Morgan Stanley 401(k) Consulting Sam Valeo, CFP, CIMA, CRPS, 401(k) Consulting Director A Healthy Retirement Plan Helps Promote a Healthy Company: How to Get There By Sam Valeo, CFP, CIMA, CRPS We live in a world where the 401(k) plan has become the main source of retirement income for most Americans. This puts significant pressures on plan sponsors and plan participants. As a major portion of the workforce draws closer to retirement, the ever increasing challenge for plan participants is learning how to invest, figuring out how much to save, and recognizing what their plan offers so retirement will be an enjoyable adventure. For plan sponsors the challenge is to give their employees an effective plan and the proper tools to lead them to participate and then to make sensible investment and deferral decisions. Most expect to work longer; many not prepared Charged with accumulating the bulk of their retirement income, participants may be ill prepared for the task. Furthermore, worker confidence in having enough money to enjoy a comfortable retirement remains low. As the accompanying chart illustrates, the Employee Benefit Research Institute (EBRI) in its 2013 Retirement Confidence Survey found that 28% of workers are not at all confident they will have enough money to live comfortably in retirement. Only 13% of survey respondents said they are very confident, and 38% indicated they were somewhat confident. Surprisingly, these findings emerged as the U.S. stock market recorded robust gains and hit record-high levels. 1 1 Source: Employee Benefit Research Institute and Mathew Greenwald & Associates, Inc., 1993-2013 Retirement Confidence Surveys, 1
As a result, many workers are adjusting their expectations about retirement. Twenty-five percent said the age at which they expect to retire has changed in the past year, and of those, the vast majority (88%) reported their expected retirement age has increased. The number of workers who expect to retire after age 65 has increased, from 11% in 1991 to 36% in the 2013 EBRI survey. In addition to the burden working longer places on employees, there are also significant consequences for the company sponsoring these plans over the long run. An aging workforce may dampen overall productivity while generating significantly higher costs. For example, the average annual cost of health and disability insurance for a 30-year-old employee is $2,592. For employees age 60 and older, the average cost increases 277%, to $9,762 a year. 2 Plan sponsors need to take charge A key challenge for plan sponsors and providers is to facilitate retirement readiness among employees, so current and future plan participants can retire on their terms. It s a responsibility that s evolved over the years, as many companies replaced their employerfunded defined pension plans with employee-funded 401(k) plans. Unlike pension plans, 401(k) plans require active employee participation. Ultimately, it s in the employer s best interests to encourage such involvement, as it helps build a workforce that understands the importance of retirement planning and saving. According to a study by Deloitte, most plan sponsors (nearly 66%) believe it s their responsibility to take an interest in their employees retirement savings plans. 3 Yet, fewer than one in five has done much about it. Retirement plan consultants and advisors can be a resource for plan sponsors to design effective solutions to better need the retirement readiness needs of their participants. For example, at Morgan Stanley we help employees achieve retirement readiness by helping plan sponsors: Recognize the extent of their plan ability to replace income Customize effective education programs Guide participants and employees to income replacement Design effective plan features and incentives 2 NCCI Holdings: Workers Compensation and an Aging Workforce, 2012 3 Deloitte Annual 401(k) Survey Retirement Readiness, 2010. 2
Knowing the plans income replacement; the first step Any company that sponsors a defined benefit plan knows what a funding ratio is and if they are underfunded, by how much. With the adoption of 401k plans as the sole retirement benefit offered, very few companies know if their employees will have enough to retire. Conducting this analysis will provide: Overall average income replacement ratio of all plan participants Overall percentage of participants on track and not on track for retirement Further breakdown of participants within each income replacement ratio range Percentage of participants on track and not on track by salary and age Our experience shows that conducting an income replacement analysis for the 401(k) plan, in a sense finding the funding ratio of their plan, provides an insight into where to target solutions. Meetings, education help if structured properly While there is no doubt education is important, the industry has spent literally millions of dollars on education and the results have been less than optimal. We believe ongoing education and assistance can help participants meet their retirement goals and achieve success if the material is appropriately designed for the audience. A recent report on financial behaviors, in 168 papers covering 201 prior studies, confirms financial education is basically ineffective if it is not elaborated or acted upon soon afterward 4. We have found the most effective method for helping employees is individual counseling sessions. These meetings provide employees the opportunity to meet with a retirement planning professional and learn about implementing an action-oriented retirement plan. Plan providers are often boastful of their educational tools, including online retirement calculators, however we found these tools are more useful if employees are informed first where to find them and secondly how to use them. Recently, we spent three days at a Chicago-based manufacturing company, meeting individually with employees about their retirement goals and their 401(k) plan. Among those who participated in the one-on-one sessions, more than 80% took action by either increasing their contribution or joining the plan. These steps encourage participants to make a retirement plan designed to achieve long-term success. 4 4 Fernandes, Lynch, Netemeyer, Financial Literacy, Financial Education and Downstream Financial Behaviors October 8, 2013. 3
Focus on income replacement, not account balances A larger educational issue involves shifting employees focus from account balances to income replacement. For years, many providers have focused on building employees 401(k) account balances. That s focusing on the wrong target. Instead, participants need to focus on replacing income through their 401(k) plans. Based on age, asset allocation, risk tolerance, and the employee s deferral rate, we must help participants craft a plan to replace at least 75% of their working income in retirement. We also need to show them alternatives, such as what a small deferral increase or a shift in the asset mix, may do to change their estimated future income, as the accompanying chart illustrates. In this example, a hypothetical 43-year-old employee earning $35,232 per year would need a plan to generate at least $26,424 annually (today s dollars) in retirement. With a current retirement account balance of $65,252 and the existing deferral rate, this employee will fall short of the 75% income needed to retire comfortably. Design a plan with auto enroll Although participant education is important, nothing may be as crucial as plan design. And in terms of plan design, nothing may be as important as implementing an automatic enrollment feature. Only 38 percent of plan sponsors use this feature, and among those that do, the vast majority only auto enrolls new hires, excluding their long-term employees. 5 Furthermore, most plans have a default deferral rate of 3%, meaning most plan sponsors are effectively endorsing a savings rate that cannot generate a successful retirement nest egg. And because most plan sponsors don t auto-escalate savings, their participants may face a significant retirement shortfall. 5 Profit Sharing Council of America 53rd Annual Survey, 2010. 4
To help ensure plan participants are prepared for retirement, consider implementing automatic enrollment for all workers, not just new hires. Also, establish a deferral default rate that can enable participants to accumulate a substantial nest egg. For example, consider a minimum deferral of 6% that automatically rises to 10% over a four-year period. Additionally, the plan should consider directing participants who don t select specific investments into lifecycle or balanced funds. The right matching formula can help drive results Including an employer match in the plan is generally a powerful motivator in boosting participant contributions. With an employer match, we have found: Participants contribute more when employers stretch target through matching contributions that is, they(?)present the matching formula in formats that encourage greater employee participation. Through stretch targeting, employers can encourage better savings behavior from their employees without increasing the plan costs. For example, offering a 25% match on up to 8% of pay can result in greater employee participation rates and the same employer costs as offering a 100% match on 2% of pay. The accompanying chart illustrates this 6. Today, retirement can represent a meaningful new stage of life. Americans tend to live 25, 30, even 35 years in retirement. Their health is better, and they are able to stay active longer. By working with an experienced, proactive 401(k) advisor, plan sponsors can help their employees meet the challenges of retirement planning and ultimately enjoy a comfortable retirement lifestyle. Mr. Valeo is 401(k) Plan Consulting Director for Morgan Stanley in Oak Brook, Illinois. He can be reached via email at Sam.Valeo@morganstanley.com and by phone at (630) 203-6184. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not fiduciaries (under ERISA, the Internal 6 Source: The Principal Financial Group. Analysis based on 6,560 contacts that showed a stated match formula. Total contribution percentage includes participant contribution and employer match (as of 12/31/2009). 5
Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a retirement plan or account, and (b) regarding any potential tax, ERISA and related consequences of any investments made under such plan or account. 6