designed and implemented with one end goal in mind: to generate sufficient retirement income for employees. Automated services are essential to achieving that goal. Employees are ready According to the Employee Benefits Research Institute, a majority of employed workers favor automatic enrollment (69 percent), automatically increasing the percentage of salary contributed when an increase in pay is received (65 percent), and automatically investing contributions for employees (59 percent). Plan participants and non-participants are equally likely to favor each of these automatic features. 5 In 2008, T. Rowe Price saw participation rates increase from 52.5% without automatic enrollment to 81.6% with automatic enrollment a 55% improvement. Sponsors and providers must take the lead Communications campaigns, advice services, and online tools are still essential and will continue to have their place, particularly for self-directed investors. But it is time to get back to basics to focus on participation, asset allocation, and a steady increase in salary deferrals. Consider our six basic, best practices: 1. Automate your plan get employees enrolled. 2. Automatically enroll eligible employees at a 6% salary deferral rate. 3. Automatically increase salary deferrals by 2% annually, up to 20%. 4. Implement automated services as opt-out rather than opt-in services. 5. Make target-date funds the default investment for automatically enrolled delegators. 6. Reenroll your nonparticipants annually. By focusing our attention on these key areas, we can help delegators the vast majority of employees to achieve a financially secure retirement. They won t get there without our help. 5 EBRI, 2006 Retirement Confidence Survey.
T. Rowe Price Investment Services, Inc., Distributor. Rev. 12/08 04929-06 79895