Adopting Automatic Enrollment in the Public Sector A Case Study

Adopting Automatic Enrollment in the Public Sector A Case Study By Robert L. Clark and Joshua M. Franzel

A version of this case study was published on the Retirement Made Simpler Web site, available at www.retirementmadesimpler.org. Between 1998 and 2000, Internal Revenue Service (IRS) rules began to allow for new and current privatesector employees to be automatically enrolled in a defined contribution retirement savings account offered by their employer primarily 401(k) plans. These rules, combined with passage of the Pension Protection Act of 2006, have led to an increase in plans automatically enrolling participants, from 1 percent of all plans in 2004 to 16 percent in 2009, with this 16 percent of plans accounting for almost half of all plan participants nationwide. 1 The private sector continues to view automatic enrollment as an important way to encourage employees to save for retirement, a feature that is also receiving increased attention in the public sector. As of 2010, 20.9 percent of respondents in a survey of state and local governments reported that their governmental unit has instituted some form of automatic enrollment feature in its defined contribution retirement plan. 2 In 2010, a few states adopted an automatic enrollment feature in one of the defined contribution plans they offer. One of these is South Dakota. The Supplemental Retirement Plan (SRP) is a 457, taxdeferred savings option offered to members of South Dakota Retirement System (SDRS). The SRP allows SDRS participants to save for retirement while postponing the payment of income tax on both contributions and earnings until these funds are withdrawn. All members of SDRS have the option of participating in the SRP, which is managed by SDRS through a contract with a third party. Prior to July 2009, newly hired public employees were given the option of completing enrollment forms that required them to specify a monthly contribution and an investment choice. If the worker did nothing, he or she was not enrolled in the plan, and no money was withheld. Subsequently, workers could decide to begin making contributions at any time during their tenure. As of 2010, 20.9 percent of respondents have instituted some form of automatic enrollment feature in their defined contribution retirement plans. In 2008, the South Dakota Legislature enacted legislation that shifted the terms of employment in regards to participating in the SRP. Now, instead of being out of the program unless they actively chose to participate, newly hired workers will be automatically enrolled in the SRP with a minimum contribution and a default investment option. Workers could choose to opt out of the system and stop contributions within 90 days of their first pay date and receive a full refund of their contributions plus associated gains or losses. RETIREMENT BENEFITS FOR PUBLIC EMPLOYEES Assessing the importance of automatic enrollment in the SRP requires knowledge of the total package of retirement benefits offered to public employees. 3 The need for additional retirement saving through supplemental retirement plans depends on the generosity of other retirement benefits. All public employees in South Dakota are eligible for coverage by at least four retirement plans. The mandatory plans are Social Security, Medicare, and SDRS, and the fourth is the optional SRP plan, which allows individuals to contribute pre-tax dollars. Additionally, retirees of the state and the Board of Regents are also eligible for coverage under the state health plan. SDRS, which is a defined benefit plan, is financed by employer and employee contributions and provides a benefit equal to about 50 percent of final salary for a retiree with 30 years of service. Retired state and Board of Regents employees are allowed to remain in the state health plan up to age 65 by paying the specific premium. South Dakota Retirement System. The SDRS benefit structure has been increased 10 times over the past three decades, reaching 1.7 percent in 2008. As a result, the normal cost of the SDRS rose from 7.1 percent of payroll in 1978 to 12 percent in 2006. In 2008, both the employee and employer contributed 6 percent of salary to the system. Participation in SDRS has grown substantially, from 23,500 public employees in 1974, of whom 2,900 were beneficiaries, to 71,434 in 2008, of whom 19,321 are retirees and beneficiaries. The system has been reasonably well funded throughout its history. The auditors report of the financial status of the retirement fund for the year ended June 30, 2008, indicated February 2011 Government Finance Review 43

6.2 percent of pay. Thus, employees pay 12.2 percent of salary for retirement benefits, and employers contribute an equal amount. that the plan had liabilities of $6.98 billion and assets of $6.78 billion, or an unfunded liability of $192 million. The plan was 97.2 percent funded, and the unfunded liability represented 14.1 percent of covered payroll. SDRS has several unique features that affect the benefits workers can expect. First, employer and employee contributions are fixed in the statutes as a percentage of salary. If these funds are not sufficient for the plan to maintain a funding ratio of at least 80 percent of promised benefits, benefits must be reduced. Second, the plan provides an automatic cost of living adjust (COLA), which is also applied to deferred vested benefits of terminated employees. Third, workers leaving public employment with less than three years of service receive a refund of their own contributions and 50 percent of the employer contributions, plus interest, using the 90-day Treasury bill rate. Workers with more than 3 years of service receive their own contributions and 85 percent of the employer contributions, plus interest, if they request a lump sum distribution. (Until recently, vested terminated workers received 100 percent of employer contributions with interest upon leaving the system.) Public employees in South Dakota are also covered by Social Security. Worker and employer each contributes Retiree Health Insurance. Retired State of South Dakota and Regent employees who are receiving a benefit from the SDRS are eligible to participate in the state health insurance plan. An individual must be at least 55 years old and have three years of service. Retirees who are not yet 65 and thus do not qualify for Medicare are covered by the same health plan as active employees; however, retirees must pay a premium, and participation in the plan is terminated when retirees reach age 65 and qualify for Medicare. Future retirees premiums increase at a rate equal to the trend rate for health-care costs. Coverage is also extended to dependents for an additional premium. Retirees can compare the cost of the premium to remain in the state plan to other types of insurance that they might be able to purchase. The actuarial report of the retiree health plan assumes that 70 percent of employees will elect to participate in the state health plan when they retire. In planning for retirement, public employees need to consider the cost of remaining in the state health plan from retirement until age 65, the cost of Medicare premiums from age 65 until death, and the cost of any supplemental or Medigap coverage. A key factor in retirement planning is whether retirement income from SDRS and Social Security is sufficient to allow a retiree to continue their standard of living and to pay for these types of health insurance. Supplemental Retirement Plan. The retirement benefit earned by South Dakota public employees plus the retirement benefit from Social Security will provide a combined retirement benefit equal to approximately 85 percent of final earnings for most career employees with 30 or more years of service. This level of retirement income is approximately the replacement rate that would allow a worker to maintain his or her living standard in retirement. However, retiring public employees in South Dakota average 20 to 25 years of service. Workers with the average length of service will typically have replacement rates from Social Security plus their SDRS pension of about 75 percent of final pay. To provide the additional retirement income needed to maintain workers pre-retirement level of consumption, the SDRS developed a 457 supplemental retirement saving plan. 44 Government Finance Review February 2011

Exhibit 1: Effect of New Policy on Enrollments and Opt-Outs New Enrollments State Employees Local Employees Opt-Outs Received During the Month July 2009 106 89 17 0 August 2009 190 90 100 8 September 2009 256 67 189 13 October 2009 141 49 92 34 November 2009 126 71 55 22 December 2009 135 84 51 11 January 2010 124 77 47 6 February 2010 94 43 51 8 Totals 1172 570 602 102 Under the 457 plan, which South Dakota established in have been no opposition to adopting automatic enrollment 1987, state employees were allowed to make pre-tax contributions to the SRP to augment their retirement income. After tatives, government employers, or policymakers. by any of the stakeholders including workers, their represen- considering national trends in savings rates and the need for After the act became effective on July 1, 2009, automatic additional retirement income for participants in the South enrollment applied only to newly hired employees. At Dakota retirement plan, the SDRS decided to increase the this time, individual agencies and public employers were prominence of the 457 plan. Changes included incorporating allowed to choose whether they would adopt the automatic the need for additional personal saving through the supplemental plan into the SDRS mission statement and adopting enrollment feature; individual public employer units had to adopt a resolution to elect to include this feature. 5 automatic enrollment for newly hired employees. 4 Beginning in January 2009, six months before automatic Before 2009, newly hired workers had to elect to participate in the SRP if employees did nothing, they were not enrollment could go into effect, the SDRS began promoting the feature to the units comprising the South Dakota enrolled in the plan. In 2008, the legislature passed a bill Retirement System. It sent letters and postcards to unit managers announcing the adoption of automatic enrollment and authorizing automatic enrollment so newly hired employees would be enrolled in the SRP at a minimum contribution of describing the process needed for the government unit to $25 per month. participate in the system. Movement to AUTOMATIC ENROLLMENT LEGISLATION AND IMPLEMENTATION The SDRS developed recommendations for automatic enrollment that were incorporated into legislation submitted to the legislature. The system was concerned about the low participation rate in the supplemental plan, low observed savings rates, and the need for most retirees to have a third source of retirement income in addition to their SDRS benefit and Social Security. There seems to In planning for retirement, public employees need to consider the cost of remaining in the state health plan from retirement until age 65, the cost of Medicare premiums from age 65 until death, and the cost of any supplemental or Medigap coverage. adopt automatic enrollment has been relatively slow, and as of March 2010, 40 governmental units had agreed to allow automatic enrollment to take effect; however, the adopting units were some of the larger public employers. According to the SDRS, this gradual adoption has been useful, as the process of introducing automatic enrollments requires each unit to restructure its payroll system to allow for automatic deduction of contributions. The money is sent from each unit to the SDRS, February 2011 Government Finance Review 45

which then sends it on to a vendor that deposits the funds in the employees individual accounts. While the state law does not require an employer match, individual units can provide an employer match if they choose. The bill specified the maximum contribution that would be required for individuals who were automatically enrolled into the SRP and provided for a 90-day period during which employees could opt out the plan and have contributions returned. During this 90-day period, employee contributions are maintained in a money market fund so there will be no loss in capital value. Workers who seek to opt out must file a written statement with SDRS asking to suspend new contributions and to have their contributions and associated gains or losses returned. To begin the opt-out process, the participant must contact the plan provider by telephone, at which time they receive information about their choices and the value of continuing contributions. The employees who choose to opt out of the SRP receive a refund for all contributions and associated returns with no penalties. After the 90-day waiting period, all funds are shifted to the default investment in the SRP. The state investment officer was given authority to select the default investment fund for individuals who were automatically enrolled and who did not specify an investment option. The current default investment is an appropriate target date or lifecycle fund. Participants can move their account balances at any time to any of 11 target date funds or 15 other investment options. In South Dakota, the SRP is considered to be an integral component of retirement benefits and employees are encouraged to incorporate the 457 plan into their own retirement plans. An interesting and unique aspect of this plan is that when workers retire, they can take the funds in the 457 account and purchase a higher retirement benefit from the SDRS. This provides a convenient method of converting the account balance into a life annuity that will receive the same COLA as the SDRS benefit. POLICY ISSUES AND POLITICAL DEBATES The South Dakota State Legislature had several main reasons for passing automatic enrollment legislation: the savings rates of certain demographic groups; the uncertainty surrounding the future of federal entitlements; and changes to Keys to Success 1. SDRS staff worked with consultants, the plan provider, employee groups, and other stakeholders to develop a policy that would be broadly acceptable. This, combined with a general agreement that increased retirement savings were needed, led to unanimous votes in both houses of the legislature to adopt automatic enrollment. 2. The policy applies only to new employees, thus eliminating the likelihood that existing employees would see their takehome pay decreased and reducing the odds that employee groups would oppose the measure. 3. Questions concerning the legality of withholding wages without workers permission were eliminated by the legislation, thus reducing the possibility that the new policy would be challenged in court. 4. The new policy did not require any new state funds, so it did not affect the budgetary status of the state and was also adopted with no costs to the state retirement plan. This no-cost policy also reduced concerns of policymakers and taxpayers. 5. The required contribution is relatively small. The hope is that once workers are participating in the plan, they will continue to contribute to the SRP throughout their careers and eventually increase their monthly contributions. 6. Workers have 90 days to opt out of the SRP, and employees who file the appropriate forms have their contributions plus associated gains or losses refunded to them. Contributions are held in a money market fund for the trial period to ensure that employees will not lose money. This policy eliminates one potential objection to automatic enrollment policies: the investment risk employees incur before they are able to opt out. 7. After the trial period, all funds are shifted from the money market into a target date or lifecycle fund, providing a diversified portfolio to individuals who never make an active election. This policy offers the prospect of a diversified risk and return portfolio to workers defaulted into the program, eliminating the prospect of funds remaining in a low-return money market account for many years. 46 Government Finance Review February 2011

federal rules. When SDRS representatives testified to endorse the automatic enrollment legislation, they reported seeing a decrease in personal savings rates, in both South Dakota and across the nation, with many employees having negative savings rates. SDRS officials believed the bill would encourage workers, especially those between 20 and 39 years old, to save more in light of potential age and benefit changes to Social Security and Medicare and rising retiree health-care and long-term care costs. The existence and success of automatic enrollment policies in the private sector were also cited as reasons for adopting similar policies in South Dakota. Officials said employees will not miss the money if they never see it in their paychecks, and employees need to take a pay myself first approach to retirement. Aside from the employee benefits of automatic enrollment, SDRS representatives also explained that automatic enrollment would have no actuarial impact on any SDRS retirement benefits (i.e., adopting automatic enrollment would have little or no cost to the retirement system). In addition, the federal Pension Protection Act of 2006 and related IRS rule changes paved the way for government plans to adopt automatic enrollment policies. The system was concerned about the low participation rate in the supplemental plan, low observed savings rates, and the need for most retirees to have a third source of retirement income in addition to their SDRS benefit and Social Security. CONCLUSIONS While automatic enrollment is still in its early stages, it is already having a powerful impact on participation rates. Only about 10 percent of the governmental units had adopted automatic enrollment as of March 2010, but the data from the first eight months provide a sense of how the policy is affecting enrollment. Prior to automatic enrollment, about 20 percent of all eligible employees participated in SRP. Between July 2009 and February 2010, 91.3 percent of new public service employees in units that adopted the new policy were automatically enrolled into the plan and remained in it, while only 8.7 percent chose to terminate their participation (see Exhibit 1). For the same 8-month period, the governmental units that had not yet adopted automatic enrollment hired 2,360 new employees, of whom only 17 had joined the SRP by February 2010 less than 1 percent. Automatic enrollment of newly hired public employees into the SRP was universally welcomed, and initial data indicate it will be an effective policy for increasing retirement saving by public employees. Other states considering an automatic enrollment feature for their supplemental retirement plans would benefit from a review of the adoption process and the policies implemented by South Dakota. y February 2011 Government Finance Review 47

Notes 1. U.S. Government Accountability Office, 401(K) Plans: Several Factors Can Diminish Retirement Savings, but Automatic Enrollment Shows Promise for Increasing Participation and Savings, October 28, 2009. 2. Center for State and Local Government Excellence, Survey Findings: The Great Recession and the State and Local Government Workforce, January 2010. 3. Information about the system comes from: South Dakota Retirement System, A Statement of Principles and Direction for the Plan Design of SDRS, 1994, revised 2005; Independent Auditors Reports on Audits of Financial Statements for the Year ended June 30, 2008; November 2008; and Annual Report of the Funded Status of the South Dakota Retirement System for Fiscal Year 2008, 2009. 4. The SDRS mission statement is: To plan, implement, and administer income replacement programs, and to encourage additional saving for retirement, all of which offer SDRS members and their families the resources and the opportunity to achieve financial security at retirement, death, or disability by providing an outstanding, appropriate, and equitable level of benefits. The Board of Trustees believes this mission is achievable with the resources available in a progressive working environment, by sound and efficient management, through superior investment performance and by exercising the fiduciary responsibility associated with the proper stewardship of member assets. 5. The requirement that individual governmental units approve this new policy is consistent with the development of the South Dakota retirement plan. By law, all state employees and employees in the South Dakota universities were included in the SDRS; however, counties, cities, and other public entities had to make a positive decision to enter the system and once they decided to participate, they could not withdraw from the SDRS. ROBERT L. CLARK is a professor of economics and of management, innovation, and entrepreneurship in the College of Management, North Carolina State University. JOSHUA M. FRANZEL is vice president of research for the Center for State and Local Government Excellence. The authors would like to thank the following people for their input on this project: Rob Wylie and Damian Prunty of the South Dakota Retirement System; Sandy Zinter, commissioner, State Bureau of Personnel and SDRS board member; June Larson and Ginny Lors of Nationwide Investment Services; and Angeline Lavin of the University of South Dakota. The authors would also like to thank Retirement Made Simpler for the financial support to carry out this research. Retirement Made Simpler is a coalition formed by AARP, the Financial Industry Regulatory Authority, and the Retirement Security Project to help Americans achieve a safe and secure retirement. For more information, visit www.retirementmadesimpler.org. 48 Government Finance Review February 2011